III. Explaining Macroeconomic Fluctuations

Short-Run and Long-Run Macroeconomic Equilibrium

• Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. This equilibrium is determined where the AD and SAS curves intersect.

· If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices.

· If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices.

• Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—equivalently, as the figure shows, when the economy is on its long-run aggregate supply curve. The figure shows the long-run macroeconomic equilibrium at a real GDP of $13 trillion and a price level of 110.

Economic Growth and Inflation

• Economic growth occurs when potential GDP increases so that the LAS curve shifts rightward.
• Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve. In the long run, only growth in the quantity of money makes the AD curve continually shift rightward.

The Business Cycle

The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP.

• A below full-employment equilibrium is a macroeconomic equilibrium in which potential GDP exceeds real GDP. The gap between real GDP and potential GDP is the output gap. With a below-full employment equilibrium, the gap is called a recessionary gap. A recessionary gap occurs when the SAS curve and the AD curve intersect to the left of the LAS curve.
• An above full-employment equilibrium is a macroeconomic equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP, the output gap, is called an inflationary gap. An inflationary gap occurs when the SAS curve and the AD curve intersect to the right of the LAS curve.
• A full-employment equilibrium is a macroeconomic equilibrium in which real GDP equals potential GDP.
• The figure below to the left shows a below-full employment equilibrium with a recessionary gap of $1 trillion. The figure on the right shows an above full-employment equilibrium with an inflationary gap of $1 trillion.

Fluctuations in Aggregate Demand

An increase in aggregate demand shifts the AD curve rightward, as in the figure where the aggregate demand curve shifts from AD0 to AD1. In the short run, a rightward shift of the AD curve leads to movement along the SAS curve so that both the price level and real GDP increase. In the figure the economy moves from an initial equilibrium at point a with real GDP equal to potential GDP of $13 trillion and a price level of 100 to point b with real GDP of $14 trillion and a price level of 105. But in the long run, the higher price level and tight labor market lead to an increase in the money wage rate. Short-run aggregate supply decreases and the SAS curve shifts leftward, in the figure from SAS0 to SAS1. The long-run equilibrium is reached when the short-run aggregate supply has decreased enough so that the economy is back producing at potential GDP, which in the figure occurs when the economy moves from b to point c. In the long run, the increase in aggregate demand has no effect on real GDP—it has returned to potential GDP, $13 trillion in the figure--and only results in a higher price level—which has risen from 100 to 110 in the figure.

Fluctuations in Aggregate Supply

Some business cycle fluctuations are driven by shifts in short-run aggregate supply. An increase in energy prices decreases the short-run aggregate supply and shifts the SAS curve leftward. The price level increases and real GDP decreases. The combination of recession and higher inflation is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks.

Date: 2015-12-11; view: 1082