Factors Affecting the Long-Run Equilibrium Price Level
Consider the situation:
A country's long-run equilibrium price level has increased, but the position of its aggregate demand schedule has changed.
You need to answer the following questions:
• What has led to the country's increase in the long-run equilibrium price level and the change in the position of its aggregate demand schedule?
• What specific factors might have accounted for this event?
The intersection of the AGGREGATE DEMAND and AGGREGATE SUPPLY curves gives the equilibrium levels of REAL OUTPUT (GDP) and PRICES in the economy.
THE AGGREGATE DEMAND CURVE shows the total of all goods and services demanded in the economy at various price levels. Movements of the AD curve are caused by any change in the constituent parts of AD - an increase in one or more of these shifts the AD curve to the right, while a decrease in one or more of these shifts the AD curve to the left. The constituent parts of AD make up the AD EQUATION which, in symbolic form, is presented as:
C + I + G + (X - M)
where C stands for Consumers' Expenditure, I stands for Investment Expenditure, G stands for Government Expenditure, and (X - M) stands for Net Exports (in other words, the difference between the value of Exports and the value of Imports).
CONSUMERS' EXPENDITURE is expenditure by households on all goods and services, and is heavily influenced by the level of disposable income and by the distribution of that income. Government monetary policy and fiscal policy can influence both.
INVESTMENT EXPENDITURE is expenditure by firms (and government) on capital goods, and is heavily influenced by interest rates, the level of profits and expectations of future sales. Again it is affected by monetary and fiscal policy. It also includes the spending of households on housing.
GOVERNMENT EXPENDITURE is expenditure by central and local government on goods and services (including the pay of those working in the public sector). It is determined by the tax revenue available to governments, together with its spending commitments and priorities. It does not include social security benefits, since these represent simply a transfer of income from one group of people (taxpayers) to another (recipients).
NET EXPORTS may be positive (X greater than M) or negative (M greater than X), and is influenced by the level of income in the rest of the world, as well as by factors influencing the relative prices of X and M, including the exchange rate.
Hence one of more of these AD components must have increased in order to produce the rightward shift of the AD curve.
THE AGGREGATE SUPPLY CURVE shows the quantity of goods and services that all producers in the economy will be willing to supply at various prices. It is upward sloping, since at higher prices suppliers will be willing to supply more. Essentially higher prices are needed to induce a greater supply since costs tend to rise as output increases. In the case you describe, there is no evidence of any shift of the AS curve. Hence the increase in the equilibrium price level has been caused by the increase in AD. In general the AS curve will tend to become steeper (more inelastic) as full employment in the economy is approached. This is because more and more firms find that they have no further scope to increase production in response to higher prices, while the costs of factor inputs will be rising in the economy as a whole as firms compete for increasingly scarce resources, hence bidding up prices.
An increase in AD shifts the AD curve to the right, resulting in an increase in real GDP and an increase in the price level. The extent to which the price level increases following an increase in AD depends upon the ELASTICITY of the AS curve. The more inelastic the curve, the greater the increase in the equilibrium price level.
I hope this is helpful.