Question

Suppose the full-employment level of real output (Q) for a hypothetical economy is $250 and the price level (P) initially is 100. Use the short-run aggregate supply schedules below to answer the questions that follow:

AS(P100)		AS(P125)		AS(P75)
P	Q	P	Q	P	Q
125	280	125	250	125	310
100	250	100	220	100	280
75	220	75	190	75	250

What is the level of real output in the short run if the price level unexpectedly rises from 100 to 125 because of an increase in aggregate demand? What happens if the price level unexpectedly falls from 100 to 75 because of a decrease in aggregate demand? Explain each situation, using numbers from the table.

b. What is the level of real output in the long run when the price level rises from 100 to 125? When it falls from 100 to 75? Explain each situation.

c. Illustrate the circumstances described in parts a and b on graph paper, and derive the long-run aggregate supply curve.

Short answer

a. If the price level rises from 100 to 125, the real output level rises from 250 to 280. If the price level drops from 100 to 75, the real output level falls from 250 to 220.

b. The level of real output remains fixed at 250 in both cases when the price rises to 125 or falls to 75.

c. The following figure illustrates the circumstances in parts a and b and the long-run aggregate supply curve of the economy.

Step-by-step solution

The explanation for part (a)

The aggregate supply curve explains a relation between real output level and aggregate price level.

The initial price and real output level of the economy are 100 and $125, respectively. Any change in price or output level will cause movement along the short-run aggregate supply schedule AS(P100).

According to schedule AS(P100), if the price level unexpectedly rises from $100 to $125 due to a rise in aggregate demand, then the real output increases from $250 to 280. Again, if the price level unexpectedly falls from $100 to $75 due to a fall in aggregate demand, according to schedule AS(P125), the real output decreases from $250 to $ 220.

Thus, it is observed that as the price level rises or falls, the output level also increases or decreases. Hence, a positive relationship between price and output level is observed in the short run.

The explanation for part (b)

In the long run, any change in price or output level will cause shifts in the short-run aggregate supply schedules. If the price level unexpectedly rises from $100 to $125, there will be a rightward shift from AS(P100) to AS(P125), and real output will remain unchanged at 250. If the price level unexpectedly falls from $100 to $75, there will be a leftward shift from AS(P100) to AS(P75), and real output will remain unchanged at 250.

Thus, it is observed that any rise or fall in price level rises does not cause any change in real output level. Hence, price and output level are unrelated in the long run.

The explanation for part (c)

The following figure illustrates the circumstances in part “a” and “b” and the long-run aggregate supply curve of the economy.

According to the given figure, a1 is the initial equilibrium point of the economy where the price is 100, and the real potential output is 250. Due to the rise in AD, price and output rise to 125 and 280, respectively. So there is an upward movement of equilibrium point from a₁ to a₂, along the SRAS₁ curve. Again, due to a fall in AD, price and output drop to 75 and 200, respectively. So there is a downward movement of equilibrium point from a1 to a₃, along the SRAS₁ curve.

In the long run, as the price level rises from 100 to 125, the SRAS₁ shifts leftward to SRAS₃, the equilibrium point moves from a₁ to b₁, and there is no change in output. Again, as the price level falls from 100 to 75, the SRAS₁ shifts leftward to SRAS₂, the equilibrium point moves from a₁ to b₂, and there is no change in output.

The long-run aggregate supply curve is derived by joining the points: a₁, b₁, and b₂. The long-run aggregate supply curve therefore obtained is vertical. It depicts that a change in the price level causes no real output level in the long run. So output remains unchanged at $250.