Question

If aggregate supply is vertical, what role does aggregate demand play in determining output? In determining the price level?

Short answer

When aggregate supply is vertical, representing the long-run aggregate supply (LRAS) at the potential output level, aggregate demand does not affect the output. However, aggregate demand does play a significant role in determining the price level in the economy. As aggregate demand increases, the price level rises, and as it decreases, the price level falls. Output remains constant at the potential output level, as the economy is at full employment with all resources fully utilized.

Step-by-step solution

Understand Aggregate Demand (AD) and Aggregate Supply (AS)

Aggregate demand represents the total demand for goods and services in an economy, while aggregate supply is the total supply of goods and services produced in an economy. They help to determine the level of output and price level in an economy.

Graphical Representation of AD and AS

In macroeconomic models, aggregate demand is generally represented by a downwards-sloping curve (AD), while aggregate supply can be represented by either an upwards-sloping curve (short-run aggregate supply - SRAS) or vertical curve (long-run aggregate supply - LRAS). The interaction between these curves determines the equilibrium output (Y) and price level (P) in the economy.

Vertical Aggregate Supply

A vertical aggregate supply curve indicates that the economy is at full employment, where resources (labor, capital, etc.) are fully utilized, and additional increases in aggregate demand will not result in higher output. Instead, increased aggregate demand will lead to higher inflation. When AS is vertical, it represents the long-run aggregate supply (LRAS), which shows the potential output or the natural level of output in the economy.

Impact of AD on Output and Price Level with Vertical AS

When aggregate supply is vertical, aggregate demand has no effect on the output. No matter how much AD increases or decreases, output remains constant at the potential output level. This is because, in the long run, the economy is at full employment, and no resources are left unused. However, aggregate demand does play a significant role in determining the price level. As AD increases, the price level in the economy will increase, and as AD decreases, the price level will decrease. To summarize: 1. When aggregate supply is vertical, aggregate demand does not affect the level of output in the economy. Output remains at the potential output level. 2. Aggregate demand does play a role in determining the price level in the economy. When AD increases, the price level goes up, and when AD decreases, the price level goes down.