Question

1. What impact would an increase in AD, in the vertical range of AS, will have on GDP and the price level according to the AD/AS model? Explain the reasons to score high marks. Ans: IF

Answer 1

1. In the vertical range of AS (long run), when AD increased from AD1 to AD2, price rises only from P1 to P2. There is no impact on output. This is because a vertical AS curve shows has the underlying assumption that prices and wages are flexible and adjust so that in the long run (vertical AS), increase in AD has no real effects on output. To understand the reasoning - lets go step by step. When AD rises, more is being demanded and to provide for this more will have to be produced. However since wages and prices are flexible - in light of rising inflation, nominal wages are raised and real wages do not change. This is why there is no change in output and only a price rise due to increase in aggregate demand. Prices rise because output is at its potential level and output cannot expand due to rise in demand. (This is in contrast to horizontal AS when wages and prices are fixed and output expands).