Question

Use an aggregate supply-and-demand diagram to study what would happen to an economy in which the aggregate supply curve never moved while the aggregate demand curve shifted outward year after year.

Short answer

Answer: In the short-term, a continuously outward-shifting aggregate demand curve leads to a higher price level (inflation) and an increase in real GDP, which may signify higher economic growth and possibly lower unemployment. However, in the long-term, this will result in persistent inflation, reduced purchasing power, and unsustainable output levels, potentially leading to economic instability. It is vital for an economy's aggregate supply curve to respond to changes in aggregate demand to maintain long-term stability.

Step-by-step solution

Draw the initial aggregate supply and demand curves

To begin, draw an aggregate supply-and-demand diagram with an upward-sloping aggregate supply curve (AS) and a downward-sloping aggregate demand curve (AD). Label the point where the curves intersect as point A, which represents the initial equilibrium in the economy.

Shift the aggregate demand curve outward

Now, shift the aggregate demand curve rightward (outward), representing an increase in aggregate demand. Label the new aggregate demand curve as AD1. The new point of intersection with the aggregate supply curve is labeled point B. In the short run, this shift leads to a higher price level and an increase in output.

Observe the short-term effects

In the short term, the outward shift in aggregate demand results in a higher price level (inflation) and an increase in real GDP. This may signify a period of higher economic growth and possibly lower unemployment. However, these short-term outcomes will not persist in the long term if the aggregate supply curve remains stationary.

Shift the aggregate demand curve outward again

Shift the aggregate demand curve outward once more to represent another year of increased aggregate demand. Label this new aggregate demand curve as AD2 and the new intersection point with the aggregate supply curve as point C. As with the previous shift, this results in a further increase in the price level and an increase in real GDP.

Observe the long-term effects

If the aggregate demand curve continues to shift outward year after year while the aggregate supply curve remains stationary, the economy will experience persistent inflation and increased real GDP. However, this long-term increase in output likely becomes unsustainable as resources become strained and production costs rise. The continuous rising of inflation will also lead to reduced purchasing power and potential economic instability.

Recognize the importance of the aggregate supply curve

In conclusion, it is vital for an economy's aggregate supply curve to respond to changes in aggregate demand to maintain long-term stability. A continuously outward-shifting aggregate demand curve combined with a stationary aggregate supply curve may lead to short-term economic growth, but will ultimately result in inflation and unsustainable output levels.

Key concepts

Economic Equilibrium

Economic equilibrium occurs at the point where the aggregate supply curve (AS) and the aggregate demand curve (AD) intersect. This point represents a state where the economy's total output corresponds to what is being demanded. In the initial setup, this equilibrium is labeled as point A, where both curves meet without affecting each other extensively.

When the aggregate demand curve shifts outward, representing a rise in demand, a new equilibrium is formed at point B. This shift suggests consumers and businesses are willing to buy more at every price level, creating a greater pressure on available goods and services.

Achieving and maintaining economic equilibrium is vital for stability within a market. If there is constant strain like persistent shifts in aggregate demand, the equilibrium point will continue shifting, impacting prices and output levels. Economic balance ensures resources are not being over or underutilized while maintaining price stability.

Inflation

Inflation is a key outcome when there is a continual outward shift of the aggregate demand curve while the aggregate supply remains fixed. This situation leads to a rising price level as seen in the transition from point A to point B, and subsequently to point C.

The primary drivers of inflation during these shifts include:

• Higher demand for goods and services
• Status quo production unable to meet the growing demand
• Prices rising because of increased competition for existing goods

However, continuous inflation carries risks. It diminishes purchasing power, meaning consumers can buy less with the same amount of money. This can cause economic tensions and requires monitoring to avoid spiraling into hyperinflation scenarios.

Controlling inflation involves understanding its triggers and ensuring the aggregate supply curve can adapt appropriately to balance supply with growing demand.

Real GDP

Real GDP measures the actual output of goods and services in an economy, adjusted for price changes. During the outward shifts of the aggregate demand curve, an increase in real GDP is observed at new equilibrium points, such as from point A to B.

This increase signifies higher production and suggests economic growth. It reflects more jobs, greater business activity, and an improved economic outlook. However, there's a catch: if the supply does not keep pace, any real GDP gains may become temporary.

• Growth in real GDP showcases positive short-term impacts
• Long-term sustainability depends on resource availability and supply-side adjustments

Real GDP should ideally support inflation-adjusted welfare improvements. Therefore, persistent demand pressures without supply adaptation can strain resources, elevate costs, and ultimately neutralize real GDP advancements.

Economic Growth

Economic growth implies an increase in the economy’s ability to produce goods and services over time, often evidenced by a shift to a higher real GDP. This growth can stem from technological advancements, increased resource availability, or higher demand. However, as seen in this scenario, if growth is driven by demand alone, it may not be sustainable.

While shifting the aggregate demand curve has resulted in short-term growth indicated by rising GDP, long-term growth requires adaptive changes in the aggregate supply to accommodate increased demands without triggering inflation.

• Short-term growth achieved by demand shifts raises economic activity
• For long-term growth, the supply side needs innovation and productivity enhancements

Strategizing for economic growth thus involves balancing both demand and supply aspects. Consistent growth solidifies economic standing, promoting stability and improving living standards. However, without bolstering the aggregate supply to match demand increase, a country's growth can become brittle and lead to imbalances.