Name ________________________
Section 4
Module 19: Equilibrium in the Aggregate Demand-Aggregate Supply Model
Lecture Notes
Pump Primer:
Explain the difference between a recessionary and inflationary gap
Learning objectives:
• The difference between short-run and long-run macroeconomic equilibrium.
• The causes and effects of demand shocks and supply shocks.
• How to determine if an economy is experiencing a recessionary gap or an inflationary gap
and how to calculate the size of output gaps.
Key Economic Concepts for This Module:
• The model assumes that the economy is always in a
state of short-run equilibrium where AD intersects
SRAS. However, this short-run equilibrium may not
coincide with potential GDP (Yp).
• If current real GDP differs from Yp, there is either a
recessionary or an inflationary gap in the short run.
• In the long run, when all prices are flexible, the model
predicts that SRAS will adjust so that AD, SRAS and
LRAS all intersect at Yp. This is shown in the key graph.
• External shocks to AD or SRAS affect the
equilibrium price level and real GDP.
Introduction
The purpose of this module is to combine the AD curve with the SRAS and LRAS curves to show
how the model describes equilibrium in the macroeconomy. External forces can “shock” either
AD or SRAS and cause both the aggregate price level and real GDP to rise above, or fall below,
potential GDP.
The AD-AS Model
The previous two modules have covered AD and AS separately. To model how the
macroeconomy comes to short-run and long-run equilibrium, we need to combine these two
curves and then we can show how external “shocks” affect the level of real GDP and the
aggregate price level.
Short-Run Macroeconomic Equilibrium

The model of AD/AS predicts a movement toward ___________________ just like the
micro model of supply and demand.
AD/AS Model
Supply and Demand Model

When the price level is above the intersection of AD and SRAS, there is a ___________
of aggregate output in the economy. When there is a surplus of output, prices begin to
fall.

When the price level is below the intersection of AD and SRAS, there is a ___________
of aggregate output in the economy. When there is a shortage of output, prices begin to
rise.

The AD/AS model presumes that the economy is usually in a state of _______________
equilibrium.
Shifts of Aggregate Demand: Short-Run Effects

An event that shifts the aggregate demand curve is known as a ____________ ________.

Suppose that consumers and firms become pessimistic about future income and future
earnings. This pessimism would cause AD to shift to the ________.
Both the aggregate price level and real GDP would _______. This would cause a
__________________.
(Note: The leftward shift of AD would cause Pe and Ye to both fall.)

Suppose that a healthy stock market has increased consumer wealth. This increase in
wealth would cause AD to shift to the _________.
Both the aggregate price level and real GDP would _________.
(Note: the instructor should show the students how the rightward shift of AD would cause
Pe and Ye to both rise.)
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(Note: The role that the government can play with fiscal and monetary policy, like a tax
cut, might affect the AD curve.)
Shifts of the SRAS Curve

An event that shifts the short-run aggregate supply curve is known as a ____________
_____________.

Suppose that commodity prices (oil, for example) rapidly increased. This would shift
SRAS to the left. This would increase aggregate price level and decrease real GDP. This
outcome can come to be known as _________________.
(Note: A leftward shift of SRAS would cause Pe to rise and Ye to fall.)

Suppose that labor productivity were to increase with better technology. This would shift
the SRAS to the ________. The aggregate price level would fall and real GDP would
________________.
(Note: A rightward shift of SRAS would cause Pe to fall and Ye to rise.)
Long-Run Macroeconomic Equilibrium

The model of AD/AS 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.
Why? Take a look at what happens when the economy
is not at Yp.

Adjustment to a negative AD shock.

Suppose that AD decreased and shifted the curve to the left.
In the short run, real GDP Ye ________ and is __________ Yp and the aggregate price
level would also _________.

The amount that GDP falls below potential output is called a _______________ ______.

What happens next?

The labor market is weakened by the poor economy and unemployment begins to _____
as workers are laid off.


Eventually nominal wages begin to _______.
As nominal wages fall, SRAS begins to shift to the _________.
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The recessionary gap begins to shrink because real
GDP is ______________.
Once real GDP has returned to Yp, the economy is back
in long-run equilibrium.
The price level has fallen even further

Adjustment to a positive AD shock.

Suppose that AD increased and shifted the curve to the right.
In the short run, real GDP Ye ____________ and is ____________ Yp and the aggregate
price level would also ________.

The amount that GDP rises above potential output is called a(n) _______________
_____.

What happens next?

The labor market is strengthened by the booming economy and unemployment begins to
________ as workers are hired.
Eventually nominal wages begin to ________.
As nominal wages rise, SRAS begins to shift to the ________.
The inflationary gap begins to shrink because real GDP is _____________.
Once real GDP has returned to Yp, the economy is back in long-run equilibrium.
The price level has increased even further.
(Note: the instructor should replicate the graphs to show the adjustment to a positive AD shock in
a similar manner to the graphs associated with the negative AD shock.)
Positive AD Shock (Fig. 19.6)
Negative AD Shock (Fig. 19.5)
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
Whenever the economy is out of long-run equilibrium, there is either a recessionary or
an inflationary gap. This ______________ ______ can be measured as a percentage Ye
lies away from Yp.

Output gap = 100 × (Ye – Yp)/Yp

Summarize:
 Recessionary gap: 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: 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.
 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.
Common Student Difficulties:



Students who practice shifting will develop a strong grasp of what external factors that shift AD
and SRAS.
Sometimes students wonder if the economy is currently in the short-run or the long-run. We are
always currently in the short run. Sometimes our short-run level of output happens to be below, or
above, the economy’s potential level of output.
If you have successfully worked through the previous module, the adjustment of nominal wages
to achieve the long-run equilibrium should be fairly painless. If not, this is a great opportunity to
review the adjustment process.
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