MODULE 19 EQUILIBRIUM IN THE

AGGREGATE DEMAND &

AGGREGATE SUPPLY MODEL

Module 19 Essential Questions

1. What is the difference between short-run and long-run macroeconomic equilibrium?

2. What are the causes and effects of demand shocks and supply shocks?

3. How is it determined if an economy is experiencing a recessionary gap or an inflationary gap? How is the size of the output gaps calculated?

The AD-AS Model: Why is it used? Notes:

The AD-AS Model: Why is it used?

1. Aggregate Demand + Aggregate Supply

2. Macroeconomic short-run and long-run equilibrium entails combining these 2 curves to show how external “shocks” affect the level of real GDP and the aggregate price level.

What Do We want? Equilibrium! When Do We Want It? Now!

The model of AD/AS predicts a movement toward equilibrium just like the micro model of supply and demand.

The AD/AS model presumes that the economy is usually in a state of short-run equilibrium.

How Does the AD/AS Model Work? A Review

Draw a correctly labeled graph of AD & SRAS in macroeconomic equilibrium. In the first model, illustrate a surplus. In the 2nd model, illustrate a shortage.

When the price level is above the intersection of AD and SRAS, there is a surplus of aggregate output in the economy. When there is a surplus of output, prices begin to fall.

When the price level is below the intersection of AD and SRAS, there is a shortage of aggregate output in the economy. When there is a shortage of output, prices begin to rise.

Shifts of Aggregate Demand: Short-Run Effects

•Demand Shock

•Negative Demand Shock

•Positive Demand Shock

Review: Demand Shocks Caused By…

I. Change in ___________II. Change in _____________III. Size of existing stock of

____________ __________IV. Government Policies

a. ________ _________b. __________ _________

Demand Shocks can be negative (G_________D_________)

Demand Shocks can be positive (gov’t spending during W_____)

Review: Demand Shocks Caused By…

I. Change in ExpectationsII. Change in WealthIII. Size of existing stock of Physical

CapitalIV. Government Policies

a. Fiscal Policyb. Monetary Policy

Demand Shocks can be negative (Great Depression)

Demand Shocks can be positive (gov’t spending during WWII)

Demand Shock: Negative

1. An event that shifts the aggregate demand curve is known as a d__________s________.

2. Suppose that consumers and firms become pessimistic about future income and future earnings. This pessimism would cause _____to shift to the _____. Both the aggregate price level and real GDP would fall. Describe this phenomenon. ____________.

3. Why do price levels and real GDP fall when AD declines?

Demand Shock: Negative

1. An event that shifts the aggregate demand curve is known as a demand shock.

2. Suppose that consumers and firms become pessimistic about future income and future earnings. This pessimism would cause AD to shift to the left. Both the aggregate price level and real GDP would fall. Describe this phenomenon. A recession.

3. Why do price levels and real GDP fall when AD declines?

Demand Shock: Positive

Suppose that a healthy stock market has increased consumer wealth.This increase in wealth would cause _____to shift to the _______. Both the aggregate price level and real GDP would rise. 1. How might a tax cut (right now)

affect the AD curve?2. Draw it.3. Demand Shocks: Aggregate

price level & output move in the _____________direction.

 

Demand Shock: Positive

Suppose that a healthy stock market has increased consumer wealth.This increase in wealth would cause AD to shift to the right.Both the aggregate price level and real GDP would rise. 1. How might a tax cut (right

now) affect the AD curve?2. Draw it.3. Demand Shocks: Aggregate

price level & output move in the SAME direction.

 

Shifts of the SRAS Curve

• Supply Shock

• Negative Supply Shock

• Stagflation

• Positive Supply Shock

Review Supply Shocks Caused By…

1. Change in C_____________ p________

2. Change in N__________ W_________

3. P_____________ Supply Shocks can be positive

(I_________ B_____ 1995 to 2000)

Supply Shocks can be negative (O______C______ 1973 – 1979)

Review Supply Shocks Caused By…

1. Change in Commodity prices

2. Change in Nominal Wages3. Productivity Supply Shocks can be positive

(Internet Boom 1995 to 2000)

Supply Shocks can be negative (Oil Crisis 1973 – 1979)

Supply Shock: Negative

1. An event that shifts the short-run aggregate supply curve is known as a s_________s________.

2. Suppose that commodity prices (oil, for example) rapidly increased. What would this do to SRAS?

3. This outcome can come to be known as s___________.

Draw a negative Supply Shock here

Supply Shock: Negative

1. An event that shifts the short-run aggregate supply curve is known as a supply shock.

2. Suppose that commodity prices (oil, for example) rapidly increased. What would this do to SRAS?

3. This would increase aggregate price levels and decrease real GDP. This would shift SRAS to the left.

4. This outcome can come to be known as stagflation.

Stagflation is the WORST!! QUIZ

1. A negative supply shock occurs and leads to l_________ aggregate output and a higher a________ p_________ l_________.

2. Real GDP goes d________; Unemployment goes u______; Prices go u________; Money loses v________; Disposable income goes d________; Consumer confidence goes d___________;Consumer spending goes d________.

