Final answer:
The situation described, an increase in the price level and a decrease in real domestic output, is most likely caused by a decrease in aggregate supply. This is characterized as a leftward shift of the aggregate supply curve, leading to a higher price level and lower output.
Step-by-step explanation:
When the economy experiences an increase in the price level and a decrease in real domestic output, the likely cause of this situation is a decrease in aggregate supply. An increase in the price level combined with a decrease in output typically indicates a supply shock or a reduction in the economy’s ability to produce goods and services at the same price levels. This is represented by a leftward shift of the aggregate supply (AS) curve. Equilibrium real GDP will decrease and the price level will increase due to the fact that equilibrium occurs at the level of GDP where Aggregate Demand (AD) equals AS.
In contrast, a decrease in aggregate demand would typically lead to a lower price level and decreased output, while an increase in aggregate demand would push both output and price level higher. An increase in aggregate supply would generally result in increased output and a lower price level.
Therefore, the correct answer to this student’s question is: 4) Decrease in aggregate supply.