Skip to main content

Macroeconomics: equilibrium in the AD/AS model

Real output and price level in the AD/AS model:
  • The short run equilibrium in the AD/AS model, is when the  intersection between the short run aggregate supply curve and the aggregate demand curve determines the level of output and price level.
       
  • This short equilibrium output can be compared to the full-employment (i.e long run equilibrium) output by adding the long run aggregate supply curve in the graph. 
    • If the difference between the short run equilibrium output and full employment output is negative than we have a recessionary gap. This could be caused by a decrease in households' consumption, a fall in private investments, or a decrease in government spending.
    • If the difference is positive, we have an inflationary gap, where the short run equilibrium output is bigger than its full employment output. This can be caused by an increase in households expenditures, expansionary fiscal policy, etc...
    • If the gap is zero, this means that the short run equilibrium output occurs at the full employment level of output. This means that this nation is achieving its macroeconomics objectives of stable prices (i.e stable inflation rate), and full employment. Thus, in the long run, its price level and output will not change.
Short run to long run AD/AS model:
  • In the long run a nation will always produce at its full employment level of output, regardless of its AD curve.
  • In the long run, wages and prices are perfectly flexible. Following a decrease in the aggregate demand, in the long run:
    • The SRAS shifts to the right, since firms are layoff workers. This increase in the size of the unemployed in the labor force causes the wage rate to fall.  
    • Output return to full employment because the lower prices (thanks to lower wages) increase the quantity of national output demanded over time.
    • The workers' nominal wages are lower, however the real wages (represented by real income, i.e GDP) are the same as they used to be before the fall in AD.
  • In this example, the movement in the SRAS relies on the fall in wages. However, this might take a long time. It might be quicker to "push" the AD to the right via fiscal expansionary policies.
  • Following an increase in the AD in the long run:
    • The SRAS will shift to the left as unemployment rate falls below the NRU, increasing the scarcity of labor, driving up the wage rate.
    • Output will return to the full employment level since higher prices caused by the higher wages will reduce the quantity of national output demanded over time.
    • workers' nominal wages are higher, but their real wages are the same as they were before the increase in AD.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 135-142.
    Labels:
    Location: New York, NY, USA

    Comments

    Post a Comment

    Popular posts from this blog

    Microeconomics: Firms and cost in the short run

    In Economics, the term short run refers to a time period where at least one variable of interest does not change . In our case, the short run for a firm is when at least one input  (labor, land, capital) stays fixed. Usually land and capital are considered fixed in the short run.  If an input is fixed during a period time, no matter how much the total product a firm produces, its cost stays the same. This cost is commonly known as fixed cost (FC). Examples of fixed costs: rent, property taxes, loan payments. Labor is often considered to be a part of the  variable cost (VC) . Variable cost can be defined as the cost a firm has control over during the short run. Unlike fixed cost, variable cost increases (decreases) as a firm's total product increases (decreases). Examples of variable costs include: utility bills, wages, raw materials A firm's total cost (TC) is the sum of its variable and fixed costs. As you can see, the fixed cost...
    Post a Comment
    Read more

    Microeconomics: Shift in Supply

    We recently talked about the factors that cause a shift in the demand. It is now time to discuss the factors that shift the supply curve which cause the equilibrium price and demand to change. Determinants of Supply: changes in supply are caused by changes in the price of inputs, the number of firms in the market, technology, changes in the price of related goods and services, and changes in expected prices. An increase (decrease) in the price of an input results in less (more) supply as per unit production costs rise (fall). More competition increases supply, and less competition leads to less supply. If a new firm enters the market for good X, then the supply of good X increases. Improvement in technology can result in an increase in the ability of producers to supply their products. For example, the invention of the printing press increased the supply of books. An increase (decrease) in the price of a related good leads to an increase (decrease) in the supply of the other...
    Post a Comment
    Read more

    Macroeconomics: measuring the inflation rate and its impact on the economy

    Inflation and deflation: Inflation: an increase in the average price level of a nation's output over time. If a country is experiencing inflation, the inflation rate must be positive. Inflation rate is the percentage change in the price level between one period and a previous period. Deflation: a decrease in the average price level of a nation's output over time. deflation means that the inflation rate must be negative.  Inflation as a macroeconomic indicator: Inflation reduces real incomes of households, thereby reducing their standard of living. Deflation reduces the incentive for firms to invest, it negatively impact borrowers (both firms and households). By knowing the rate of change in price level, policy-makers can implement targeted policies to keep the price level stable. Shortcomings of inflation as an economic indicator: Inflation is derived from a price index (e.g CPI), which estimates a change in prices based on a particular selection of goods. If the index fails to...
    Post a Comment
    Read more