Module 19 equilibrium in the aggregate demand aggregate supply modelPresentation Transcript
In the AD-AS model, the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations. This is the basic model used to understand economic fluctuations.
The point where the AD and the SRAS curve intersect is the short-run macroeconomic equilibrium. This is the point at which the quantity of aggregate output supplied is equal to the quantity demanded by domestic households, businesses, the government, and the rest of the world.
The aggregate price level at which macroeconomic equilibrium is reached is the short-run equilibrium aggregate price level. The level of output at which macroeconomic equilibrium is reached is the short-run equilibrium aggregate output. The short-run equilibrium aggregate output and the short-run equilibrium aggregate price level can change because of shifts in either the AD or the SRAS curve.
An event that shifts the AD curve, such as a change in expectations or wealth, the effect of the size in the existing stock of physical capital, or the use of fiscal or monetary policy, is known as a demand shock A positive demand shock will increase AD and shift the AD curve to the right; a negative demand shock will decrease AD and shift the AD curve to the left. Demand shocks cause aggregate demand output and aggregate price level to move in the same direction.
An event that shifts the SRAS curve, such as a change in commodity prices, nominal wages, or productivity, is known as a supply shock. A positive demand shock reduces production costs and increases the quantity supplied at any given aggregate price level, shifting the SRAS curve to the right. A negative supply shock raises production costs and reduces the quantity producers are willing to supply at any given price level, shifting the SRAS curve to the left.
Supply shocks cause the aggregate price level and aggregate output to move in opposite directions. The combination of inflation (rising price level) and falling aggregate output is called stagflation (stagnation plus inflation). Falling output leads to rising unemployment, while the purchasing power of money decreases due to the rise in prices. This situation creates a dilemma for policy- makers!
Long-run macroeconomic equilibrium is reached when the short-run macroeconomic equilibrium is on the long-run aggregate supply curve. We assume that enough time has passed so that the economy is in short-run macroeconomic equilibrium and on the long- run aggregate supply curve. So, the long-run macroeconomic equilibrium is at the intersection of all three curves: SRAS, AD, and LRAS.
LRASP SRASRICE LONG-RUN MACROECONOMIC EQUILIBRIUMLEVEL AD POTENTIAL REAL GDP OUTPUT
Changes in short-run macroeconomic can move the economy away from the long-run macroeconomic equilibrium. However, the economy is self-correcting in the long run.
If aggregate demand falls for any reason, aggregate output would be below potential output; in this case, the economy faces a recessionary gap. In the face of the high unemployment resulting from a recessionary gap, nominal wages eventually fall, which will lead producers to increase output. This process continues until the economy again attains potential output, but at a lower aggregate price level. The economy is in long-run macroeconomic equilibrium once again, see next graph:
Ifaggregate demand were to increase for any reason, aggregate output would be above potential output; in this case, the economy faces an inflationary gap. In the face of the low unemployment resulting from the inflationary gap, nominal wages will rise, which will lead producers to reduce output. This process continues until the economy again attains potential output, but at a higher aggregate price level. The economy is in long-run macroeconomic equilibrium once again, see the next graph:
If there is a recessionary gap, the output gap is negative. In this case, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero. If there is an inflationary gap, the output gap is positive. In this case, nominal wages eventually rise, moving the economy back to potential output and 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.