Download The AD-AS Model

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Equilibrium in the Aggregate Demand/Aggregate Supply Model

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.
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Demand Shock: an event that shifts the aggregate demand
curve
AD shift to the left
o Aggregate price level ↓and real GDP ↓
o This causes a recession

AD shift to the right
o Aggregate price level ↑and ↑real GDP
o This causes inflation
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Supply shock: an event that shifts the short-run aggregate
supply curve
SRAS shift to the left
o Aggregate price level ↑ and real GDP ↓
o This causes stagflation
o 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

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.
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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.
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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 selfcorrecting adjustments that shift the SRAS curve.
 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 output
o 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
 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