Explain how the static aggregate demand and aggregate supply model gives us misleading results about the price level, particularly with respect to decreases in aggregate demand
Describe how the aggregate demand curve is different in the dynamic model as compared to the static model. Describe how potential GDP is different in the dynamic model as compared to the static model.
The static model incorrectly predicts that a recession caused by a shift to the left in the aggregate demand curve will cause the price level to fall. This has not happened for an entire year since the 1930s. The misleading results stem from one assumption of the static model: the economy does not experience continuing inflation. The dynamic model changes this by assuming instead that the aggregate demand curve will shift to the right during most years. Even if demand growth slows, the price level rises.
Also in the dynamic model, potential GDP is constantly growing. If the aggregate demand curve shifts to the right by less than the shift in the long-run aggregate supply curve, then equilibrium GDP falls below potential GDP, but the price level is still rising.
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a. True b. False
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