Equilibrium in the AD-AS Model

Short Run Equilibrium

• SR Equilibrium: the current level of national output (GDP) and price level given the levels of AD and SRAS of a particular period of time

• Negative (recessionary) output gaps: When output has decreased to a level below full employment

  • Ye + PLe < Yfe + PLfe

    • When equilibrium national output and the equilibrium price level are less than the full employment level of output and the full employment price level.

  • The AD curve = SRAS curve to the left of the LRAS curve

  • Effects of Recessionary Output Gaps

    • higher unemployment

    • failing wages

    • deflation

    • reduced confidence

• Positive (inflationary) output gaps: When output has increased to a level beyond employment

  • Ye + PLe > Yfe + PLfe

    • When equilibrium national output and the equilibrium price level are more than the full employment level of output and the full employment price level

  • The AD curve = SRAS curve to the right of the LRAS curve

  • Effects of Inflationary Output Gaps

    • higher prices

    • rising wages

    • less capacity → fewer resources

    • reduced economic growth

• Full Employment: What current output is what the company is capable of in the LR

  • Ye + PLe = Yfe + PLfe

    • When equilibrium national output and the equilibrium price level equals the full employment level of output and the full employment price level

  • The AD curve = SRAS curve = LRAS curve

Demand and Supply Shocks

• Aggregate Demand Shocks

  • positive: an increase in AD resulting from an increase in C, I, G, or Xn → shortage

    • demand-pull inflation → increase in prices & output

    • inflationary gap

  • negative: a decrease in AD stemming from a reduction in C, I, G, or Xn → surplus

    • deflation → decrease in prices & output

    • recessionary gap

• Aggregate Supply Shocks:

  • negative: an increase in the cost of production → shortage

    • cost-push inflation → higher prices & reduced output

  • positive: an increase due to the falling cost of production → surplus

    • deflation → lower prices & higher output

Long Run Equilibrium

• Equilibrium Long Run: the flexible wage period; the amount of time it takes for wages and other costs to fully adjust to changes in the price level

• LR Self-Correction: output returns to its natural rate despite fluctuations in demand

Economic Growth

• Economic Growth: an increase in a nation’s actual and potential output over time

  • growth rate = [(GDP2 - GDP1)/GDP1] x 100

• Sources of economic growth

  • increase in quantity of land, labor, or capital

    • technology, population growth/immigration, investment → increase in productivity

• “Recovery” vs “Growth”

  • recovery is when GDP increases following a recession

• short run economic growth is when only AD increase

• long run economic growth is when both AD and AS increase