The AD-AS ModelEquilibrium in the Aggregate Demand/Aggregate Supply

Model

Short-Run Macroeconomic

Equilibrium What happens when there is a price level above the intersection of AD and SRAS?o There is a surplus of aggregate output in the economy.When there is a surplus of output, what will eventually happen?.o Prices begin to fall

What happens when the price level is below the intersection of AD and SRAS?o There is a shortage of aggregate output in the economy.When there is a shortage of output, what will eventually happen?o Prices begin to rise

The AD/AS model presumes that the economy is usually in a state of short-run equilibrium.

Short-Run Macroeconomic

Equilibrium

Shifts of AD: Short-Run Effects

Demand Shock: an event that shifts the aggregate demand curve

AD shift to the lefto Aggregate price level ↓and real GDP ↓o This causes a recession

AD shift to the righto Aggregate price level ↑and ↑real GDP o This causes inflation

Demand Shocks

Shifts of the SRAS Curve

Supply shock: an event that shifts the short-run aggregate supply curve

SRAS shift to the lefto Aggregate price level ↑ and real GDP ↓o This causes stagflationo Stagflation: High unemployment and High inflation

(stagnation and inflation put together) SRAS shift to the right

o Aggregate price level ↓ and ↑real GDP o Creates optimism and leads to long-run growth

Supply Shocks

Long-Run Equilibrium Long-Run Macroeconomic Equilibrium: the

point when short-run macroeconomic equilibrium is on the LRAS.

The AD/AS Model 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.

What happens with a Recessionary Gap?

Recessionary gap: when aggregate output is below potential output

Draw a AD/AS Model in LR Macro Equilibrium Now draw an initial negative demand shock

o What happens to agg price level, agg output and employment?

o Reduces agg price level and agg output and leads to higher unemployment in the short-run…

What self-correcting policy will eventually take place?o Fall in nominal wages in the long-run increases short-run

aggregate supply and moves the economy back to potential output.

What happens with a Recessionary Gap?

What happens with an Inflationary Gap?

Inflationary gap: when aggregate output is above potential output

Draw a AD/AS Model in LR Macro Equilibrium Now draw an initial positive demand shock

o What happens to agg price level, agg output and employment?

o increases agg price level and agg output and reduces unemployment in the short-run…

What self-correcting policy will eventually take place?o Rise in nominal wages in the long-run reduces short-run

aggregate supply and moves the economy back to potential output.

*Inflationary and recessionary gaps are closed by self-correcting adjustments that shift the SRAS curve.

What happens with an Inflationary Gap?

Output Gap To summarize the analysis of how the

economy responds to recessionary and inflationary gaps, we can focus on the output gap

Output Gap: the percentage difference between actual output and potential outputo Measured as the percentage Y2 lies away from

Y1

o Always trends towards zero

Output gap = actual aggregate output — potential output X 100

Potential output

Key Concepts Recessionary Gap:

o 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:o 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