Aggregate Equilibrium Macroeconomic Theory
Inflationary Gap Recessionary Gap Economy above full output Economy below full output LRAS1 Price Level Real GDP SRAS1 LRAS1 Price Level Real GDP SRAS1 AD1 AD1 Unemployment high, output low Below PPF, Actual Px level < Expected Unemployment very low, output high Above PPF, Actual Px level > Expected
Short Run vs. Long Run In short run, a shift in AD cause changes in real GDP, Unemployment & price level In long run, wages & prices are not “sticky” and do not affect output Prices are perfectly flexible in long run Actual price level must equal expected price level
LONG RUN EQUILIBRIUM IN LONG RUN EQUILIBRIUM: This must be true: Expected Price Level = Actual Price Level Employment = Full Employment Real GDP = Potential Output Quantity = Natural rate + a( Actual Px - Expected Px) Supplied of Output ( Level Level )
Example: Stock Market Crash 2- causes output to fall in short run . . . Short run —Step 1 & 2 Price Long Run– Step 3 & 4 Level LRAS SRAS1 AD1 SRAS2 AD2 3. . . . but over time, the SRAS Shifts as expected Price level falls . . A P Y B P2 Y2 1-Decrease in AD C P3 4. . . . and output returns to its natural rate. . Real GDP
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Analyzing Economic Changes Four step process: (1) Determine if the event affects SRAS, LRAS or AD (2) Decide which direction curve shifts (3) Compare the initial & new equilibrium (4) Determine both short & long run equilibrium
Stagflation A period of recession and inflation. Output falls & price level rises Example: late 1970’s in USA (oil crisis) Challenge: Policymakers who can influence aggregate demand cannot offset both simultaneously
“Supply Shock” in SRAS Consider an adverse shift in short run aggregate supply: curve shifts to the left Output falls below natural rate of employment BOTH unemployment & price level rise
Example: “Supply Shock” 1. An adverse shift in SRAS (supply shock). Price Level LRAS SRAS2 SRAS1 AD B Y2 P2 Y A P 3. . . . and the price level to rise. Quantity of 2. . . . causes output to fall . . . Output