ECO Global Macroeconomics TAGGERT J. BROOKS

Module 19 EQUILIBRIUM IN THE AGGREGATE DEMAND-AGGREGATE SUPPLY MODEL

The AS–AD Model  The AS-AD model uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations. 3 of 17

Short-Run Macroeconomic Equilibrium  The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded.  The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium.  Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short- run macroeconomic equilibrium. 4 of 17

The AS–AD Model Y E P E E SR SRAS AD Real GDP Short-run macroeconomic equilibrium Aggregate price level 5 of 17

Demand Shocks Y 2 2 P 2 AD 2 A negative demand shock... Y 1 E 1 E SRAS AD 1 Y 1 2 E 1 SRAS AD 1 P 1 P 1 Real GDP Aggregate price level Real GDP Aggregate price level...leads to a higher aggregate price level and higher aggregate output. (a) A Negative Demand Shock(b) A Positive Demand Shock E P 2 Y 2 AD 2 A positive demand shock......leads to a lower aggregate price level and lower aggregate output. 6 of 17

Supply Shocks P 1 AD Y 1 E 1 Real GDP Aggregate price level (a) A Negative Supply Shock SRAS 1 Y 2 2 E P 2 2 Y 1 1 AD E 2 E SRAS P 1 Real GDP Aggregate price level (b) A Positive Supply Shock P 2 Y 2 SRAS 2 1 A negative supply shock... …leads to a lower aggregate output and a higher aggregate price level....leads to a higher aggregate output and lower aggregate price level. A positive supply shock... 7 of 17

Long-Run Macroeconomic Equilibrium  The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.

Long-Run Macroeconomic Equilibrium Y P P E SRAS LR AD E LR Real GDP Aggregate price level Long-run macroeconomic equilibrium Potential output

Short-Run Versus Long-Run Effects of a Negative Demand Shock Y 1 P E 1 2 SRAS 1 LR AD 1 Real GDP Aggregate price level Potential output E 3 P 3 SRAS 2 3. …until an eventual fall in nominal wages in the long run increases short-run aggregate supply and moves the economy back to potential output …reduces the aggregate price level and aggregate output and leads to higher unemployment in the short run… AD 2 Recessionary gap Y 2 E 1. An initial negative demand shock… 1 P

Short-Run Versus Long-Run Effects of a Positive Demand Shock Y 1 P 3 E 3 E1E1 P 1 P SRAS 1 LR AD Real GDP Potential output AD 2 1.An initial positive demand shock… Inflationary gap Y 2 2 E 2 2. …increases the aggregate price level and aggregate output and reduces unemployment in the short run… 1 11 of 17 Aggregate price level

Long-Run Macroeconomic Equilibrium  There is a recessionary gap when aggregate output is below potential output.  There is an inflationary gap when aggregate output is above potential output.  The output gap is the percentage difference between actual aggregate output and potential output.

Long-Run Macroeconomic Equilibrium  The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run.