LONG RUN AGGREGATE SUPPLY the amount of real output the economy is able to supply at different price levels if the economy is at Natural Real GDP

the economy could produce if it operated at full employment NATURAL REAL GDP the amount of output the economy could produce if it operated at full employment called Qn or Qf

LONG RUN AGGREAGATE SUPPLY LRAS vertical line at full employment Real GDP Qn = Qf

THREE POSSIBLE STATES OF THE ECONOMY Full employment equilibrium Recessionary gap Inflationary gap

FULL EMPLOYMENT EQUILIBRIUM The intersection of SRAS and AD is equal to the Natural Real GDP

FULL EMPLOYMENT OUTPUT (other terms) Potential GDP the Natural Rate of Employment the Natural Rate of Unemployment QF or QN

FULL EMPLOYMENT EQUILIBRIUM LRAS PRICE LEVEL SRAS AD Qn REAL GDP

Short run equilibrium output is less than full employment RECESSIONARY GAP Short run equilibrium output is less than full employment People are not spending enough to purchase all that has been produced (inventories increase) unemployment is a concern

RECESSIONARY GAP LRAS PRICE LEVEL SRAS AD Qn Q1 REAL GDP

POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY Recessionary gaps are eliminated by decreases in wages and other input prices Graphically this is an increase in SRAS

Self-Regulating Economy Exhibit 2 (1 of 2) P r i c e L e v e l P a r t ( a ) S R A S 1 T h e e c o n o m y i s i n a 1 P r e c e s s i o n a r y g a p a t 1 p o i n t 1 . A D 1 5 , 2 6 , R e a l G D P ( b i l l i o n s o f U n e m p l o y m e n t r a t e S u p p o s e b a s e - y e a r d o l l a r s ) i s h i g h e r a t $ 5 , 2 t h i s i s b i l l i o n t h a n a t $ 6 , N a t u r a l b i l l i o n R e a l G D P

Self-Regulating Economy Exhibit 2 (2 of 2)

Equilibrium output is greater than full employment output INFLATIONARY GAP Equilibrium output is greater than full employment output People are spending more than businesses anticipated and inventories are being drawn down Inflation is a major concern

INFLATIONARY GAP P r i c e L e v e l L R A S S R A S S h o r t - r u n q u i l i b r i u m e q u i l i b r i u m A D Q N N a t u r a l R e a l G D P

POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY Inflationary gaps are eliminated by increases in wages and input prices Graphically, this is a decrease in SRAS

Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (1 of 2) . A D 1 R e a l G D P ( b i l l i o n s o f b a s e - y e a r 6 , 6 , 5 d o l l a r s ) U n e m p l o y m e n t r a t e i s S u p p o s e t h i s i s l o w e r a t $ 6 , 5 b i l l i o n N a t u r a l R e a l G D P t h a n a t $ 6 , b i l l i o n

Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (2 of 2)

CLASSICAL ECONOMIC REASONING Inflationary and Recessionary gaps will be automatically eliminated due to flexible prices flexible wages flexible interest rates

CLASSICAL VIEW OF THE PRODUCT MARKET

SUPPLY CREATES ITS OWN DEMAND SAY’S LAW SUPPLY CREATES ITS OWN DEMAND

REASONING BEHIND SAY’S LAW People don’t work just to earn money. They work for the things that money can buy. People don’t save just to hold the money. They save in order to invest. All that is earned will be spent.