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LONG RUN AGGREGATE SUPPLY • the amount of real output • the economy is able to supply • at different price levels • if the economy is at Natural Real GDP Transparency 6-1 NATURAL REAL GDP • the amount of output • the economy could produce • if it operated at full employment • called Qn or Qf Transparency 6-2 LONG RUN AGGREAGATE SUPPLY LRAS • vertical line • at full employment Real GDP • Qn = Qf Transparency 6-3 THREE POSSIBLE STATES OF THE ECONOMY • Full employment equilibrium • Recessionary gap • Inflationary gap Transparency 6-4 FULL EMPLOYMENT EQUILIBRIUM The intersection of SRAS and AD is equal to the Natural Real GDP Transparency 6-5 FULL EMPLOYMENT OUTPUT (other terms) • Potential GDP • the Natural Rate of Employment • the Natural Rate of Unemployment • QF or QN Transparency 6-6 FULL EMPLOYMENT EQUILIBRIUM PRICE LEVEL LRAS SRAS AD Qn Transparency 6-7 REAL GDP RECESSIONARY GAP • Short run equilibrium output is less than full employment • People are not spending enough to purchase all that has been produced (inventories increase) • unemployment is a concern Transparency 6-8 RECESSIONARY GAP LRAS PRICE LEVEL SRAS AD Q1 Transparency 6-9 Qn REAL GDP POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY • Recessionary gaps are eliminated by decreases in wages and other input prices • Graphically this is an increase in SRAS Transparency 6-10 Self-Regulating Economy Price Level Exhibit 2 (1 of 2) Part (a) SRAS1 The economy is in a recessionary gap at point 1. 1 P1 AD1 0 5,200 6,000 Unemployment rate is higher at $5,200 billion than at $6,000 Transparency 6-11 billion Suppose this is Natural Real GDP Real GDP (billions of base-year dollars) Self-Regulating Economy Exhibit 2 (2 of 2) Transparency 6-12 INFLATIONARY GAP • Equilibrium output is greater than full employment output • People are spending more than businesses anticipated and inventories are being drawn down • Inflation is a major concern Transparency 6-13 INFLATIONARY GAP Price Level LRAS SRAS Short-run equilibrium Long-run equilibrium AD 0 Transparency 6-14 QN Natural Real GDP POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY • Inflationary gaps are eliminated by increases in wages and input prices • Graphically, this is a decrease in SRAS Transparency 6-15 Self-Regulating Economy: Removing an Inflationary Gap Price Level Exhibit 3 (1 of 2) Part (a) SRAS1 1 P1 0 6,000 Suppose this is Transparency 6-16 Natural Real GDP 6,500 The economy is in an inflationary gap at point 1. AD1 Real GDP (billions of base-year dollars) Unemployment rate is lower at $6,500 billion than at $6,000 billion Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (2 of 2) Transparency 6-17 CLASSICAL ECONOMIC REASONING • Inflationary and Recessionary gaps will be automatically eliminated due to – flexible prices – flexible wages – flexible interest rates Transparency 6-18 CLASSICAL VIEW OF THE PRODUCT MARKET Transparency 6-19 SAY’S LAW SUPPLY CREATES ITS OWN DEMAND Transparency 6-20 REASONING BEHIND SAY’S LAW • People don’t work just to earn money. They work for the things that money can buy. • People don’t save just to hold the money. They save in order to invest. • All that is earned will be spent. Transparency 6-21