Question

An economy is producing at full employment when AD unexpectedly shifts to the left. A new classical economist would assume that as the economy adjusted back to producing at full employment, the price level would _____. a. Increase. b. Decrease. c. Stay the same.

Short answer

b. Decrease.

Step-by-step solution

Understanding Aggregate Demand and Full Employment

Aggregate Demand (AD) represents the total demand for goods and services in an economy at a given overall price level and in a given time period. Full employment occurs when all available labor resources are being used efficiently, meaning the economy is producing at its potential output.

Identifying the Shift in Aggregate Demand

If Aggregate Demand shifts to the left, it indicates a decrease in the total demand for goods and services. In the context of a full employment economy, this shift suggests the economy is now below its previous level of output.

Adjustment in a New Classical Framework

New classical economists believe that wages and prices are flexible and can adjust quickly to bring the economy back to equilibrium. They assume that in the long term, the economy self-corrects without the need for government intervention.

Analyzing Price Level Changes

According to new classical economics, if AD shifts left, initially, there will be underutilized resources causing downward pressure on prices. Over time, prices and wages decrease, leading to an adjustment that brings the economy back to its natural level of output at full employment.

Conclusion on Price Level Adjustment

Given that the economy is self-correcting and prices are flexible, new classical economists would predict that as the economy adjusts back to full employment, the price level would decrease.

Key concepts

Aggregate Demand

Aggregate Demand (AD) is a fundamental concept in macroeconomics. It represents the total quantity of all goods and services demanded across all levels of the economy at a specific price level and during a certain time period. When thinking about AD, imagine all the purchasing desires of households, firms, and the government combined. It is often depicted as a downward-sloping curve on a graph where the vertical axis represents the price level, and the horizontal axis represents the level of output.

• Components of AD: Consumption, Investment, Government Spending, and Net Exports.
• Influences on AD: Changes in income, interest rates, expectations, and foreign economies can all shift aggregate demand.

In our context, a leftward shift in aggregate demand points to a reduction in economic activity. This can happen due to decreased consumer confidence, cuts in government spending, or rises in interest rates. Such a shift implies that at the current price level, the quantity of goods and services demanded has decreased.

Full Employment

Full employment does not mean zero unemployment, but it represents a state where all available labor resources are being used in the most efficient way possible. Essentially, it occurs when the economy is operating at its potential output without the presence of cyclical unemployment, which is the type caused by economic downturns.

• Natural Rate of Unemployment: Even at full employment, there is still frictional and structural unemployment.
• Implications of Full Employment: At this level, the economy is considered to be at its maximum sustainable output.

Reaching full employment indicates a healthy economy where resources are allocated correctly, allowing for growth and productivity. However, shifts in aggregate demand, like the one we're discussing, can temporarily move the economy away from this ideal state.

New Classical Economics

New Classical Economics is a school of thought in macroeconomics that emphasizes the importance of rational expectations and the ability of markets to adjust to changes quickly. Economists from this school argue that economic actors, like consumers and firms, respond quickly to economic changes, adjusting their behavior based on expectations about the future.

• Market Flexibility: Prices and wages adjust rapidly to restore equilibrium.
• Minimal Government Intervention: The belief that economies are self-correcting without the need for government policy adjustments.

In the context of our exercise, new classical economists would argue that even though aggregate demand decreases and disrupts full employment, the economy will naturally adjust. This adjustment process is usually reflected in changes in prices and wages rather than long-term downturns in production.

Price Level Adjustment

In macroeconomics, the price level refers to a hypothetical measure of overall prices for goods and services in an economy. When aggregate demand changes, the price level can also change as a result of market forces.

• Downward Price Pressure: When AD shifts to the left, there is often less demand for goods and services, creating downward pressure on prices.
• Wage Flexibility: New classical economics suggests wages will adjust alongside prices to help restore full employment.

In the scenario of a leftward AD shift at full employment, the theories from new classical economics suggest that prices will decline. This decrease in the price level helps the economy self-correct by making goods and services cheaper, thereby increasing demand again and eventually bringing the economy back to its full employment equilibrium. This self-correcting mechanism means government intervention is not necessary for the economy to stabilize.