Macroeconomics

2.2 SHORT-RUN AGGREGATE SUPPLY

&
SHORT-RUN EQUILIBRIUM IN THE AD-AS
MODEL
Learning outcomes
Learning outcomes
 The short-run & long-run in Macroeconomics

The short run in macroeconomics is the period of

time when prices of resources are roughly constant
or inflexible (they do not change much in response to
supply and demand)
The long run in macroeconomics is the period of
time when the prices of all resources, including the
price of labour (wages), are flexible and change along
with changes in the price level.
Wage rigidity in the short-run
1. There is a positive (direct)relationship
between the price level and real GDP
supplied
2. A higher price level is associated with a
greater quantity of real GDP
3. A lower price level with a lower
quantity of real GDP.
 Why the SRAS curve is upward-sloping

firm profitability
when there is an increase in the price level—this
means that output prices have increased; but with
unchanging resource prices (since the economy is in
the short run), firms’ profits increase.
As production becomes more profitable, firms
increase the quantity of output produced, resulting
in the positive relationship between the price level
and the quantity of real GDP supplied.
Changes in short-run aggregate supply
(shifts in the SRAS curve)
 Factors that cause shift of SRAS curve

1. Changes in wages
2. Changes in non-labour resource prices
3. Changes in business taxes
4. Changes in subsidies offered to businesses.
5. Supply shocks: sudden and strong impact on SRAS
Short-run equilibrium in the
AD-AS model

 Ple is the equilibrium price level and Ye is the

equilibrium level of real GDP.
 The level of real GDP is closely related to how
much unemployment there is in the economy.
 As real GDP increases, firms hire more labour
and unemployment falls;
 as real GDP decreases, firms need fewer
labour resources, and unemployment rises.
 Therefore, the equilibrium level of real GDP
also determines how much unemployment
there is in the economy.
 At any price level and real GDP other than Ple
and Ye, the economy is in disequilibrium.
 At price level Pl1, there is an excess amount of
real GDP supplied, putting a downward pressure
on the price level, which falls until it reaches Ple.
 At a price level lower than Ple, such as Pl2, there
is an excess amount of real GDP demanded,
putting an upward pressure on the price level,
which moves upward until it settles at Ple.
 At Ple, the amount of real GDP demanded
is equal to the amount supplied, and there
is short-run equilibrium.
 Three short-run equilibrium positions: recessionary (deflationary)
gaps, inflationary gaps and short-run full employment equilibrium

 Three possible kinds of short-run macroeconomic equilibrium

positions for the economy
 All are defined in relation to the economy’s potential GDP, or the
full employment level of real output (GDP), where unemployment =
natural rate of unemployment
 a vertical line drawn at Yp represents the level of real GDP at which
there is ‘full employment’
Deflationary/Recessionary Gap
Equilibrium real GDP, Ye, lies to the left of
potential GDP, Yp.
When real GDP < potential GDP, the
economy is experiencing a recessionary
gap
and unemployment > natural rate of
employment.
Why does this happen?
The recessionary gap has been created
because at the price level Ple, the amount of
real GDP that the four components of
aggregate demand want to buy is less than
the economy’s potential GDP.
There is not enough total demand in the
economy to make it worthwhile for firms to
produce potential GDP. This also means that
firms require less labour for their production
unemployment is greater than the natural
rate of unemployment.
Inflationary Gap
Equilibrium real GDP, Ye, lies to the right of
potential GDP, Yp.
When real GDP >potential GDP, the economy
is experiencing an inflationary gap,
Unemployment is < the natural rate of
unemployment.
An inflationary gap arises because with
aggregate demand AD, the quantity of real
GDP that the four components want to buy at
the price level (Ple) is >economy’s potential
output.
There is too much total demand in the
economy, and firms respond by producing a
greater quantity of real GDP than potential
GDP.
To produce more output, firms’ labour needs
increase, and unemployment falls to become
less than the natural rate of unemployment.
Full employment level of real
GDP.

In part (c), equilibrium

real GDP =potential
GDP.
When the economy is
producing its potential
GDP, unemployment =
the natural rate of
unemployment and there
is no recessionary or
inflationary gap.
Summary
 Impacts of changes in short-run
equilibrium

 The short-run equilibrium of an economy changes whenever there is a

change in aggregate demand or short-run aggregate supply
 Shifts in AD or SRAS as possible causes of
the business cycle

 Shift of AD & SRAS leads to economic fluctuations.

 Most economists believe that changes in aggregate demand are more
important than changes in aggregate supply as causes of the business
cycle.
Short-run equilibrium states & The Business Cycle