A student was asked to draw an aggregate demand and aggregate supply graphLOADING... to illustrate the effect of an increase in aggregate supply. The student drew the following graph: The student explained the graph as follows: "An increase in aggregate supply causes a shift from SRAS1 to SRAS2. Because this shift in the aggregate supply curve results in a lower price level, consumption, investment, and net exports will increase. This change causes the aggregate demand curve to shift to the right from ADl to AD2. We know that real GDP will increase, but we can't be sure whether the price level will rise or fall because that depends on whether the aggregate supply curve or the aggregate demand curve has shifted farther to the right. I assume that aggregate supply shifts out farther than aggregate demand, so I show the final price level, P3, as being lower than the initial price level, P1." Which of the following is a correct statement about the student's analysis? A. The student is incorrect because the aggregate demand curve does not shift because of the price level change. B. The student's analysis is correct. C. The student is incorrect because the price level should rise when SRAS increases. D. The student is incorrect because the aggregate demand curve should decrease, not increase.

Explanation: A shift to the right of the supply curve indicates an increase in the aggregate supply or total market supply (which is due to certain factors). Producers only do this provided there would be an increase in market price. However, the equilibrium price would fall from P1 to P2. This follows the law of demand, that is, the higher the price the lower the quantity demanded.”

The fall in price would result in a new equilibrium price, P2. At this lower price level, consumers aggregate demand would also experience an increase, shown by a shift to the right in the demand curve. A new equilibrium price P3, would again be reached which would be convenient for both consumers and producers.

It is important to note that rational consumer behavior is such that a slight increase in price would discourage buying and vice versa. On the other hand, a rational producer is out to make profit and so a slight increase in price would encourage them to supply more and vice versa. Hence if the producers supply curve shifts to the right (an increase), it only means there is a price increase and if the consumers respond by reducing quantity demanded, then there has to be a new meeting point (new equilibrium price).

That explains the fall from equilibrium price P1 to equilibrium price P3.