We will now consider AD and AS together An economy’s equilibrium price level and real output

occur at the intersection of the AD and AS curves

10.3 Equilibrium

Inventory Increase & Decrease Imagine price level is above equilibrium price level, at “a” At “a”, real output exceeds real expenditures, i.e. more is

produced than purchased Businesses have a surplus “Positive Unplanned Investment” An unintended rise in

inventories causes businesses to lower prices until output and expenditures are at the same point, “B”

When price level is below eq. value “c”, there is an unintended fall in inventories, so businesses increase prices until equilibrium is reached, “b”

Inventory Changes

a a

b

c c

The Role of Unplanned Investment Whether there is an unintended increase or decrease

in inventory, unplanned investment plays a big role in stabilizing the economy

Unplanned Investment is the difference between AD and AS

The $20 trillion discrepancy between AD and AS at a price level of 100 means there is an unintended $20 trillion increase in inventories

Inventory Changes

Movement toward equilibrium can also be seen by looking at flows of income payments and purchases that connect resource and product markets 3 Flows/Injections that add to the main income-

spending stream in any economy: Investment (I) Government Purchases (G) Exports (X)

3 outward flows/Withdrawals Savings (S) Taxes (T) Imports (M)

Injections & Withdrawals

The amount saved and invested in an economy are different

Companies keep a portion of profits to reinvest Governments also borrow money International flows (borrowing from

foreign countries)

Investment and Saving

Transfer payments/business subsidies = “Negative Taxes”

At some points in time, government purchases exceed taxes, so they borrow money in financial markets

At other times, taxes exceed government purchases, so governments use excess revenues to pay off some outstanding debt

Government Purchases & Taxes

Typically, Canada imports more than it exports i.e. we spend more on products from the rest of the

world that receive revenues from selling products to rest of the world

Exports & Imports

While individual injections and withdrawals aren’t necessarily equal, they all balance each other overall, otherwise Canada’s economy wouldn’t be working as it is

Total Injections = I + G + X Total Withdrawals = S + T + M

If TI > TW, we have an expanding economy If TI < TW, we have a declining economy If TI = TW, we have equilibrium

Total Injections & Withdrawals

Recessionary GapsAn economy’s real output rarely equals its potential outputIf equilibrium output is below potential level, unemployment is above the natural unemployment rate

Difference between equilibrium output and potential output is known as a recessionary gapVertical, purple line is potential output

Equilibrium vs Potential Output

Inflationary GapsIf equilibrium output is above potential level, unemployment is below the natural unemployment rateInflation will accelerate if this situation persists

Difference between equilibrium output and potential output is known as an inflationary gapVertical, purple line is potential output

*Note* a recession differs from a recessionary gap. Coming up: during a recession, real output moves from above to below its potential level

Equilibrium vs Potential Output