Consider the AD/AS model after factor prices have fully adjusted to output gaps. A reduction in the level of potential output, with aggregate demand constant, will
A)decrease real output and leave the price level unchanged.
B)leave real output unaffected and increase the price level.
C)decrease real output and decrease the price level.
D)decrease real output and increase the price level.
E)increase real output and decrease the price level.

Question

Quizplus · Accepted Answer

A reduction in the level of potential output means that the economy is now producing less than its potential output, which creates a negative output gap. With aggregate demand constant, the AD curve will remain unchanged. However, this reduction in potential output will shift the LRAS curve to the left. As a result, both the equilibrium level of output and price level will decrease, decreasing real output and increasing the price level, resulting in stagflation.

Consider the AD/AS Model After Factor Prices Have Fully Adjusted