Question

Desired Aggregate Expenditure Assume the economy is initially in equilibrium with desired aggregate expenditure equal to real GDP at point W. The price level is P0 . Now, suppose there is an exogenous fall in the price level to P2 . Which of the following statements describes the likely macroeconomic effects?

A. The AE curve shifts to AE2 , a new equilibrium is established at point V, and the economy moves from point B to point A along AD .
B. The AE curve shifts to AE1 , a new equilibrium is established at point U, and the economy moves from point B to point A along AD0
C. The AE curve shifts to AE1 , a new equilibrium is established at point U, and the AD curve shifts from AD0 to AD1 , and equilibrium moves from point B to point G
D. The AE curve shifts to AE2 , a new equilibrium is established at point V, and the AD curve shifts from AD0 to AD1 , and equilibrium from point B to point G.

Answer 1

An exogenous fall in the price level is likely to shift the aggregate demand curve to the right, leading to a higher real GDP and potentially a higher price level, depending on the slope of the aggregate supply curve. This results in a new equilibrium with increased aggregate expenditure and output.

Option 'a' is the correct.

Step-by-step explanation:

When considering how an exogenous fall in the price level impacts the economy, it's important to understand the relationship between the aggregate demand (AD) curve, the aggregate expenditure (AE) curve, and the overall equilibrium in an economy.

If we assume that the economy is initially in equilibrium with the desired AE equal to real GDP and that the AE curve intersects with the 45-degree line and the AD curve at this equilibrium point, an exogenous decrease in the price level will lead to a shift in the AD curve.

Following Keynesian logic, a lower price level increases the real value of money, leading to an increase in the consumption component of AE. This causes an outward shift in the AE curve. Consequently, the AD curve would also shift to the right as consumption, investment, government spending, and net exports (C, I, G, X-M) potentially increase in response to the initial fall in the price level.

Thus, the new equilibrium will reflect a higher real GDP and possibly a higher price level than at the initial equilibrium, depending on the shape and slope of the aggregate supply (AS) curve at this point. If the AS curve is relatively flat, output increases more than the price level. If it's steep, the price level could rise more than output.