Consider the AD/AS model after factor prices have fully adjusted to output gaps. An increase in the level of potential output, with aggregate demand constant, will
A)decrease real GDP and the price level.
B)decrease real GDP and raise the price level.
C)increase real GDP and lower the price level.
D)affect only the price level.
E)affect only the level of real GDP.

Question

Quizplus · Accepted Answer

When the level of potential output increases, it means that the economy can produce more goods and services without putting upward pressure on factors prices. This, in turn, shifts the long-run aggregate supply (LRAS) curve to the right. With aggregate demand being constant, the intersection of AD and the new LRAS curve will occur at a higher level of real GDP and a lower price level. Therefore, an increase in the level of potential output will result in an increase in real GDP and a lower price level.

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