Equilibrium in the AD/AS Model
Module 19
Learning Objectives
• The difference between short-run and longrun 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 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. (shown in graph below)
Key Economic Concepts for this
Module (cont.)
• External shocks to AD or SRAS affect the
equilibrium price level and real GDP.
Remember:
• 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.
The AD-AS Model
•
•
•
•
A. Short-Run Macroeconomic Equilibrium
B. Shifts of AD: Short-Run Effects
C. Shifts of SRAS Curve
D. Long-Run Macroeconomic Equilibrium
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 equilibrium just like the micro model of
supply and demand.
• When the price level is above the intersection of
AD and SRAS, there is a surplus of aggregate
output in the economy, and prices begin to fall.
• When the price level is below the intersection of
AD and SRAS, there is a shortage of aggregate
output in the economy, and prices begin to rise.
Short-Run Macroeconomic Equilibrium
The AD/AS model presumes that the economy is usually in a state of short-run
equilibrium.
Shifts of the Aggregate Demand:
Short-Run Effects
• An event that shifts the aggregate demand curve
is known as a demand shock.
• Suppose that consumers and firms become
pessimistic about future income and future
earnings.
• This pessimism would cause AD to shift to the
left.
• Both the Aggregate price level and real GDP
would fall.
• This would cause a recession.
Shifts of the SRAS Curve
• An event that shifts the short-run aggregate
supply curve is known as a supply shock.
• 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
stagflation.
Shifts of the SRAS Curve
• Suppose the labor productivity were to
increase with better technology.
• This would shift the SRAS to the right.
• The aggregate price level would fall and real
GDP would increase.
Long-Run Equilibrium
• The model of AD/AS that 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 falls and is below Yp and the aggregate price level would also fall.
The amount that GDP falls below potential output is called a recessionary gap.
Long Run Equilibrium (cont.)
• What happens next?
• The labor market is weakened by the poor economy
and unemployment begins to rise as workers are laid
off.
• Eventually nominal wages begin to fall.
• As nominal wages fall, SRAS begins to shift to the right.
• The recessionary gap begins to shrink because real GDP
is rising.
• Once real GDP has returned to Yp, the economy is back
in long-run equilibrium.
• The price level has fallen even further.
Long Run Equilibrium (cont.)
• Adjustment to a positive AD shock:
• Suppose that AD increased and shifted the
curve to the right.
• In the short run, real GDP Ye increases and is
above Yp and the aggregate price level would
also rise.
• The amount that GDP rises above potential
output is called an inflationary gap.
Long Run Equilibrium (cont.)
• What happens next?
– The labor market is strengthened by the booming
economy and unemployment begins to fall as
workers are hired.
– Eventually nominal wages begin to rise.
– The inflationary gap begins to shrink because real
GDP is falling.
– Once real GDP has returned to Yp, the economy is
back in long-run equilibrium.
– The price level has increased even further.
Long Run Equilibrium (cont.)
• Whenever the economy is out of long-run
equilibrium, there is either a recessionary or
an inflationary gap.
• This output gap can be measured as a
percentage Ye lies away from Yp.
• Output gap = 100 x (Ye – Yp)/Yp
In Summary
• Recessionary Gap:
– Output gap is negative
– Nominal wages eventually fall, moving the ecoomy 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.
• 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.
Assignment: Lesson 5; Activity 25