Stagflation is the WORST!! QUIZ

A negative supply shock occurs and leads to lower aggregate output and a higher aggregate price level.

Real GDP goes DOWN; Unemployment goes UP; Prices go UP, Money loses VALUE; Disposable income goes DOWN; Consumer confidence goes DOWN; Consumer spending goes DOWN.

Supply Shock: Positive

1. Suppose that labor productivity were to increase with better technology. What would happen to SRAS?

2. The aggregate price level would f____ and real G_____ would i__________.

3. Draw the positive supply shock.

4. Supply Shocks: Aggregate price level and output move in ____________ directions.

Supply Shock: Positive

1. Suppose that labor productivity were to increase with better technology. What would happen to SRAS?

This would shift the SRAS to the right.

2. The aggregate price level would fall and real GDP would increase.

3. Draw the positive supply shock.

4. Supply Shocks: Aggregate price level and output move in opposite directions.

Terms to Know

Long Run Macroeconomic Equilibrium: when short run macro equilibrium is on the long run aggregate supply curve

Recessionary gap: aggregate output (RGDP) is below potential output

Inflationary gap: aggregate output (RGDP) is above potential output

Output gap: % difference between actual aggregate output and potential output

Self correcting: shocks to aggregate demand affect the short run aggregate output, but not long run

Long-Run Macroeconomic Equilibrium

• Long-Run Macroeconomic Equilibrium

• Recessionary Gap

• Self-Correction

• Inflationary Gap

• Self-Correction

• Output Gap

Recessionary Gap: An Explanation

AD/AS model predicts that in the long run, when all prices (including wages) are flexible, that the AD, SRAS and LRAS curves will all intersect at potential output Yp.

What happens when the

economy is not at Yp? (potential output)

Suppose that AD decreased and shifted the curve to the left.

In the short run, real GDP falls and is below Potential Real GDP (Yp) and the aggregate price level also falls.

The amount that GDP falls below potential output is called a recessionary gap.

The Rest of the Recessionary Gap Story

What happens next?1. Labor market goes d_________ or w_________; 2. Unemployment begins to r_____because workers

are ______ off. 3. Eventually nominal wages begin to f_____

because there is a s________ of workers.4. As nominal wages fall, SRAS begins to shift to the

r_______because wages are an i_____ c____.5. Lower i______costs lead to higher real _____.6. The recessionary gap begins to shrink because real

_____is r______.7. Once real GDP has returned to Yp, the economy is

back in l_____-r____equilibrium.8. Price level f______ even further.

The Rest of the Recessionary Gap Story

What happens next?1. Labor market goes down or weakens; 2. Unemployment begins to rise because workers

are laid off. 3. Eventually nominal wages begin to fall because

there is a surplus of workers.4. As nominal wages fall, SRAS begins to shift to

the right because wages are an input cost.5. Lower input costs lead to higher real GDP.6. The recessionary gap begins to shrink because

real GDP is rising.7. Once real GDP has returned to Yp, the economy

is back in long-run equilibrium.8. Price level falls even further.

Inflationary Gap: An Explanation

Suppose that AD increased and shifted the curve to the right.

In the short run, real GDP (Ye) increases and is above Yp (Potential GDP) and the aggregate price level also rises.

The amount that GDP rises above potential output is called an inflationary gap.

What happens next?

1. The labor market grows s__________by the booming economy.

2. Unemployment begins to f________as workers are h_______.

3. Eventually n__________ w_______ begin to rise. 4. As nominal wages r_______, SRAS begins to shift to

the l______.5. The inflationary gap begins to d________because

real _______is falling.6. Once real GDP has returned to Yp, the economy is

back in l_______-r_______ equilibrium.7. The price level i____________even further.

The Rest of the Inflationary Gap Story

What happens next?

1. The labor market grows stronger by the booming economy.

2. Unemployment begins to fall as workers are hired. 3. Eventually nominal wages begin to rise. 4. As nominal wages rise, SRAS begins to shift to the

left.5. The inflationary gap begins to decrease because real

GDP is falling.6. Once real GDP has returned to Yp, the economy is

back in long-run equilibrium.7. The price level increases even further.

The Rest of the Inflationary Gap Story

Summary Whenever the economy is out of long-run equilibrium, there is

either a r____________or an i_____________gap. This output gap can be measured as a percentage Ye lies away

from Yp. Output gap = 100*(Ye – Yp)/Yp

Recessionary gap: output gap is n__________, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero.

Inflationary gap: output gap is p__________, 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 s_____- c___________: shocks to aggregate demand affect aggregate output in the short run but not in the long run.

Summary Whenever the economy is out of long-run equilibrium, there is

either a recessionary or an inflationary gap. This output gap can be measured as a percentage Ye lies away

from Yp. Output gap = 100*(Ye – Yp)/Yp

Recessionary gap: 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: 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.

Module 19 Review p. 197-198Read Module 20 p. 199-207