Long-Run Macroeconomic Equilibrium The model of AD/AS 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. Why? Take a look at what happens when the economy is not at Yp. Suppose that AD decreased and shifted the curve to the left. In the short run, real GDP Ye 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. 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. Suppose that AD increased and shifted the curve to the right. In the short run, real GDP Ye increases and is above Yp and the aggregate price level would also rise. The amount that GDP rises above potential output is called an inflationary gap. The labor market is strengthened by the booming economy and unemployment begins to fall as workers are hired. Eventually nominal wages begin to rise. As nominal wages rise, SRAS begins to shift to the left. The inflationary gap begins to shrink because real GDP is falling. The price level has increased even further. Note: the instructor should replicate the graphs to show the adjustment to a positive AD shock in a similar manner to the graphs associated with the negative AD shock. 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*(Ye – Yp)/Yp Summarize for the students: Recessionary gap: 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: 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.

Long-Run Macroeconomic Equilibrium The model of AD/AS 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. Why? Take a look at what happens when the economy is not at Yp. Suppose that AD decreased and shifted the curve to the left. In the short run, real GDP Ye 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. 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. Suppose that AD increased and shifted the curve to the right. In the short run, real GDP Ye increases and is above Yp and the aggregate price level would also rise. The amount that GDP rises above potential output is called an inflationary gap. The labor market is strengthened by the booming economy and unemployment begins to fall as workers are hired. Eventually nominal wages begin to rise. As nominal wages rise, SRAS begins to shift to the left. The inflationary gap begins to shrink because real GDP is falling. The price level has increased even further. Note: the instructor should replicate the graphs to show the adjustment to a positive AD shock in a similar manner to the graphs associated with the negative AD shock. 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*(Ye – Yp)/Yp Summarize for the students: Recessionary gap: 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: 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.