Question

How does a change in autonomous spending impact equilibrium GDP and the price level:

- when prices are fixed (horizontal SRAS curve)

- when prices are fully flexible (vertical SRAS curve)

- when prices adjust gradually (upward-sloping SRAS curve)

Answer 1

An autonomous spending change works on the aggregate demand in an economy. An increase in autonomous spending shifts the AD curve to the right, while a decrease shifts it to the left. The new equilibrium is determined at the intersection of shifted AD curve and the SRAS.

1. When prices are fixed (Horizontal SRAS curve): It implies that the producers can supply goods at the same price in the short run i.e. prices are sticky. This view has been taken by Keynesians as they believe that prices are sticky in the short run. Any shift in AD, will cause GDP to shift in the same direction and maximum magnitude.

1. When prices are fully flexible (Vertical SRAS curve): This is the Classical approach. They believe that AS curve is vertical always and everytime. This arises from their assumption of flexible wages and prices which results in no unemployment. Thus, production resources are fully utilised and can not change. This gives it a vertical shape. Any change in AD, will lead to a one on one change in prices. There will be no effect on Real GDP.

1. When prices adjust gradually (Upward sloping SRAS curve): This view of SRAS has been taken by many schools of thought. Monetarists, New Classicals etc realised that prices and wages are indeed sticky in the short run and can't just change with the market suddenly. Thus, they believed that prices adjust gradually and in the short run, AS is upward sloping. Any change in AD, will cause both, an increase in prices as well as an increase in Real GDP. The magnitude of both will depend upon the slope of the curves.

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