Equilibrium in the Aggregate Demand-Aggregate Supply Model Module 19 April 2015

The AD-AS Model In the AD-AS Model, the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations

SR Macroeconomic Equilibrium The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded Short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium

AD-AD Model

Shifts of Aggregate Demand: Short-Run Effects Demand shock – events that shift the aggregate demand curve (Great Depression was a negative demand shock fixed by WWII government spending which was a positive demand shock).

Demand Shocks

Shifts of the SRAS Curve Supply shock – an event that shifts the short- run aggregate supply curve Negative supply shock raises production costs and reduces quantity produced – oil crises of 1973 and 1979 Positive supply shock reduces production costs and increase quantity supplied – Internet and new technology between 1995- 2000

Shifts of SRAS Curve Stagflation – the combination of inflation and stagnating (or falling) aggregate output Leads to rising unemployment Supply shocks - cause the aggregate price level and aggregate output to move in the opposite directions

Supply shocks

Long-Run Macroeconomic Equilibrium The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long- run aggregate supply curve

Long-Run Macroeconomic Equilibrium

Long-Run Macroeconomic Equilibrium Recessionary gap – when aggregate output is below potential output Corresponds to high unemployment Early 1930s Germany Causes the SRAS to shift gradually to the right

Short-Run vs Long-Run Effects of a negative demand shock

Long-Run Macroeconomic Equilibrium Inflationary gap – when aggregate output is above potential output Output gap – the percentage difference between actual aggregate output and potential output. The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run 𝑂𝑢𝑡𝑝𝑢𝑡 𝑔𝑎𝑝= 𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑜𝑢𝑡𝑝𝑢𝑡−𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 x 100

Short-Run vs. Long-Run Effects of a positive demand shock

Check Your Understanding 1. Describe the short-run effects of each of the following shocks on the aggregate price level and on aggregate output. A. the government sharply increases the minimum wage, raising the wages of many workers. B. solar energy firms launch a major program of investment spending C. congress raises taxes and cuts spending. D. severe weather destroys crops around the world

Check your understanding 2. A rise in productivity increases potential output, but some worry that demand for the additional output will be insufficient even in the long run. How would you respond?

MC ??? 1. Which of the following causes a negative supply shock? I. a technological advance II. Increasing productivity III. An increase in oil prices I only II only III only I and III only I, II, and III

MC ??? 2. Which of the following causes a positive demand shock? a. an increase in wealth b. pessimistic consumer expectations c. a decrease in government spending D. an increase in taxes E. an increase in the existing stock of capital

MC ??? During stagflation, what happens to the aggregate price level and real GDP? Aggregate Price Level Real GDP A. decreases increases B. decreases decreases C. increases increases D. increases decreases E. stays the same stays the same

MC ??? Refer to the graph for questions 4 and 5 4. Which of the following statements is true if this economy is operating 𝑃 1 𝑎𝑛𝑑 𝑌 1 ? I. the level of aggregate output equals potential output II. It is in short-run macroeconomic equilibrium III. It is in long-run macro equilibrium A. I only B. II only C. III only D. II and III E. I and III

MC ??? 5. The economy depicted in the graph is experiencing a(n) A. contractionary gap B. recessionary gap C. inflationary gap D. demand gap E. supply gap

Free Response 1. Refer to the other graph A. is the economy in short-run macroeconomic equilibrium? explain. B. is the economy in long-run macroeconomic equilibrium? Explain. C. what type of gap exists in this economy? D. calculate the size of the output gap. E. what will happen to the size of the output gap in the long run?