What will happen to the equilibrium price level and real GDP if aggregated demand decreases and aggregated supply increase?

Answer 1

To make it easier to understand, let's pretend that our aggregate economy is made up of 100 loaves of bread. Now, aggregate demand decreases. Instead of 100 loaves of bread at say $2.00 per loaf, our economy is only willing to buy 80 loaves at $2.00 per loaf. Aggregate supply now increases, and suppliers are willing to produce 120 loaves at $2.00 per loaf instead of the original 100 loaves. There are now 40 loaves of surplus bread. The price is forced down in order to rid the market of the surplus. Our loaves of bread are now $1.50 per loaf. Buyers are now willing to buy 100 loaves again because the price has come down; although, now sellers are only willing to produce 100 loaves again because of the price drop. What has happened? 100 loaves of bread are still being produced, thus Real GDP remains constant. The loaves of bread are now $1.50 instead of $2.00. The price level is forced down and Real GDP remains the same. So to recap, the price level drop reinstates the decrease in demand and brings down the increase in supply. Our economy is producing its original amount of product only at a lower price level. Hope this helps! =)