Module 19: Equilibrium in the AD/AS Model
Short Run Equilibrium – is always where the SRAS and AD curves intersect. The
model assumes that we are always in SR Equilibrium.
Demand Shocks – these are events that will shift the AD curve.
Negative Demand Shock – Let’s say that consumers and firms are pessimistic about
future incomes and earnings. This would cause a leftward shift of the AD curve
causing both APL and Real GDP to fall.
Historical example: The Great Depression
Positive Demand Shock – Let’s say that a booming stock market has increased
consumer wealth. This would cause a rightward shift of the AD curve and increase
both APL and Real GDP.
Historical example: WW II
Supply Shocks – these are events that will shift the SRAS curve.
Negative Supply Shock – Let’s say that commodity prices rapidly increase. This
would cause a leftward shift of the SRAS curve causing the APL to increase and Real
GDP to fall. This situation is called stagflation, inflation with stagnant growth.
Historical example: The Oil crisis of 1979
Positive Supply Shock – Let’s say that productivity increases with better
technology. This would cause a rightward shift of the SRAS curve causing the APL to
fall and Real GDP to increase.
Historical example: .com boom in the 1990’s – 2000’s
Long Run Equilibrium – Our AD/AS model predicts that in the Long Run, when
prices are fully flexible, all three curves, the AD, SRAS, & the LRAS, will intersect at
potential output.
How does this happen????
EX Negative Demand Shock (on the board)
After AD has shifted to the left we have what is called recessionary gap. That is Real
GDP has fallen below potential output and thus we will experience unemployment
and our economy is not working to its potential.
Due to the poor economy, the labor market falters and unemployment rises, leading
nominal wages to fall. This will cause SRAS to shift to the right because costs to
businesses have been cut and it is now more profitable to supply products.
Over time, real GDP will rise due to the shift of SRAS and EQ will move back toward
LRAS. Once it reaches the LRAS curve, we are back to LR EQ.
What happens to the APL & Real GDP?
If it were a Positive Demand Shock, the opposite would happen!
AD would shift to the right causing an inflationary gap. That is when Real GDP has
exceeded potential output causing inflation (notice APL is rising). The labor market
strengthens and nominal wages increase. That causes costs to rise for
businesses and thus they decide to decrease production (SRAS shifts left). Over
time, SRAS shifts back to LRAS where LR EQ will be reached again when all three
curves intersect at potential output again.
Recessionary Gap: when the output gap is negative, nominal wages eventually
fall, moving the economy back to potential output and the output gap to zero.
Inflationary Gap: when the output gap is positive, nominal wages eventually
rise, moving the economy back to potential output and the output gap to zero.
In the Long Run, the economy is self-correcting: shocks to AD affect output in the
short run but NOT in the long run.
Helpful hints:
1.
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3.
4.
SR EQ is where SRAS & AD intersect.
LR EQ is where all 3, SRAS, AD, & LRAS intersect.
Shocks move us away from LRAS but we always move back toward it.
Nominal wages will always follow the APL in the LR.