1. LONG RUN AGGREGATE SUPPLY
the amount of real output
the economy is able to supply
at different price levels
if the economy is at Natural Real GDP

2. the economy could produce if it operated at full employment
NATURAL REAL GDP
the amount of output
the economy could produce
if it operated at full employment
called Qn or Qf

3. LONG RUN AGGREAGATE SUPPLY LRAS
vertical line
at full employment Real GDP
Qn = Qf

4. THREE POSSIBLE STATES OF THE ECONOMY
Full employment equilibrium
Recessionary gap
Inflationary gap

5. FULL EMPLOYMENT EQUILIBRIUM
The intersection of SRAS and AD is equal to the Natural Real GDP

6. FULL EMPLOYMENT OUTPUT (other terms)
Potential GDP
the Natural Rate of Employment
the Natural Rate of Unemployment
QF or QN

7. FULL EMPLOYMENT EQUILIBRIUM
LRAS
PRICE LEVEL
SRAS AD Qn
REAL GDP

8. Short run equilibrium output is less than full employment
RECESSIONARY GAP
Short run equilibrium output is less than full employment
People are not spending enough to purchase all that has been produced (inventories increase)
unemployment is a concern

9. RECESSIONARY GAP
LRAS
PRICE LEVEL
SRAS AD Qn Q1
REAL GDP

10. POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY
Recessionary gaps are eliminated by decreases in wages and other input prices
Graphically this is an increase in SRAS

11. Self-Regulating Economy Exhibit 2 (1 of 2)P r i c e L e v e l P a r t ( a ) S R A S 1 T h e e c o n o m y i s i n a 1 P r e c e s s i o n a r y g a p a t 1 p o i n t 1 . A D 1 5 , 2 6 , R e a l G D P ( b i l l i o n s o f U n e m p l o y m e n t r a t e S u p p o s e b a s e - y e a r d o l l a r s ) i s h i g h e r a t $ 5 , 2 t h i s i s b i l l i o n t h a n a t $ 6 , N a t u r a l b i l l i o n R e a l G D P

12. Self-Regulating Economy Exhibit 2 (2 of 2)

13. Equilibrium output is greater than full employment output
INFLATIONARY GAP
Equilibrium output is greater than full employment output
People are spending more than businesses anticipated and inventories are being drawn down
Inflation is a major concern

14. INFLATIONARY GAP P r i c e L e v e l L R A S S R A S S h o r t - r u nq u i l i b r i u m e q u i l i b r i u m A D Q N N a t u r a l R e a l G D P

15. POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY
Inflationary gaps are eliminated by increases in wages and input prices
Graphically, this is a decrease in SRAS

16. Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (1 of 2). A D 1 R e a l G D P ( b i l l i o n s o f b a s e - y e a r 6 , 6 , 5 d o l l a r s ) U n e m p l o y m e n t r a t e i s S u p p o s e t h i s i s l o w e r a t $ 6 , 5 b i l l i o n N a t u r a l R e a l G D P t h a n a t $ 6 , b i l l i o n

17. Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (2 of 2)

18. CLASSICAL ECONOMIC REASONING
Inflationary and Recessionary gaps will be automatically eliminated due to
flexible prices
flexible wages
flexible interest rates

19. CLASSICAL VIEW OF THE PRODUCT MARKET

20. SUPPLY CREATES ITS OWN DEMAND
SAY’S LAW
SUPPLY CREATES ITS OWN DEMAND

21. REASONING BEHIND SAY’S LAW
People don’t work just to earn money. They work for the things that money can buy.
People don’t save just to hold the money. They save in order to invest.
All that is earned will be spent.