Question

Suppose that an economy begins in long-run equilibrium before the price level and real GDP both decline simultaneously. If those changes were caused by only one curve shifting, then those changes are best explained as the result of: \(L O 38.2\) a. The AD curve shifting right. b. The AS curve shifting right. c. The AD curve shifting left. d. The AS curve shifting left.

Short answer

The changes are due to the AD curve shifting left.

Step-by-step solution

Define Long-Run Equilibrium

In the context of an economy, long-run equilibrium is a state where the Aggregate Demand (AD) and Aggregate Supply (AS) curves intersect at the full-employment level of output, meaning the economy is operating at its potential GDP without inflationary or recessionary pressures.

Analyze the Changes

Both the price level and real GDP have decreased simultaneously. This indicates a reduction in overall demand or supply within the economy.

Consider AD Curve Shifts

If the AD curve shifts to the right, it implies increased demand, generally resulting in higher price levels and greater real GDP, which contradicts the stated situation. Therefore, the AD curve shifting right is not the cause.

Evaluate AS Curve Shifts

If the AS curve shifts to the right, this indicates an increase in supply, leading to a lower price level and higher real GDP, again contrary to the observed changes. Hence, the AS curve shifting right is not the cause.

Assess AD Curve Shifting Left

An AD curve shifting left signifies a decrease in overall demand, which would result in both lower price levels and decreased real GDP. This matches the observed changes in the economy.

Examine AS Curve Shifting Left

If the AS curve shifts to the left, it would cause the price level to rise and real GDP to fall, which does not align with the observed scenario. Thus, AS curve shifting left is not the explanation.

Key concepts

Long-Run Equilibrium

In economics, long-run equilibrium is a significant state where the economy finds balance over time. This situation occurs when the Aggregate Demand (AD) and Aggregate Supply (AS) curves meet precisely at the level of full employment output.

This balance means that the economy is producing at its maximum capacity without experiencing inflation or recession. In simple terms, all resources, including labor and capital, are being used in the most efficient way possible.

• Long-run equilibrium helps to understand potential GDP.
• It indicates economic stability.
• No inflationary or recessionary gap exists when the economy is in long-run equilibrium.

Recognizing long-run equilibrium is crucial for analyzing any shift that might cause economic fluctuations.

Aggregate Demand Curve

The Aggregate Demand (AD) curve is a vital concept that reflects the overall demand for goods and services in an economy at various price levels. It slopes downward, indicating that as prices decrease, demand generally increases, and vice versa.

Various factors can shift the AD curve:

• A shift to the right suggests increased demand, leading to higher real GDP and rising prices.
• A shift to the left indicates decreased demand, leading to lower real GDP and declining prices.

Recognizing shifts in the AD curve helps in understanding macroeconomic changes, such as those in employment, consumer confidence, and national income.

For instance, a leftward shift in the AD curve can align with simultaneous decreases in price levels and real GDP, signaling reduced overall demand.

Aggregate Supply Curve

The Aggregate Supply (AS) curve explains the total quantity of goods and services that producers are willing and able to supply at various price levels. Generally, it slopes upward, representing that as prices rise, the quantity supplied increases.

Important factors affecting AS curve shifts include:

• A shift to the right means an increase in supply, typically decreasing price levels and increasing real GDP.
• A shift to the left signifies a decrease in supply, generally raising prices and decreasing real GDP.

By analyzing the AS curve, we can predict how changes in production costs, technologies, or resource availability affect the economy.

However, in situations where both price levels and real GDP decline, an AS curve shift is not a complete explanation, emphasizing the need to explore changes in aggregate demand as well.

Real GDP

Real GDP, or Gross Domestic Product, measures the total value of all goods and services produced within an economy, adjusted for inflation. It provides an accurate reflection of an economy's size and how well it's performing over time.

Why is Real GDP important?

• It helps to compare economic productivity from one year to another, without price changes skewing the data.
• Analysts use real GDP to determine whether an economy is in an expansion or recession phase.

During economic analysis, shifts in real GDP are crucial for understanding changes in economic health, including employment levels and production output. Lower real GDP, often associated with reduced aggregate demand or supply-side issues, indicates less economic activity and potential recessionary concerns.

Price Level

The price level represents the average of current prices across the entire spectrum of goods and services produced in the economy. It's a crucial indicator used to gauge inflation and the purchasing power of money.

The price level holds significance for:

• Consumers and businesses, as it affects buying power and costs of production respectively.
• Policymakers, who use it to make monetary decisions.

When economists note a decrease in the price level, it suggests potential deflation, possibly caused by a decline in aggregate demand. Conversely, an increasing price level is often a sign of inflation, possibly due to rising demand or reduced supply. Understanding shifts in price levels helps predict consumer behavior, saving patterns, and judgments on monetary policies.