Question

Use the nearby figure to answer the following questions. Assume that the economy initially is operating at price level 120 and real output level $870. This output level is the economy’s potential (full-employment) level of output. Next, suppose that the price level rises from 120 to 130. By how much will real output increase in the short run? In the long run? Instead, now assume that the price level drops from 120 to 110. Assuming flexible product and resource prices, by how much will real output fall in the short run? In the long run? What is the long-run level of output at each of the three price levels shown?

Short answer

As the price level rises from 120 to 130, the output level increases by $20 in the short-run, while it remains unchanged at $870 in the long-run.

As the price level falls from 120 to 110, the output level decreases by $20 in the short-run while it remains unchanged at $870 in the long run.

The long-run level of output at each price level is $870.

Step-by-step solution

The short-run and long-run impact on output level when the price level rises

The price and output levels are positively correlated in the short-run, while they are uncorrelated in the long run. So the short-run aggregate supply (SRAS) curve is upward sloping while the long-run aggregate supply (LRAS) curve is vertical.

Here, the economy operates at the price level 120, and the potential output level is $870, corresponding to AS2. Now there is an increase in the price level from 120 to 130. In the short run, the economy will move upward along AS2. So, according to the given figure, as the price level rises from 120 to 130, the output level would increase from $870 to $890. Thus, the output level rises by $20 when the price rises from 120 to 130 in the short run.

However, in the long run, when the price level rises from 120 to 130, the aggregate supply curve would shift leftwards from AS2 to AS3. It happens due to a rise in nominal wages which decreases the producers’ profit. So, according to the given figure, as the price rises from 120 to 130, the real output level remains unchanged at $870 in the long--run.

The short-run and long-run impact on output level when the price level falls

Now there is a decline in the price level from 120 to 110. In the short run, the economy will move downward along AS2. So, according to the given figure, as the price level falls from 120 to 110, the output level would decrease from $870 to $850. Thus, the output level falls by $20 when the price rises from120 to 110 in the short run.

However, in the long run, when the price level decreases from 120 to 130, the aggregate supply curve would shift rightwards from AS2to AS1.It happens due to a fall in nominal wages which increases the producers’ profit. So as the price declines from 120 to 110, the real output level remains unchanged at $870 in the long run.

Hence, the long-run level of output at each price level is $870.