Macroeconomic equilibrium (ad

2. MACROECONOMIC EQUILIBRIUM
(AD/AS)
PREPARED BY :
UMAIR

3. MACROECONOMIC EQUILIBRIUM
 The interaction of aggregate demand and aggregate
supply determines macroeconomic equilibrium, and
understanding macroeconomic equilibrium provides
insight into changes in real GDP and the price level.
 In considering determination of real GDP and the price
level, however, we must distinguish between the short
run and the long run.

4. SHORT-RUN MACROECONOMIC EQUILIBRIUM
 Short-run macroeconomic equilibrium occurs
(geometrically) at the intersection of the short-run
aggregate supply curve (SRAS) and the aggregate
demand curve (AD).
 This intersection indicates the price level at which the
aggregate quantity of final goods and services supplied
in the economy is equal to the aggregate quantity
demanded, and indicates as well the corresponding level
of real GDP.

5. SHORT-RUN MACROECONOMIC EQUILIBRIUM

6. SHORT-RUN MACROECONOMIC EQUILIBRIUM
 To see that this point of intersection is an equilibrium point, consider
first a situation where the price level is below that corresponding to
the short-run equilibrium.
 At this price level, the quantity of real GDP that will be supplied by
firms will be less than the quantity of real GDP that will be
demanded by households, business firms, government, and net
foreign demand.
 With firms unable to meet demand, inventories decline and back
orders become the rule.
 In order to meet the strong demand, firms will begin to increase
production; and in so doing will incur additional resource costs that
will result in price increases (i.e., there will be a movement up along
the SAS curve).
 As prices increase, this will lead to a moderating of demand
(movement up along the AD curve). These movements will continue
until quantity supplied equals quantity demanded -- at the point of
intersection of the SAS and AD curves.

7. SHORT-RUN MACROECONOMIC EQUILIBRIUM
 Similarly, if the price level is greater than the equilibrium
level, the quantity of real GDP supplied will exceed the
quantity demanded.
 In this case, inventories will accumulate, goods and
services will go unsold, and eventually firms will lay off
workers, cut production, and reduce prices in order to
sell their output.
 This translates into a movement down along the SAS
curve, and as prices fall there will be a corresponding
movement down along the AD curve.
 These movements will continue until equilibrium is
reached.

8. LONG-RUN MACROECONOMIC EQUILIBRIUM
 Long-run macroeconomic equilibrium requires that real
GDP be equal to potential GDP, and corresponds to a
situation of full employment.
 That is, long-run macroeconomic equilibrium entails the
economy being on its vertical long-run supply curve.
 This contrasts with the short-run equilibrium situation, in
which real GDP may be less than or greater than (or
equal to) potential GDP.
 Let's take a look at the different possible short-run
situations vis-à-vis long-run equilibrium

9. LONG-RUN MACROECONOMIC EQUILIBRIUM
 Consider first the case where there is a short-run
equilibrium at a real GDP below the level of potential
GDP.
 This is called a below full-employment equilibrium, and
the difference between potential GDP and real GDP is
called a recessionary gap.
 A recessionary gap is associated with a business cycle
contraction.
 In any case, the most obvious manifestation of a
recessionary gap is the presence of high unemployment.

10. RECESSIONARY GAP

11. RECESSIONARY GAP
 If real GDP < Potential real GDP (full employment
GDP), then a recessionary gap exist.
 At the same time: Unemployment rate > natural rate of
unemployment.
 Since more job seekers are in the market, they tend to
settle with a lower wage.
 Lower wage will lower the AS curve (increase AS) and
causing the price to decrease.
 Lower price will increase consumption.
 This process will continue until the economy reaches the
long run equilibrium (potential real GDP).

12. LONG-RUN MACROECONOMIC EQUILIBRIUM
 Short-run equilibrium at a real GDP in excess of
potential GDP is called an above full-employment
equilibrium.
 The excess of real GDP over potential GDP is called an
inflationary gap.
 That is, this gap creates inflationary pressure.

13. INFLATIONARY GAP

14. INFLATIONARY GAP
 If real GDP > Potential real GDP (full employment
GDP), then an inflationary gap exist.
 At the same time: Unemployment rate < natural rate of
unemployment.
 Since job seekers are less than job openings in the
market, employers are forced to raise the wage to attract
new workers.
 High wage will decrease the AS (upward shift), and raise
the price.
 Higher price will lower consumption.
 This process will repeat until the long run equilibrium is
reached.

15. FULL-EMPLOYMENT EQUILIBRIUM
 The third possibility is with a short-run equilibrium at a
real GDP just equal to potential GDP.
 This is a full-employment equilibrium, and is the only
case where we have long-run equilibrium as well as
short-run equilibrium.

16. FULL-EMPLOYMENT EQUILIBRIUM

17. CHANGES IN AD
 First consider the consequences of an increase in
aggregate demand, as might occur
in response to increases in expected future incomes, profits,
or inflation;
in response to a lower exchange rate or higher foreign
incomes;
in response to fiscal policy increasing government spending
or transfer payments, or decreasing taxes;
or in response to expansionary monetary policy (increasing
the money supply) or lowering of interest rates.

18. CHANGES IN AD
 Increased aggregate demand will result in a new short-
run macroeconomic equilibrium, with a higher price
level and a higher level of real GDP.
 This results in demand-pull inflation.
 As AD rises, output rises, and unemployment falls.

19. CHANGES IN AD

20. CHANGES IN AS
 Similarly, changes in SAS can result in fluctuations in
real GDP around potential GDP.
 For example, a leftward shift of the SAS curve (as
would occur with an increase in factor prices) will bring
about a new short-run macroeconomic equilibrium, with
higher prices and lower real GDP than prior to the shift.
 It results in cost-push inflation.
 This combination of higher prices and reduced output is
known as stagflation.

21. CHANGES IN AS