Transparency 6-1

LONG RUN AGGREGATE SUPPLYLONG RUN AGGREGATE SUPPLY

• the amount of real output

• the economy is able to supply

• at different price levels

• if the economy is at Natural Real GDP

Transparency 6-2

NATURAL REAL GDPNATURAL REAL GDP

• the amount of output

• the economy could produce

• if it operated at full employment

• called Qn or Qf

Transparency 6-3

LONG RUN AGGREAGATE SUPPLYLRAS

LONG RUN AGGREAGATE SUPPLYLRAS

• vertical line

• at full employment Real GDP

• Qn = Qf

Transparency 6-4

THREE POSSIBLE STATES OF THE ECONOMY

THREE POSSIBLE STATES OF THE ECONOMY

• Full employment equilibrium

• Recessionary gap

• Inflationary gap

Transparency 6-5

FULL EMPLOYMENT EQUILIBRIUMFULL EMPLOYMENT EQUILIBRIUM

The intersection of SRAS and AD is equal to the

Natural Real GDP

Transparency 6-6

FULL EMPLOYMENT OUTPUT(other terms)

FULL EMPLOYMENT OUTPUT(other terms)

• Potential GDP

• the Natural Rate of Employment

• the Natural Rate of Unemployment

• QF or QN

Transparency 6-7

FULL EMPLOYMENT EQUILIBRIUMFULL EMPLOYMENT EQUILIBRIUM

PRICE LEVEL

REAL GDP

AD

SRASLRAS

Qn

Transparency 6-8

RECESSIONARY GAPRECESSIONARY GAP

• Short run equilibrium output is less than full employment

• People are not spending enough to purchase all that has been produced (inventories increase)

• unemployment is a concern

Transparency 6-9

RECESSIONARY GAPRECESSIONARY GAP

PRICE LEVEL

REAL GDP

AD

SRAS

LRAS

QnQ1

Transparency 6-10

POLICY IMPLICATIONS OF A SELF REGULATING ECONOMYPOLICY IMPLICATIONS OF A

SELF REGULATING ECONOMY

• Recessionary gaps are eliminated by decreases in wages and other input prices

• Graphically this is an increase in SRAS

Transparency 6-11

Self-Regulating Economy Exhibit 2 (1 of 2)

Self-Regulating Economy Exhibit 2 (1 of 2)

Price Level

Supposethis is

NaturalReal GDP

SRAS1

0

P1

AD1

Part (a)

1 The economy is in arecessionary gap at

point 1.

5,200 6,000

Unemployment rateis higher at $5,200

billion than at $6,000billion

Real GDP(billions ofbase-yeardollars)

Transparency 6-12

Self-Regulating Economy Exhibit 2 (2 of 2)Self-Regulating Economy Exhibit 2 (2 of 2)

Transparency 6-13

INFLATIONARY GAPINFLATIONARY GAP

• Equilibrium output is greater than full employment output

• People are spending more than businesses anticipated and inventories are being drawn down

• Inflation is a major concern

Transparency 6-14

INFLATIONARY GAPINFLATIONARY GAP

Price Level

NaturalReal GDP

SRAS

0

AD

QN

LRAS

Long-runequilibrium

Short-runequilibrium

Transparency 6-15

POLICY IMPLICATIONS OF A SELF REGULATING ECONOMYPOLICY IMPLICATIONS OF A

SELF REGULATING ECONOMY

• Inflationary gaps are eliminated by increases in wages and input prices

• Graphically, this is a decrease in SRAS

Transparency 6-16

Self-Regulating Economy: Removing an Inflationary Gap

Exhibit 3 (1 of 2)

Self-Regulating Economy: Removing an Inflationary Gap

Exhibit 3 (1 of 2)Price Level

Suppose this isNatural Real GDP

SRAS1

0

P1

AD1

Part (a)

1 The economy is in aninflationary gap at

point 1.

6,5006,000

Unemployment rate islower at $6,500 billionthan at $6,000 billion

Real GDP(billions ofbase-yeardollars)

Transparency 6-17

Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (2 of 2)

Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (2 of 2)

Transparency 6-18

CLASSICAL ECONOMIC REASONINGCLASSICAL ECONOMIC REASONING

• Inflationary and Recessionary gaps will be automatically eliminated due to

– flexible prices

– flexible wages

– flexible interest rates

Transparency 6-19

CLASSICAL VIEW OF THE PRODUCT MARKETCLASSICAL VIEW OF THE PRODUCT MARKET

Transparency 6-20

SAY’S LAWSAY’S LAW

SUPPLY CREATES ITS OWN DEMAND

Transparency 6-21

REASONING BEHIND SAY’S LAWREASONING BEHIND SAY’S LAW

• People don’t work just to earn money. They work for the things that money can buy.

• People don’t save just to hold the money. They save in order to invest.

• All that is earned will be spent.