National Income and Price Determination: Equilibrium in AD/AS Model AP Economics Mr. Bordelon

SR Macroeconomic Equilibrium When APL is above intersection of AD and SRAS, at ESR, there is a surplus of aggregate output in the economy. When there is a surplus of output, prices begin to fall. When APL is below intersection of AD and SRAS, at ESR, there is a shortage of aggregate output in the economy. Where there is a shortage of output, prices begin to rise. The AD/AS model assumes that the economy is in a state of short-run equilibrium (SRE).

Shifts of AD

Shifts of AD Events that shift AD are called demand shocks. Positive demand shock. Assume that consumers and firms become pessimistic about future income and future earnings. AD shifts left. APL and real GDP decrease. Recession. Plagues. Locusts.

Shifts of AD Negative demand shock. Assume that the stock market has increased consumer wealth. The increase in wealth would cause AD to shift right. APL and real GDP increase.

Shifts of SRAS

Shifts of SRAS Events that shift SRAS are called supply shocks. Positive supply shock. Assume that labor productivity increased with better technology. SRAS shifts right. APL decreases and real GDP increases.

Shifts of SRAS Negative supply shock. Assume commodity prices rapidly increased. SRAS shifts left. APL increases and real GDP decreases. This is also known as stagflation. AP Note: This is a commonly tested item. Know this, understand it, because if you can explain the problems that arise from stagflation, you understand the AD/AS model in the long-run.

Long-Run Equilibrium

Long-Run Equilibrium The AD/AS model predicts that in the long run, when all prices are flexible (remember, all fixed costs become variable costs in the long-run), that the AD, SRAS, and LRAS curves will intersect at LRE, at potential output YP. For the most part, this is an examination of fiscal policy and demand shocks. You will learn later, there is little fiscal policy can do regarding supply shocks.

LRE Positive demand shock. Assume that AD increases and shifts right. In short run, real GDP and APL increases. The amount GDP increases above YP is called an inflationary gap. Labor market is strengthened by a booming economy and unemployment decreases as workers are hired. Nominal wages rise. As nominal wages rise, SRAS shifts left. Inflation gap falls because real GDP falls. Once real GDP returns to YP, the economy is in LRE. APL increased.

LRE Negative demand shock. Assume that AD decreases and shifts left. In short run, real GDP and APL decrease. The amount GDP decreases below YP is called a recessionary gap. Labor market is weakened by a poor economy and unemployment begins to rise as workers are laid off. Nominal wages decrease. As nominal wages decrease, SRAS shifts right. Recessionary gap decreases because real GDP increases. Once real GDP returns to YP, economy is in LRE. APL has decreased.

LRE Whenever the economy is out of LRE, there is either a recessionary or an inflationary gap. This output gap can be measured as a percentage between YP and current real GDP. Output gap = (Y1 – YP)/YP x 100% Recessionary gap. Output gap is negative, nominal wages decrease, economy moves to YP and output gap returns to zero. Inflationary gap. Output gap is positive, nominal wages increase, economy moves to YP and output gap returns to zero. Self-correcting. In the long run, the economy is self-correcting. Shocks to AD affect aggregate output in short run, but not long run.

Question 1 Use AD/AS graphs to show short-run effects of each of the following shocks on APL and aggregate output. Price of copper, steel, and other commodities has risen in global markets. A weak auto industry has prompted less investment spending by many firms that manufacture auto parts (brake pads, fan belts, spark plugs, etc.). Congress lowers taxes and increases spending. More and more students are graduating from high school and receiving college degrees. (Assume that a more educated workforce is a more productive workforce).

Question 2 Draw a graph that shows the economy currently in LRE. Suppose that household wealth has been falling for several months. Given this, adjust your graph to show both the short- run change in APL and real GDP. Describe how the economy will adjust in the long run. Show in your graph this adjustment to LRE. Use complete sentences.