1. Equilibrium in the AD/AS Model Module 19

2. Learning Objectives The difference between short-run and long- run macroeconomic equilibrium. The causes and effects of demand shocks and supply shocks How to determine if an economy is experiencing a recessionary gap or an inflationary gap and how to calculate the size of output gaps

3. Key Economic Concepts for this Module The model assumes that the economy is always in a state of short-run equilibrium where AD intersects SRAS. However, this short-run equilibrium may not coincide with potential GDP (Yp) If current real GDP differs from Yp, there is either a recessionary or inflationary gap in the short run.

4. In the long run, when all prices are flexible, the model predicts that SRAS will adjust so that AD, SRAS and LRAS all intersect at Yp. (shown in graph below)

5. Key Economic Concepts for this Module (cont.) External shocks to AD or SRAS affect the equilibrium price level and real GDP.

6. Remember: We are always currently in the short-run Sometimes our short-run level of output happens to be below, or above, the economy’s potential level of output.

7. The AD-AS Model A. Short-Run Macroeconomic Equilibrium B. Shifts of AD: Short-Run Effects C. Shifts of SRAS Curve D. Long-Run Macroeconomic Equilibrium

8. The AD/AS Model The previous two modules have covered AD and AS separately. To model how the macroeconomy comes to short-run and long-run equilibrium, we need to combine these two curves and then we can show how external “shocks” affect the level of real GDP and the Aggregate Price Level

9. Short-Run Macroeconomic Equilibrium The model of AD/AS predicts a movement toward equilibrium just like the micro model of supply and demand. When the price level is above the intersection of AD and SRAS, there is a surplus of aggregate output in the economy, and prices begin to fall. When the price level is below the intersection of AD and SRAS, there is a shortage of aggregate output in the economy, and prices begin to rise.

10. Short-Run Macroeconomic Equilibrium The AD/AS model presumes that the economy is usually in a state of short-run equilibrium.

11. Shifts of the Aggregate Demand: Short-Run Effects An event that shifts the aggregate demand curve is known as a demand shock. Suppose that consumers and firms become pessimistic about future income and future earnings. This pessimism would cause AD to shift to the left. Both the Aggregate price level and real GDP would fall. This would cause a recession.

12. Shifts of the SRAS Curve An event that shifts the short-run aggregate supply curve is known as a supply shock. Suppose that commodity prices (oil, for example) rapidly increased. This would shift SRAS to the left. This would increase aggregate price level and decrease real GDP. This outcome can come to be known as stagflation.

13. Shifts of the SRAS Curve Suppose the labor productivity were to increase with better technology. This would shift the SRAS to the right. The aggregate price level would fall and real GDP would increase.

14. Long-Run Equilibrium The model of AD/AS that predicts that in the long-run, when all prices are flexible, that the AD, SRAS, and LRAS curves will all intersect at potential output Yp.

15. Why? Take a look at what happens when the economy is not at Yp. Adjustment to a negative AD shock. Suppose that AD decreased and shifted the curve to the left. In the short-run, real GDP falls and is below Yp and the aggregate price level would also fall. The amount that GDP falls below potential output is called a recessionary gap.

16. Long Run Equilibrium (cont.) What happens next? The labor market is weakened by the poor economy and unemployment begins to rise as workers are laid off. Eventually nominal wages begin to fall. As nominal wages fall, SRAS begins to shift to the right. The recessionary gap begins to shrink because real GDP is rising. Once real GDP has returned to Yp, the economy is back in long-run equilibrium. The price level has fallen even further.

18. Long Run Equilibrium (cont.) Adjustment to a positive AD shock: Suppose that AD increased and shifted the curve to the right. In the short run, real GDP Y e increases and is above Y p and the aggregate price level would also rise. The amount that GDP rises above potential output is called an inflationary gap.

19. Long Run Equilibrium (cont.) What happens next? – The labor market is strengthened by the booming economy and unemployment begins to fall as workers are hired. – Eventually nominal wages begin to rise. – The inflationary gap begins to shrink because real GDP is falling. – Once real GDP has returned to Yp, the economy is back in long-run equilibrium. – The price level has increased even further.

20. Long Run Equilibrium (cont.) Whenever the economy is out of long-run equilibrium, there is either a recessionary or an inflationary gap. This output gap can be measured as a percentage Ye lies away from Yp. Output gap = 100 x (Ye – Yp)/Yp

21. In Summary Recessionary Gap: – Output gap is negative – Nominal wages eventually fall, moving the ecoomy back to potential output and bringing the output gap back to zero. Inflationary Gap: – Output gap is positive – Nominal wages eventually rise, also moving the economy back to potential output and again bringing the output gap back to zero. So in the long-run, the economy is self-correcting: – Shocks to aggregate demand affect aggregate output in the short run but not in the long run.

22. Assignment: Lesson 5; Activity 25