1.  Equilibrium in the Aggregate Demand/Aggregate Supply Model

2.  What happens when there is a price level above the intersection of AD and SRAS? o There is a surplus of aggregate output in the economy. When there is a surplus of output, what will eventually happen?. o Prices begin to fall  What happens when the price level is below the intersection of AD and SRAS? o There is a shortage of aggregate output in the economy. When there is a shortage of output, what will eventually happen? o Prices begin to rise  The AD/AS model presumes that the economy is usually in a state of short-run equilibrium.

4.  Demand Shock: an event that shifts the aggregate demand curve  AD shift to the left o Aggregate price level ↓ and real GDP ↓ o This causes a recession  AD shift to the right o Aggregate price level ↑ and ↑ real GDP o This causes inflation

6.  Supply shock: an event that shifts the short-run aggregate supply curve  SRAS shift to the left o Aggregate price level ↑ and real GDP ↓ o This causes stagflation o Stagflation: High unemployment and High inflation (stagnation and inflation put together)  SRAS shift to the right o Aggregate price level ↓ and ↑ real GDP o Creates optimism and leads to long-run growth

8.  Long-Run Macroeconomic Equilibrium: the point when short-run macroeconomic equilibrium is on the LRAS.  The AD/AS Model 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.

9.  Recessionary gap: when aggregate output is below potential output  Draw a AD/AS Model in LR Macro Equilibrium  Now draw an initial negative demand shock o What happens to agg price level, agg output and employment? o Reduces agg price level and agg output and leads to higher unemployment in the short-run…  What self-correcting policy will eventually take place? o Fall in nominal wages in the long-run increases short-run aggregate supply and moves the economy back to potential output.

11.  Inflationary gap: when aggregate output is above potential output  Draw a AD/AS Model in LR Macro Equilibrium  Now draw an initial positive demand shock o What happens to agg price level, agg output and employment? o increases agg price level and agg output and reduces unemployment in the short-run…  What self-correcting policy will eventually take place? o Rise in nominal wages in the long-run reduces short-run aggregate supply and moves the economy back to potential output. *Inflationary and recessionary gaps are closed by self- correcting adjustments that shift the SRAS curve.

13.  To summarize the analysis of how the economy responds to recessionary and inflationary gaps, we can focus on the output gap  Output Gap: the percentage difference between actual output and potential output o Measured as the percentage Y 2 lies away from Y 1 o Always trends towards zero Output gap = actual aggregate output — potential output X 100 Potential output

14.  Recessionary Gap: o Output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero.  Inflationary Gap: o 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