Question

Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently operating at its full-employment output. Other things equal, how will each of the following affect the equilibrium price level and equilibrium level of real output in the short run?

1. An increase in aggregate demand.

2. A decrease in aggregate supply, with no change in aggregate demand.

3. Equal increases in aggregate demand and aggregate supply.

4. A decrease in aggregate demand.

5. An increase in aggregate demand that exceeds an increase in aggregate supply.

Short answer

1. The equilibrium level of output and price increases in the short run.

2. The equilibrium output falls while the price rises.

3. The equilibrium output increases at a constant price.

4. The equilibrium output declines at a constant price.

5. The equilibrium output increases more than the increase in price.

Step-by-step solution

Explanation for part (a)

An increase in aggregate demand will shift the AD curve to the right, and the economy will achieve a higher equilibrium at point e’.

At point e’ the output has increased to Y’ and price to P’.

Explanation for part (b)

A decrease in aggregate supply with constant aggregate demand will shift the AS curve to the left, leaving the AD curve undisturbed. Thus, the equilibrium will move to the left along the AD curve.

At the new equilibrium e’, the price will be higher at point P’, while the output will fall to Y’.

Explanation for part (c)

As the AD curve will shift to the right, increasing the output and the prices, the change in prices will be balanced by an equal rightward shift in the AS curve.

The new equilibrium point of the economy e’ shows that the equal shifts in the AD and AS curve to the right will only increase the output to Y’ while the prices remain constant at P.

Explanation for the part (d)

A decrease in aggregate demand will reduce the output and prices by a leftward shift of the economy’s equilibrium. However, the prices are inflexible downward. So the prices will stick to point P.

Therefore, the aggregate supply curve will shift to the left to maintain the equilibrium of the economy. Thus, the new equilibrium of the economy will be e’ where the output will decline at YY’ at constant prices P.

Explanation for part (e)

As the aggregate supply increases, the AS curve shifts to the right (AS’), increasing the output and decreasing the price level. At the same time, a more significant change in the AD curve increases the output and prices.

At the new equilibrium formed by the shift in aggregate demand and aggregate supply curve e’, the output increases to Y’ and price increases to P’.An increase in output is more significant than the prices because shifts in both curves contribute towards the rise in output.

On the other hand, the price increases a little because of the decrease in aggregate supply, which is smaller than the increase in aggregate demand. Thus, the net effect in price change is positive.