ECO 102: LECTURE 3: AGGREGATE DEMAND & AGGREGATE SUPPLY 2 1. Macroeconomic Equilibrium Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve. SHAPE \* MERGEFORMAT If real GDP is below equilibrium GDP, firms increase production and raise prices If real GDP is above equilibrium GDP, firms decrease production and lower prices. In short-run equilibrium, the money wage is fixed. It does not adjust to bring full employment. So in the short-run, real GDP can be greater or less than the potential GDP. Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP?when the economy is on its LAS curve. SHAPE \* MERGEFORMAT In the long-run macroeconomic equilibrium, real GDP = potential GDP. Hence, the long-run equilibrium occurs where AD intersects the LAS. In the long run, AD determines the price level and has NO effect on real GDP. In the long run, the money wage adjustment has adjusted to put the SAS curve through the long-run equilibrium (we will look at this money wage adjustment later). Economic growth and inflation Economic growth occurs because the quantity of labor grows, capital is accumulated, and technology advances, all of which increase potential GDP and bring a rightward shift of the LAS curve. SHAPE \* MERGEFORMAT Inflation occurs because the aggregate demand increases by more than long-run aggregate supply. In the long run, the main influence on aggregate demand is the growth rate of the quantity of money. SHAPE \* MERGEFORMAT The business cycle The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate but the money wage does not change rapidly enough to keep real GDP at potential GDP. A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP. The amount by which potential GDP exceeds real GDP is called a recessionary gap. SHAPE \* MERGEFORMAT A long-run equilibrium is an equilibrium in which potential GDP equals real GDP. SHAPE \* MERGEFORMAT An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP is called an inflationary gap. SHAPE \* MERGEFORMAT In summary, the economy moves from one type of equilibrium to another as a result of fluctuations in real GDP and the price level. We are now going to look at some of the sources of these fluctuations around potential GDP. Fluctuation in AD One reason real GDP fluctuates around potential GDP is that aggregate demand fluctuates. Short-run effect SHAPE \* MERGEFORMAT Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward (e.g. increase in exports by foreign citizens). SHAPE \* MERGEFORMAT Faced with an increase in demand, firms increase production and raise prices. Real GDP exceeds potential GDP, and there is an inflationary gap. At this stage, prices of goods and services have increased but wage rates have not changed. Long-run effect The economy cannot produce in excess of potential GDP forever. There are forces at work that bring real GDP back to potential GDP. SHAPE \* MERGEFORMAT Because the price level has ( and the money wage rate is unchanged, workers? purchasing power of their wage ( . In this case, workers demand higher wages. Firms, which are anxious to maintain their employment and output levels, meet those demands. As money wage (, the SAS shifts to left. Along the adjustment path, real GDP ( and the price level ( as the economy moves along its AD curve. Eventually, the money wage ( by the same % as the price level. New equilibrium is reached when AD1 intersects SAS1; real GDP is back at potential GDP. Fluctuations in Aggregate Supply Fluctuations in short-run aggregate supply can bring fluctuations in real GDP around potential GDP. SHAPE \* MERGEFORMAT Starting at long-run equilibrium, a rise in the price of oil decreases short-run aggregate supply and the SAS curve shifts leftward. Why? As oil price (, firms face higher energy and transportation costs, and hence ( production. This causes the aggregate supply to ( and SAS shift to the left. There is inflation because of the price increase. There is recession because real GDP has fallen. A combination of recession and inflation is called stagflation. PAGE PAGE 1
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