Question

Problem 5

Suppose the economy is initially in equilibrium at an output level of 100 and a price level of 100. The Fed then manages to shift aggregate demand rightward by 20.

1. Illustrate the initial equilibrium (E₁) and the shift of AD.
2. Show your work and explain what happens to output and prices if the aggregate supply curve is (i) horizontal, (ii) vertical, and (iii) upward-sloping.

Answer 1

a. Equilibrium is determined where the Aggregate Demand (AD) curve intersects the Aggregate Supply (AS) curve. It is given that the economy is initially in equilibrium at an output level of 100 units and a price level of $100. At this initial equilibrium, the total demand by the consumers in the economy is equal to the total supply by the producers in the economy which means that aggregate quantity demanded is equal to aggregate supply at 100 units and at a market equilibrium price of $100 which is set by the market forces of demand and supply. The Fed increases the aggregate demand by $20 due to which there will be a rightward shift in the aggregate demand curve keeping the aggregate supply the same as before.

b.

In the above three diagrams, the effect on equilibrium is shown when the AD curve shifts rightward in three cases:

(a) AS curve is horizontal (b) AS curve is vertical and (c) AS curve is upward sloping. Initial equilibrium is shown at point e where the initial price is denoted by P and the initial quantity is denoted by Q and the new equilibrium is shown by point e' in all three diagrams.

It is clearly visible that equilibrium quantity increases and there is no change in equilibrium price when the AS curve is horizontal, equilibrium price increases with no change in equilibrium quantity when the AS curve is vertical and both equilibrium quantity and equilibrium price increase when the AS curve is upward sloping.