Where does the aggregate demand curve and the short run aggregate supply curve intersect?

This chapter introduces the Aggregate Demand/Aggregate Supply model of macroeconomics. Read the introduction and Section 1 to learn about Aggregate Demand and the three effects (weath, interest rate, and international trade) that cause the downward slope. Recall the difference between quantity demanded and demand - the same logic applies to Aggregate Demand. Identify the variables that change (shift) the Aggregate Demand curve. Read this chapter and attempt the "Try It" exercises. You will revisit certain sections of the chapter later in this unit.

Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium

Recessionary and Inflationary Gaps

At any time, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. If employment is below the natural level of employment, real GDP will be below potential. The aggregate demand and short-run aggregate supply curves will intersect to the left of the long-run aggregate supply curve.

Suppose an economy's natural level of employment is Le, shown in Panel (a) of Figure 7.10 "A Recessionary Gap". This level of employment is achieved at a real wage of ωe. Suppose, however, that the initial real wage ω1 exceeds this equilibrium value. Employment at L1 falls short of the natural level. A lower level of employment produces a lower level of output; the aggregate demand and short-run aggregate supply curves, AD and SRAS, intersect to the left of the long-run aggregate supply curve LRAS in Panel (b). The gap between the level of real GDP and potential output, when real GDP is less than potential, is called a recessionary gap.

Figure 7.10 A Recessionary Gap

If employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b) shows the recessionary gap YP−Y1, which occurs when the aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the left of the long-run aggregate supply curve LRAS.

Just as employment can fall short of its natural level, it can also exceed it. If employment is greater than its natural level, real GDP will also be greater than its potential level. Figure 7.11 "An Inflationary Gap" shows an economy with a natural level of employment of Le in Panel (a) and potential output of YP in Panel (b). If the real wage ω1 is less than the equilibrium real wage ωe, then employment L1 will exceed the natural level. As a result, real GDP, Y1, exceeds potential. The gap between the level of real GDP and potential output, when real GDP is greater than potential, is called an inflationary gap. In Panel (b), the inflationary gap equals Y1−YP.

Figure 7.11 An Inflationary Gap

Panel (a) shows that if employment is above the natural level, then output must be above potential. The inflationary gap, shown in Panel (b), equals Y1−YP. The aggregate demand curve AD and the short-run aggregate supply curve SRAS intersect to the right of the long-run aggregate supply curve LRAS.

Review section 2 of Aggregate Demand and Aggregate Supply chapter assigned in 3.1, about short run aggregate supply and the way it differs from long-run aggregate supply.

KEY TAKEAWAYS

• The short run in macroeconomics is a period in which wages and some other prices are sticky. The long run is a period in which full wage and price flexibility, and market adjustment, has been achieved, so that the economy is at the natural level of employment and potential output.
• The long-run aggregate supply curve is a vertical line at the potential level of output. The intersection of the economy's aggregate demand and long-run aggregate supply curves determines its equilibrium real GDP and price level in the long run.
• The short-run aggregate supply curve is an upward-sloping curve that shows the quantity of total output that will be produced at each price level in the short run. Wage and price stickiness account for the short-run aggregate supply curve's upward slope.
• Changes in prices of factors of production shift the short-run aggregate supply curve. In addition, changes in the capital stock, the stock of natural resources, and the level of technology can also cause the short-run aggregate supply curve to shift.
• In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the aggregate demand and the short-run aggregate supply curves. In the short run, output can be either below or above potential output.