Chapter 10 Aggregate Demand and Aggregate Supply: The Basic Model

Short-Run Macroeconomic Equilibrium The forces of short-run aggregate supply and aggregate demand meet at an equilibrium price level in an environment of incomplete adjustment of wages and prices.

Short-Run Macroeconomic Equilibrium (cont’d) If the price level is below the equilibrium level:  Aggregate quantity demanded is greater than aggregate quantity supplied.  Firm’s inventories will decline.  Firms will respond by increasing both production and price.  The higher price level reduces the aggregate quantity demanded.  Process continues until equilibrium is reached.

Short-Run Macroeconomic Equilibrium (cont’d) If the price level is above the equilibrium level:  Aggregate quantity supplied is greater than aggregate quantity demanded.  Firm’s inventories will increase.  Firms will respond by decreasing both production and price.  The lower price level increase the aggregate quantity demanded.  Process continues until equilibrium is reached.

Figure 10.5(a) Short-Run Macroeconomic Equilibrium

Figure 10.5(b) Short-Run Macroeconomic Equilibrium

Characteristics of Short-Run Equilibrium If an economy is in short-run equilibrium, it will stay there unless there are changes in the behavior of suppliers, households, firms, governments or the foreign sector. If an economy is not in short-run equilibrium, the forces of aggregate demand and aggregate supply will cause the economy to move to equilibrium.

Characteristics of Short-Run Equilibrium (cont’d) Combination of price level and output where there is no incentive to change their behavior. But it may not represent optimal economic conditions.  May not be consistent with the full-employment level of GDP.  Adjustment to short-run equilibrium may result in inflation.

Can we do it? Let’s try number 10… Consider the following information about AD and SR AS in a macroeconomy:  At which prices are there surpluses? At which prices are there shortages?  What is the equilibrium price level? What is the SR equilibrium level of output?  Draw the AD and SR AS curve and label the equilibrium price and quantity. PriceADSR AS

The Basics of Long-Run Aggregate Supply The long-run aggregate supply curve is the level of output that occurs at full- employment production in the economy after all adjustments to changing prices have occurred.

Figure 10.7 The Long-Run Aggregate Supply Curve

Shape of the Long-Run Aggregate Supply Curve Vertical because it reflects the complete adjustment by all of the participants in the economy to changing prices.  In the long run: Firms will have no incentive to change output in response to changes in the price level, because Nominal wages and other resources prices will move with the price level.

Location of the Long-Run Aggregate Supply Curve Located at full-employment real GDP.  Level of output achieved when there are complete and accurate adjustments by all participants in the economy in the long run.

Movement of the Long-Run Aggregate Supply Curve The determination of full employment real GDP is similar to the determination of the maximum amount of output shown by the production possibilities frontier.  The same factors that shift the PPF outward will shift the long-run aggregate supply curve to the right: Improvements in technology Increases in other resources

Figure 10.8 Production Possibilities Frontier and Long-Run Aggregate Supply

Long-Run Macroeconomic Equilibrium Intersection of the aggregate demand curve with both the short-run aggregate supply curve and the long-run aggregate supply curve.

Figure 10.9 Long-Run Equilibrium

Long-Run Macroeconomic Equilibrium The long-run equilibrium is optimal in that:  There is no over- or under-production in the economy.  The economy is producing all of the output it is capable of producing.  There is full employment.  There is no upward or downward pressure on the price level.  All participants in the economy have obtained enough information to adjust their behavior accordingly.

Chapter 10 homework Numbers 4, 7, 11, 12 and 18