Equilibrium in the Aggregate Demand-

Aggregate Supply ModelModule 19April 2015

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

The AD-AS Model

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

SR Macroeconomic Equilibrium

AD-AD Model

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).

Shifts of Aggregate Demand: Short-Run Effects

Demand Shocks

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 the 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

Shifts of SRAS Curve

Supply shocks

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

Long-Run Macroeconomic Equilibrium

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

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

x 100

Long-Run Macroeconomic Equilibrium

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

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?

Check your understanding

1. Which of the following causes a negative supply shock?◦ I. a technological advance◦ II. Increasing productivity◦ III. An increase in oil pricesa. I onlyb. II onlyc. III onlyd. I and III onlye. 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 ? 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

MC ???

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?

Free Response