Module Equilibrium in the Aggregate Demand- Aggregate Supply Model 19 KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: 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 the output gaps

The AD-AS Model Model used to analyze economic fluctuations 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.

Short-Run Macroeconomic Equilibrium Price Level Aggregate Output Shortage/Surplus Relative Declines The model of AD/AS predicts a movement toward equilibrium just like the micro model of supply and demand.   Note: the instructor can redraw a micro demand and supply graph side-by-side with a macro AD/AS graph. This might help the students to recall how the market comes to equilibrium. When the price level is above the intersection of AD and SRAS, there is a surplus of aggregate output in the economy. When there is a surplus of output, 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. When there is a shortage of output, prices begin to rise. The AD/AS model presumes that the economy is usually in a state of short-run equilibrium.

Shifts of Aggregate Demand: Short-Run Effects Demand Shock Negative Demand Shock Positive Demand Shock 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. A recession. Note: the instructor should show the students how the leftward shift of AD would cause Pe and Ye to both fall. Suppose that a healthy stock market has increased consumer wealth. This increase in wealth would cause AD to shift to the right. Both the aggregate price level and real GDP would rise. Note: the instructor should show the students how the rightward shift of AD would cause Pe and Ye to both rise. Note: the instructor can also use the opportunity to preview the role that the government can play with fiscal and monetary policy. Talk about how a tax cut might affect the AD curve.

Shifts of the SRAS Curve Supply Shock Negative Supply Shock Stagflation Positive Supply Shock 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. Note: the instructor should show the students how the leftward shift of SRAS would cause Pe to rise and Ye to fall. Suppose that 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. Note: the instructor should show the students how the rightward shift of SRAS would cause Pe to fall and Ye to rise.

Long-Run Macroeconomic Equilibrium Recessionary Gap Self-Correction Inflationary Gap Output Gap 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.

Figure 19.2 Demand Shocks Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 19.3 Supply Shocks Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 19.5 Short-Run Versus Long-Run Effects of a Negative Demand Shock Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 19.6 Short-Run Versus Long-Run Effects of a Positive Demand Shock Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Unnumbered Figure 19.1 Supply Shocks Versus Demand Shocks in Practice Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers