Question

Describe and show what happens to SR equilibrium when AD changes (both increase and decrease; be sure to give at least one reason for that shift).

Answer 1

Answer : Aggregate demand (AD) curve shift when income level change at existing price level. When income level increase then the AD curve shift to rightward. In the following picture's diagram the AD curve shifts to rightward and becomes AD'. As a result, the new SR equilibrium occurs above the prior equilibrium. At new equilibrium the price level is P1 which is higher than before and quantity is Q1 which is also higher than before.

Now if income level decrease then the AD curve shift to leftward. In the following picture's diagram the AD curve shifts to leftward and becomes AD". As a result, the new SR equilibrium occurs below the initial equilibrium. At new equilibrium the price level is P2 which is lower than before and quantity is Q2 which is also lower than before.