Question

Starting from a full employment equilibrium, how do the real GDP and price level change in the short run and in the long run in response to an increase in AD ?

Answer 1

If the economy is in full employment equilibrium. (point E1). The price level is at P1 and output(real GDP) is at Y*

hence the resources are in being utilised its full capacity.

now let's see what will happen when AD increases;

In the short run:

if the aggregate demand increases in the short run, the suppliers may use their resources overtime i.e.

a. making their workers work longer hours.

b. using their machines beyond their full capacity time.

this will lead to an increase in the supply costs too because workers are going to get paid some extra charge and some extra cost will be required to run the machines over time. hence we can see that short-run aggregate supply curve to be upward sloping(SRAS) and hence when AD increases the price and output both are going to increase.(price:P1 to P2 and real GDP:Y* to Y**) The output may increase beyond the full capacity long-run equilibrium level.

In the long run:

But in the long run, the output/real GDP will return to its full-employment level(Y*) because:

a. we cannot make the workers work overtime forever.

b. the machines will get depreciated fast if their use is beyond the full capacity.

hence, in the long run, the output will not increase(Y* will stay at Y*) but only the price will increase.(P1 to P2 to P3)

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