Using the concepts of aggregate demand and aggregate supply, explain how the economy reaches an equilibrium level of real GDP and price level.

Question

What will be an ideal response?

Answer 1

Equilibrium of real GDP and price level occurs at the intersection of aggregate demand and aggregate supply. At a unique price level, the aggregate quantity demanded equals the aggregate quantity supplied. As in all equilibrium models, the economy automatically moves to this point and remains there until some shock causes a change in the determinants of aggregate demand or aggregate supply. If at a certain price level the quantity of aggregate demand is greater than the quantity of aggregate supply, the price level will rise until it reaches the equilibrium price level. As the price level rises, the quantity of aggregate demand will decrease and the quantity of aggregate supply will increase. If at a different price level the quantity of aggregate supply is greater than the quantity of aggregate demand, the price level will fall until it reaches the equilibrium price level. As the price level falls, the quantity of aggregate supply will decrease and the quantity of aggregate demand will increase. Eventually they will meet at a lower price level.