Question

The imaginary country of Harris Island has the aggregate supply and aggregate demand curves as Table 10.3 shows. \begin{equation}\begin{array}{c|c|c}\hline \text { Price Level } & \text { AD } & \text { AS } \\\\\hline 100 & 700 & 200 \\\\\hline 120 & 600 & 325 \\\\\hline 140 & 500 & 500 \\\\\hline 160 & 400 & 570 \\\\\hline 180 & 300 & 620 \\\\\hline\end{array}\end{equation} a. Plot the AD/AS diagram. Identify the equilibrium. b. Would you expect unemployment in this economy to be relatively high or low? c. Would you expect concern about inflation in this economy to be relatively high or low? d. Imagine that consumers begin to lose confidence about the state of the economy, and so AD becomes lower by 275 at every price level. Identify the new aggregate equilibrium. e. How will the shift in AD affect the original output, price level, and employment?

Short answer

In summary, the equilibrium point is found at the intersection of AD and AS curves. Unemployment in Harris Island would be relatively high if the equilibrium output level is below the potential output level, and concern about inflation would be greater if the economy is operating at or near its potential output. When AD decreases by 275 at every price level, a new aggregate equilibrium emerges, shifting the original output, price level, and employment, which could result in higher unemployment and changes in inflation concerns.

Step-by-step solution

a. Plot the AD/AS diagram and identify the equilibrium.

Begin by plotting the AD/AS diagram using the provided table. AD values are given in the second column and AS values are given in the third column. The x-axis represents the output level (\(Y\)) and the y-axis represents the Price Level (\({P}\)). Once the plot is completed, identify the equilibrium by locating the point where the AD and AS curves intersect.

b. Determine unemployment status

Unemployment would be relatively high if the economy is operating below its potential output level (the output level at the point where the AS curve becomes vertical). Compare the equilibrium output level found in part (a) to the potential output level and determine if unemployment would be high or low accordingly.

c. Determine concern about inflation

Concern about inflation would be high if the economy is operating at or near its potential output level since any increase in output beyond this level would lead to a rapid increase in price levels. Compare the equilibrium output level found in part (a) to the potential output level and determine if concern about inflation should be high or low accordingly.

d. Identify the new aggregate equilibrium

To find the new aggregate equilibrium when AD becomes lower by 275 at every price level, adjust the table's AD values by subtracting 275 from each of the original values. Once the new table is constructed, plot the new AD curve on the graph. Find the new equilibrium point by locating where the new AD curve intersects the original AS curve.

e. Impact of shift in AD on output, price level, and employment

Analyze the changes in the original output, price level, and employment by comparing the original equilibrium point with the new equilibrium point found in part (d). If the output level has decreased, the unemployment level would have likely risen, and vice versa. If the price level has increased, there is more concern about inflation, and if the price level has decreased, there is less concern.

Key concepts

AD/AS Diagram

Understanding the AD/AS diagram is crucial in macroeconomics as it visually displays the aggregate demand (AD) and aggregate supply (AS) in a nation’s economy over time. This involves plotting two curves on a graph where the horizontal axis represents the total output of the economy (or the Gross Domestic Product - GDP), and the vertical axis represents the overall price level.

To begin with, the AD curve typically slopes downward, indicating that as price levels decrease, consumers and firms are predisposed to purchase more goods and services, given their purchasing power increases. Secondly, the AS curve might slope upward, demonstrating that as the price level rises, producers are incentivized to supply more due to the potential for increased profits.

In the exercise, when plotting the AD/AS graph based on the provided data, the intersection of these two curves represents the macroeconomic equilibrium—the point where the amount of products and services demanded equals the amount supplied. This equilibrium is essential for determining the overall economic health and guiding policymakers.

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs when the quantity of goods and services demanded equals the quantity supplied at a given price level, which is seen at the intersection of the AD and AS curves. This balance indicates that an economy is neither expanding too rapidly, which might lead to inflation, nor contracting, which might cause unemployment.

The equilibrium is a snapshot of the economy at a specific moment, reflecting the interaction of various economic forces. However, it's dynamic and can shift in response to changes in economic conditions, such as variations in fiscal policy, consumer sentiment, or global economic events. For example, in the exercise, if consumer confidence decreases, this could shift the AD curve to the left, indicating a lower quantity of goods and services demanded at each price level. Such a shift leads to a new equilibrium with potentially lower output and higher unemployment, which can signal the need for policy intervention to restore balance and sustain economic health.

Inflation and Unemployment

Inflation and unemployment are two significant factors that macroeconomists constantly monitor. Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. On the other hand, unemployment refers to the state of actively seeking employment but not being currently employed.

These two factors often have an inverse relationship, known as the Phillips curve, implying that policies aimed at reducing inflation may increase unemployment and vice versa. In our exercise, if we find ourselves at equilibrium with a relatively high output, inflation concerns might be more prominent as the economy could be at or nearing full capacity. If output is lower, unemployment could be a more significant issue due to underutilized resources.

A leftward shift in the AD curve, as mentioned in the exercise, signifies a drop in demand resulting in a lower equilibrium price level which can moderate inflationary pressures. However, this shift can also lead to higher unemployment if producers cut back on output in response to the decreased demand. Thus, understanding the balance between these two factors is vital for making informed policy decisions in macroeconomic management.