Macroeconomic Equilibrium and Shocks Study Guide

Macroeconomic Equilibrium in the Short Run and the Long Run

• Macroeconomic equilibrium is the central application of the aggregate demand and supply model, typically covered over at least three class lectures.

• Long-run equilibrium is defined by the intersection of the Long-Run Aggregate Supply ($LRAS$) and the Aggregate Demand ($AD$) curves.

• While the Short-Run Aggregate Supply ($SRAS$) curve also happens to pass through this point in long-run equilibrium, the defining characteristic is the intersection with $LRAS$.

• This intersection occurs at potential GDP, which represents the economy's normal operating level.

• At potential GDP, the only people who are unemployed are those experiencing frictional or structural unemployment.

• In long-run equilibrium, prices and wages have become "unstuck," meaning they have fully adjusted to economic conditions.

Key Characteristics of Short Run and Long Run Changes

• The analysis involves three types of changes: two demand shocks (leftward or rightward shifts in $AD$) and one negative supply shock.

• In the Short Run (SR):

  • Both the price level and real GDP (output) will change.

  • Every scenario analyzed results in a simultaneous shift in both price and output.

• In the Long Run (LR):

  • Output never changes from its starting point in the long term; it always returns to potential GDP.

  • The only variable that changes in the long run is the price level.

  • The economy starts at potential GDP ($Q^*$) and eventually returns to $Q^*$ after the adjustment process.

• Inverse Relationship of Output and Unemployment:

  • As output ($Y$) falls, unemployment rises.

  • As output ($Y$) rises, unemployment falls.

Negative Demand Shock: Mechanisms and Outcomes

• A negative demand shock occurs when aggregate demand ($AD$) shifts to the left.

• Scenario Example: Investment falls, or consumers become pessimistic about the economy and reduce spending.

• Point A: The starting point at long-run equilibrium where $AD$, $SRAS$, and $LRAS$ intersect at potential GDP ($Q^*$).

• The Shock: $AD$ shifts left to $AD_2$.

• Short Run Effect (Point B):

  • The new equilibrium is at the intersection of $SRAS$ and $AD_2$.

  • The price level falls from $P_1$ to $P_2$.

  • Real GDP/Output falls below potential GDP.

  • This decrease in output signals a recession and leads to higher unemployment.

• Potential Government Interventions (Optional):

  • Increase government spending.

  • Lower taxes.

  • The Federal Reserve (the Fed) can increase the money supply (as seen in the $2002 \text{ to } 2008$ period).

• The Automatic Adjustment Process (Without Intervention):

  • Due to high unemployment at Point B, workers eventually begin to accept lower wages because jobs are difficult to secure.

  • Expected price levels decline, and unit production costs for firms decrease.

  • As a result, the $SRAS$ curve shifts to the right ($SRAS_2$).

• Long Run Result (Point C):

  • The economy returns to the vertical $LRAS$ curve.

  • The price level falls further to $P_3$.

  • Output remains the same as it was at Point A ($Q^*$).

  • Conclusion: The only long-run effect of a decrease in aggregate demand is a decrease in the price level.

Positive Demand Shock: Mechanisms and Outcomes

• A positive demand shock occurs when aggregate demand ($AD$) shifts to the right.

• Scenario Example: Consumers are optimistic about the future, leading to an increase in consumption.

• Short Run Effect (Point B):

  • $AD$ shifts right to $AD_2$.

  • The price level rises (P_2 > P_1).

  • Output rises above potential GDP (Q_2 > Q^*), representing an economic expansion.

  • The economy operates beyond typical capacity (e.g., working $6 \text{ or } 7$ days a week, long hours, factories open longer).

  • Unemployment is lower than the normal/natural rate.

• The Automatic Adjustment Process:

  • Low unemployment creates intense competition for workers among firms.

  • Workers gain negotiating power and push for higher wages because each dollar buys fewer goods and services due to rising prices.

  • Firms start charging higher prices to cover increased labor costs.

  • The expected price level rises, causing the $SRAS$ curve to shift to the left.

• Long Run Result (Point C):

  • The $SRAS$ curve shifts left until it intersects $AD_2$ and $LRAS$.

  • The price level rises further to $P_3$.

  • Output remains at potential GDP ($Q^*$).

  • Conclusion: The only long-run effect of an increase in aggregate demand is a permanently higher price level.

Negative Supply Shock and the Phenomenon of Stagflation

• A negative supply shock is an unexpected event that causes the $SRAS$ curve to shift to the left.

• Scenario Example: A sudden and rapid increase in oil prices. Oil is a critical input for many products, so its cost affects the entire economy.

• Short Run Effect (Point B):

  • $SRAS$ shifts left.

  • Price level rises.

  • Output falls, leading to recession and high unemployment.

• Stagflation:

  • Definition: The combination of stagnation (falling output/recession) and inflation (rising prices).

  • This is considered a "double whammy" or worst-case scenario because the government cannot easily fix both problems simultaneously.

  • Increasing $AD$ to fix the recession would worsen inflation; decreasing $AD$ to fix inflation would worsen the recession.

• Historical Context: The $1970s$ oil crisis caused by war in the Middle East resulted in unemployment rates of $6\%$, $7\%$, or $8\%$ and double-digit inflation around $12\%$.

• Automatic Adjustment Process:

  • Massive unemployment eventually forces workers to accept lower wages.

  • As wages fall, production costs decrease, eventually shifting the $SRAS$ curve back to the right.

  • The economy eventually returns to Point A (Potential GDP) at the original price level.

• Summary of Supply Shock:

  • Like demand shocks, the short run involves a change in both price and output.

  • The long-run outcome returns the economy to potential GDP ($Q^*$).