Question

Beginning with long-run equilibrium, explain what happens to the price level and Real GDP in the short run and in the long run as a result of (a) a decline in \(A D,(b)\) a rise in AD, (c) a decline in \(S R A S\), and \((\) d) a rise in SRAS.

Short answer

A decline in AD lowers both price level and real GDP in the short run, and results in a lower price level in the long run. A rise in AD increases both in the short run, but causes inflation without change in GDP in the long run. A decline in SRAS causes price level to rise and GDP to decline both in the short and long run, possibly leading to stagflation. A rise in SRAS lowers price level and raises GDP both in the short and long run.

Step-by-step solution

Understanding Aggregate Demand and Aggregate Supply

The first step is to appreciate the dynamics of the AD-AS model, where AD represents the total demand for goods and services within an economy at a given overall price level and in a given time period. SRAS, on the other hand, represents total supply of goods and services at different price levels.

Analyzing the Impact of a Decline in AD

Decline in AD implies there is less demand for goods and services. In the short run, this leads to a decrease in the price level and a decrease in real GDP due to surplus of goods. In the long run, economy will adjust itself by reducing the amount of goods produced to match demand, so Real GDP returns back to its normal but at a lower price level.

Analyzing the Impact of a Rise in AD

A rise in AD means there is an increase in demand for goods and services. In the short run, there will be increased competition among buyers, causing price level to rise, and so does Real GDP due to production of more goods to match demand. In the long run however, the increase in demand could result in inflation since producers will increase prices due to increased demand, but Real GDP will return back to its normal as economy adjust itself to meet the increased price.

Analyzing the Impact of a Decline in SRAS

A decline in SRAS indicates that the total production of goods and services decreases. In the short run, this would lead to an increase in price level due to scarcity of goods and decrease in Real GDP. But in the long run, the economy might face stagflation (a situation of high inflation and unemployment) as producers are unable to produce enough goods to meet demand.

Analyzing the Impact of a Rise in SRAS

A rise in SRAS means more goods and services are being produced. In the short run, the abundance of goods would decrease the price level and increase Real GDP. The long run effect will be a decrease in price level and an increase in Real GDP as the economy adjusts with increased production capacity.

Key concepts

Aggregate Demand

Understanding the overall demand for all goods and services within an economy is crucial for analyzing economic trends. This total demand is known as Aggregate Demand (AD). It takes into consideration consumption by households, investments by businesses, government spending, and net exports. Essentially, AD is the sum of all demand in the economy at various price levels.

When we say there is a 'decline in AD,' it means consumers, businesses, and the government are spending less, leading to a surplus of goods and services which can reduce prices and slow economic growth, as seen in the Real GDP, a measure of all goods and services produced. On the flip side, a 'rise in AD' suggests an increased expenditure, causing higher demand which, in the short term, boosts economic activity and raises prices; however, it may also lead to inflation in the long run.

Short-Run Aggregate Supply

On the other side of the market equilibrium is Short-Run Aggregate Supply (SRAS). This represents the total supply of goods and services that businesses are willing and able to sell at different price levels in the short run. Notably, in the short run, some factors of production like capital are fixed.

The term 'short run' refers to a period wherein not all prices, especially those of wages and raw materials, are fully flexible. Thus, a decline in SRAS, perhaps due to a spike in the cost of raw materials or production issues, leads to less production, causing prices to jump and the Real GDP to shrink. Contrarily, a rise in SRAS typically results in more goods and services being available which tends to lower prices and increase Real GDP, reflecting an economy's adaption with increased productive capacity.

Long-Run Macroeconomic Equilibrium

Long-term stability in the economy comes when we reach a point called the Long-Run Macroeconomic Equilibrium. This is characterized by a balance where the quantity of AD equals the long-run aggregate supply (LRAS), where the LRAS reflects the maximum potential output of an economy without putting upward or downward pressure on the price level.

In this state, the Real GDP is at its potential level, often referred to as full employment output. However, any changes in AD or SRAS can disrupt this equilibrium. In the long run, though, if AD declines or rises, or if SRAS declines or increases, the economy tends to adjust back to this equilibrium state, often through changes in price levels and wages. The long-run adjustment mechanisms ensure that temporary booms or recessions eventually stabilize to this natural level of output.

Real GDP

Real Gross Domestic Product (Real GDP) is a key economic indicator that measures the value of all goods and services produced in an economy over a specific time period, adjusted for inflation. It differs from nominal GDP in that it accounts for changes in price level, giving a more accurate reflection of an economy's size and growth.

Following changes in AD or SRAS, Real GDP fluctuates in the short run but has a tendency to return to its long-run equilibrium level, which is indicative of the economy's health and capacity. An increased Real GDP signals economic growth and improved standards of living, while a decrease can indicate economic downturns. Understanding the movements of Real GDP is essential for grasping the broader economic circumstances triggered by shifts in AD and SRAS.