Final answer:
Price levels may not adjust after a decline in aggregate demand due to sticky prices and inflation expectations, which keep them fixed in the short run. Over time, however, prices are expected to become more flexible and eventually align with the aggregate demand level.
Step-by-step explanation:
The price level may remain stuck at its old level even when aggregate demand declines due to the presence of sticky prices, meaning that prices and wages are slow to adjust in the short run. One significant contributor to this phenomenon is the fact that even if actual aggregate demand falls, the expectations of consumers and businesses regarding future inflation can cement current price levels. If they anticipate that inflation will continue at a certain rate, prices, wages, and interest rates may not decrease as they might in a fully flexible market. Additionally, if the government continuously stimulates the economy, this can reinforce expectations of persistent inflation, causing current price levels to stick.
The AD/AS model helps to explore this behavior by showing that shifts in aggregate demand can lead to different levels of inflationary pressure, depending on the economic context. However, in the long run, prices are expected to be flexible, allowing the economy to return to its potential GDP. This flexibility implies that if the aggregate demand decreases substantially and stays at the lower level, eventually the price level should adjust downward to reflect the changes in demand.