Question

Suppose that AD and AS intersect at an output level that is higher than the full-employment output level. After the economy adjusts back to equilibrium in the long run, the price level will be LO38.2 a. Higher than it is now. b. Lower than it is now. c. The same as it is now.

Short answer

a. Higher than it is now.

Step-by-step solution

Understanding Aggregate Demand and Aggregate Supply

Aggregate Demand (AD) and Aggregate Supply (AS) represent the total demand and total supply of goods and services in the economy at different price levels. When they intersect, it signifies an equilibrium state in the short run.

Assessing Full-Employment Output Level

Full-employment output is the level of output that the economy can sustain when all resources are utilized efficiently. When AD and AS intersect at an output level higher than this, it means the economy is overproducing, leading to potential inflationary pressures.

Analyzing Long-Run Adjustments

In the long run, overproduction forces aggregate supply to adjust. As resources like labor become overly utilized, wages and input costs rise, shifting the aggregate supply curve left towards the long-run full-employment output level.

Predicting the Change in Price Level

As the AS curve shifts left to meet the AD curve at the full-employment output level, the price level will increase due to increased production costs. Therefore, the price level adjusts to a higher level than it was initially.

Key concepts

Full-Employment Output

In the world of economic concepts, full-employment output plays a vital role. It represents the maximum level of goods and services that an economy can produce without causing inflation, given the full and efficient use of available resources. Think of it as the sweet spot where all factors of production like labor and capital are used effectively, but without stretching limits.

When aggregate demand and aggregate supply intersect at a level higher than the full-employment output, it signifies that the economy is producing more than its sustainable capacity. This isn't always a good thing. Overproduction can lead to inflationary pressures as resources become over-used, which will eventually cause prices to rise.

• Full-employment output is sustainable and efficient.
• Overproduction beyond this level leads to economic overheating.

Long-Run Equilibrium

Long-run equilibrium is a key concept that finds balance between aggregate demand and aggregate supply over a longer period. Unlike short-run scenarios where variables can fluctuate, long-run equilibrium stabilizes them through adjustments in production levels and resource prices.

When the economy is producing above the full-employment level, it doesn’t stay that way forever. In the long run, adjustments occur. Input costs like wages rise as labor becomes scarce. This shifts the aggregate supply curve leftward, moving it towards the full-employment output.

• Long-run equilibrium stabilizes the economy.
• Adjustments ensure sustainable levels of output and resource use.

Inflationary Pressures

Inflationary pressures occur when prices in the economy are driven upward, primarily due to an increase in demand or a decrease in supply. In the scenario where aggregate supply and demand intersect at an output higher than the full-employment level, inflationary pressures are natural due to the excessive production.

As demand exceeds what can be efficiently produced, businesses raise prices to balance their costs, leading to inflation. Concurrently, as resources like labor are over-utilized, wages increase, further driving costs up and pushing the price level higher.

• Excess demand fuels inflationary pressures.
• Increased production costs also elevate price levels.