Effect of the rise in the price level induced by increase an increase in aggregate demand on Real G.D.P
Macroeconomics entails two equilibriums that match up differently in short run and long run (Legrand, 2017). The short run period is characterized by non- response of wages and some other prices in economic conditions. On the other hand, the long run period shows flexibility in price and wages. In this period, the real G.D.P moves to its potential while the employment shifts to its natural level. That is, the occurrence of a natural level of employment is after the changes in real wage to ensure the quantity of labor demanded is equal to the quantity of labor supplied.
The Long-run equilibrium period is when there is the intersection of the Aggregate Demand curve and Long-run Aggregate Supply Curve, and which determines the real G.D.P and the price level. The Aggregate Demand refers to the total quantity of goods and services demanded in the economy. The causes of aggregate demand include an increase in consumer confidence in periods of economic growth, increase in consumption expenditure because of expected inflation and decrease in taxes by the federal government. On the other hand, the real price level is achieved at by comparing the prices of goods and services against the purchasing power of money. There is no direct link between the aggregate demand and the general price levels of commodities. Nevertheless, an upward shift in aggregate demand curve corresponds with an increase in the price levels while the downward shift in aggregate demand curve corresponds to the lower price level (Miller, 1976).
The aggregate demand effect in the long-run market equilibrium will be a shift in price levels upwards or downward, but it will not have any impact on the Real G.D.P. The table below illustrates the equilibrium levels of price and output in the long-run economy.
AD2 AD1 AD3
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With the aggregate demand at AD1 and the Long run supply curve intersecting, the Real G.D.P will be at R. When aggregate demand shift to AD3, the Real G.D.P will be re-established at R. Continually, if the Aggregate Demand shifts downwards to AD2, the Real G.D.P will be still at R.
Combination of occurrences causing the nation long-run equilibrium Real GDP and price level to increase simultaneously
Generally, in the long-run equilibrium, a shift in aggregate demand leads to changes in price levels but does not result in any changes in the Real G.D.P. However, there are some combinations of factors causing both increases in the Real G.D.P and price levels in the long- run equilibrium. One is when there is an increase in the quantity of money circulation in the year, after technological improvement in the previous year. Increase in technology increases production in the economy leading to growth in output of commodities. Additionally, increase in quantity of money in circulation increases the purchasing power of consumers, because they have the disposable income to purchase products. In the long-run equilibrium, increase in Aggregate Demand results to rise in prices level of a commodity, because it is only in short-run where the suppliers will be able to increase the production. This situation means that there will be increases in the price level, but the Real G.D.P will remain the same. Nonetheless, the technological improvement in the previous year resulted in growth in production, with this development enabling increase the total output in the economy to match the consumers’ demand for the commodities (Miller, 1976).
Moreover, increase in labor productivity throughout the year, and significant consumers’ increase in total planned purchases of goods and services, results to both increases in the Real G.D.P and price levels in the long- run equilibrium. Increase in Aggregate Demand in the economy occurs when consumers drastically increase their total planned purchase of goods and services. In long-run equilibrium, only the price levels will rise with suppliers aiming to take advantage of the situation. However, they cannot increase the level of output. Nevertheless, increase in labor productivity in adjustment to price changes will result into increase in production. Increase in both labor productivity and consumer willingness to purchase more of the commodity will lead to both increases in the Real G.D.P and price levels in the long- run equilibrium.
Policymakers’ strategy to prevent equilibrium price level from changing in response to the oil price increase
Oil is a vital commodity in the manufacturing industry. Its changes have a significant effect on the prices of goods. The microeconomic implication of higher oil prices is an increase in household spending like that of gasoline, and this in turn reduces the purchase of other commodities. Additionally, in the macroeconomic level, the rise in oil prices increases inflation levels while lowering the economic growth. The high prices of oil affect the demand and supply of other commodities as they make them expensive to supply, because of the substantial cost of producing the products. The high price of oil is because of several factors, notable the purchasing power of the consumer. The high purchasing power of consumers is a result of having disposable income, due to the oversupply of money in the economy and lower unemployment rates. Oil producers react to the increase in demand for oil and oil products by increasing its prices.
The Federal Reserve in the United States sets monetary policies to control the supply of money in the economy. A large quantity of money circulating in the economy affects micro and macroeconomic developments. The high amount of money in the economy is a result of unrestricted access to loans, thereby increasing consumer spending. Policymakers in a bid to reduce the large quantity of money circulating in the economy employ monetary policies, which includes raising the interest rates to prevent loan borrowings, setting reserve requirements to all financial institution and engaging in open market operations. Further still, the policymakers resolve that central bank should print less money to prevent oversupply.
The resultant effect of reduction of money supply in the economy will be a shift of the supply curve upwards. The decrease in the money supply will lower the consumption demand of oil, which in turn will get prices back to the old levels. Reduction of money supply means that consumers will have less disposable income. Lowering the Aggregate Demand will pull back the prices back to old level before the rise in the price of oil.
Short run effect on export nation’s economy if there is a significant downturn in economic activity in other importing nations around the world
The primary characteristic of the short-run period is the non-response of wages and the prices of the commodities to the underlining economic conditions. The increase in demand for exports from importing country increases the production in the exporting country. However, since the short-run period is affected by price stickiness, the exporting nation’s G.D.P operates either above its potential or below. When trading increase between the country and the importing countries, the effect is an increase in demand to meet the export requirements. There is an upward shift in Aggregate demand curve in the short-run, because of the rise in exports to the importing countries. The effect of an increase in demand will increase in prices of commodities to take advantage of the situation. Additionally, there will be demand for additional labor force judging on the nominal wage in such environment. However, the benefit of an increase in demand for short-run will be dependent on the ability of the market to react quickly by increasing the price of exports.
A decline in the importation of commodity by other countries will result to decrease in Aggregate demand, and therefore G.D.P will reduce. The price and wage stickiness mean that the reduction in demand of export will have little effects in the two factors. Prices of commodities will take a little longer to reduce in response to the declining economic conditions. Further still, the fall in prices of the product does not correspond to the real wage, which instead shows an increasing trend. The firms in the economy will then react by employing less individual to maintain the high real wages. Subsequently, the economy will erode because of lower outputs and minimal income. An economy should strive to ensure that it is not dependent on export only as the country’s leading economic activity. Divestment should also be in line to assure G.D.P risk minimization in case there are problems with the nations, which the state is exporting its commodities.
Miller, R. L., & Antler, S. D. (1976). Economics today (No. HB171. 5. M54 1979.). Canfield Press.
Legrand, M. D. P., & Pascal, B. (2017). Combining short–run and long-run analysis: some historical perspectives. Journal of the History of Economic Thought, 39(1).
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