Equilibrium: Real Equilibrium: Real Output (GDP) & the Output (GDP) & the

Price LevelPrice Level

Unit 3 Part 5Unit 3 Part 5

Krugman Section 4 Module 19Krugman Section 4 Module 19

ReviewReview

Equilibrium PL and Y are found where Equilibrium PL and Y are found where the AD and AS curves intersect.the AD and AS curves intersect.

See skeleton graphSee skeleton graph

Decreases in ADDecreases in AD

If AD decreases, recession and cyclical If AD decreases, recession and cyclical unemployment may result (prices unemployment may result (prices don’t fall easily)don’t fall easily)– 1. wage contracts are not flexible (or 1. wage contracts are not flexible (or

sticky) so businesses cannot afford to sticky) so businesses cannot afford to reduce pricesreduce prices

– 2. employers are reluctant to cut wages 2. employers are reluctant to cut wages because of impact of employee effortbecause of impact of employee effort

– 3. fear of price wars keep prices from 3. fear of price wars keep prices from being reduced alsobeing reduced also

Shifting ASShifting AS

Leftward shift in the curve illustrates Leftward shift in the curve illustrates cost-push inflationcost-push inflation

Rightward shift in curve will cause a Rightward shift in curve will cause a decline in price leveldecline in price level

Manipulating the AS and AD Manipulating the AS and AD modelmodel

Read each scenario. Draw a correctly Read each scenario. Draw a correctly labeled AD and AS graph to illustrate labeled AD and AS graph to illustrate each short-run impact. You do not each short-run impact. You do not need to graph the LRAS at this point.need to graph the LRAS at this point.

During a long, slow recovery from a During a long, slow recovery from a recession, consumers postponed major recession, consumers postponed major purchases. Suddenly they begin to purchases. Suddenly they begin to buy cars, refrigerators and furnaces to buy cars, refrigerators and furnaces to replace their failing models.replace their failing models.

PL

Real GDP

SRAS

ADAD2

AD will increase as a result of increased consumer spending

PL1

Y1

PL2

Y2

With no other dramatic changes, the With no other dramatic changes, the government raises taxes & reduces government raises taxes & reduces transfer payments in the hope of transfer payments in the hope of balancing the federal budget.balancing the federal budget.

PL

Real GDP

SRAS

ADAD2

Higher taxes and a reduction in transferpayments reduceDI, which reducesconsumer spending.

PL2

Y2

PL1

Y1

Because of rising tensions in many Because of rising tensions in many developing countries, firms begin to build new developing countries, firms begin to build new factories infactories in Econoland.Econoland.

PL

GDPr

AD

SRAS

AD2

The increase in investment spendingwill increase AD.

P1

Y1 Y2

P2

Econoland’s factories have Econoland’s factories have to pay for pollution clean to pay for pollution clean

up.up.PL

GDP

PL1

Y1

SRAS

AD

SRAS2

PL2

Y2

SRAS to the leftdue to gov’t regulationof pollution clean up—Input price

News of possible future layoffs News of possible future layoffs frightens the public into reducing frightens the public into reducing spending and increasing saving for spending and increasing saving for the feared “rainy day.”the feared “rainy day.”

PL

GDPr

SRAS

ADAD2

A decrease inconsumer confidencedecreases consumptionspending.

PL1

Y1

PL2

Y2

Brazil solves its foreign debt and Brazil solves its foreign debt and inflation problems. It then orders $10 inflation problems. It then orders $10 billion worth of capital machinery from billion worth of capital machinery from Econoland. Draw the AD and SRAS Econoland. Draw the AD and SRAS graph for Econoland.graph for Econoland.PL

GDPr

AD

SRAS

AD2

Econoland’s exportsincrease. AD increases.

PL1

Y1

PL2

Y2

OPEC decided to lower the OPEC decided to lower the price of oil.price of oil.

PL

GDP

PL1

Y1

SRAS

AD

SRAS2

PL2

Y2

SRAS to the right due to cheaper input prices