[answered] LongRun Equilibrium in the ADAS Model Figure 19.2 helps us

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Long?Run Equilibrium in the AD?AS Model

 

Figure 19.2 helps us understand the equilibrium in the long?run AD?AS model, which includes the

 

distinction between short?run and long?run aggregate supply. In the long?run AD?AS model, the price

 

level, the wage rate, and the prices of other inputs are all flexible. The equilibrium price level and level

 

of real GDP are determined by the intersection of the AD curve and the vertical long?run AS curve. FIGURE 19.2

 

The long?run AD?AS model.The equilibrium price level P1 and level of real output Qf occur at the

 

intersection of the aggregate demand curve AD1, the long?run aggregate supply curve ASLR, and the

 

short?run aggregate supply curve AS1. At this equilibrium price?output combination, neither a positive

 

GDP gap nor a negative GDP gap occurs. The economy achieves it full?employment level of real GDP.

 

In the short run, equilibrium occurs wherever the downsloping aggregate demand curve and upsloping

 

short?run aggregate supply curve intersect. This can be at any level of output, not simply the full?

 

employment level. Either a negative GDP gap or a positive GDP gap is possible in the short run.

 

INTERACTIVE GRAPHS

 

G 19.1 Long?run AD?AS model

 

Interactive Graph 19.1: Long?run AD?AS model

 

But in the long run, the short?run aggregate supply curve adjusts as we have just described. After those

 

adjustments, long?run equilibrium occurs where the aggregate demand curve, vertical long?run aggregate

 

supply curve, and short?run aggregate supply curve all intersect. Figure 19.2 shows the long?run

 

outcome. Equilibrium occurs at point a, where AD1 intersects both ASLR and AS1, and the economy

 

achieves its full?employment (or potential) output, Qf. At long?run equilibrium price level P1 and output

 

level Qf, there is neither a negative GDP gap nor a positive GDP gap. The economy's natural rate of

 

unemployment prevails, meaning that the economy achieves full employment. In the United States, output Qf in Figure 19.2 implies a 4 to 5 percent unemployment rate. The natural

 

rate of unemployment can vary from one time period to another and can differ between countries. But

 

whatever the rate happens to be, it defines the level of potential output and establishes the location of the

 

long?run AS curve.

 

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APPLYING THE ANALYSIS Demand?Pull Inflation in the Long?Run AD?AS Model

 

The long?run AD?AS model provides added understanding of demand?pull inflation. Recall that demand?

 

pull inflation occurs when an increase in aggregate demand pulls up the price level. Previously, we

 

depicted this inflation by shifting an aggregate demand curve rightward along a stable aggregate supply

 

curve (Figure 15.8)?and that was the end of the matter.

 

In our more complex version of aggregate supply, however, an increase in the price level will eventually

 

lead to a ?catch?up? increase in nominal wages and thus a leftward shift of the short?run aggregate supply

 

curve. This is shown in Figure 19.3, where we initially suppose the price level is P1 at the intersection of

 

aggregate demand curve AD1, short?run supply curve AS1, and long?run aggregate supply curve ASLR.

 

Observe that the economy is achieving its full?employment real output Qf at point a. FIGURE 19.3

 

Demand?pull inflation in the long?run AD?AS model.An increase in aggregate demand from AD1 to AD2

 

drives up the price level and increases real output in the short run. But in the long run, nominal wages

 

rise and the short?run aggregate supply curve shifts leftward, as from AS1 to AS2. Real output then

 

returnsto its prior level, and the price level rises even more. In this scenario, the economy moves from a to b and then eventually to c.

 

Now consider the effects of an unexpected increase in aggregate demand as represented by the rightward

 

shift from AD1 to AD2. This shift might result from any one of a number of factors, including an

 

increase in investment spending or a rise in net exports. Whatever its cause, the increase in aggregate

 

demand boosts the price level from P1 to P2 and expands real output from Qf to Q2 at point b. There, a

 

positive GDP gap of Q2?Qf occurs.

 

So far, none of this is new to you. But now the distinction between short?run aggregate supply and long?

 

run aggregate supply becomes important. With the economy producing above potential output, inputs

 

will be in high demand. Input prices, including nominal wages, therefore will rise. As they do, the short?

 

run aggregate supply curve will ultimately shift leftward such that it intersects long?run aggregate supply

 

at point c. There, the economy has reestablished long?run equilibrium, with the price level and real output

 

now P3 and Qf, respectively. Only at point c does the new aggregate demand curve AD2 intersect both

 

the short?run aggregate supply curve AS2 and the long?run aggregate supply curve ASLR.

 

In the short run, demand?pull inflation drives up the price level and increases real output? in the long run,

 

only the price level rises. In the long run, the initial increase in aggregate demand moves the economy

 

along its vertical aggregate supply curve ASLR. For a while, an economy can operate beyond its full?

 

employment level of output. But the demand?pull inflation eventually causes adjustments of nominal

 

wages that return the economy to its full?employment output Qf.

 

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The analysis provides a major insight: What sometimes appears to be cost?push inflation because

 

nominal wages, natural resource prices, and other input prices are rising rapidly is often simply a facet of

 

demand?pull inflation. Higher product prices caused by increasing aggregate demand eventually pull up

 

input prices through the adjustment process that we have just described.

 

QUESTION: ?How do long?term contracts between resource suppliers and resource buyers affect

 

the length of the time it takes for the economy to move from b to c in Figure 19.3?

 

APPLYING THE ANALYSIS Cost?Push Inflation in the Long?Run AD?AS Model

 

The long?run model also clarifies a policy dilemma relating to cost?push inflation. Recall that this kind of

 

inflation arises from factors that increase the cost of production at each price level, shifting the aggregate

 

supply curve leftward and raising the equilibrium price level. Previously (Figure 15.9), we considered

 

cost?push inflation using only the short?run aggregate supply curve. Now we want to analyze that type of

 

inflation in its long?run context.

 

Look at Figure 19.4, in which we again assume that the economy is initially operating at price level P1

 

and output level Qf (point a). Suppose that an unanticipated international crisis causes a boost in the price of oil by, for example, 100 percent in a very short period of time. As a result, the per?unit production cost

 

of producing and transporting goods and services rises substantially in the economy represented by

 

Figure 19.4. This increase in per?unit production costs shifts the short?run aggregate supply curve to the

 

left, as from AS1 to AS2, and the price level rises from P1 to P2 (as seen by comparing points a and b).

 

In this case, the leftward shift of the short?run aggregate supply curve is not a response to a price?level

 

increase, as it was in our previous discussions of demand?pull inflation? it is the initiating cause of the

 

price?level increase. FIGURE 19.4

 

Cost?push inflation in the long?run AD?AS model.Cost?push inflation occurs when the short?run

 

aggregate supply curve shifts leftward, as from AS1 to AS2. If government counters the decline in real

 

output by increasing aggregate demand to the broken line, the price level rises even more. That is, the

 

economy moves in steps from a to b to c. In contrast, if government allows a recession to occur, nominal

 

wages eventually fall and the aggregate supply curve shifts back rightward to its original location. The

 

economy moves from a to b and eventually back to a.

 

Cost?push inflation creates a dilemma for policymakers. Without some expansionary stabilization policy,

 

aggregate demand in Figure 19.4 remains in place at AD1 and real output declines from Qf to Q2.

 

Government can counter this recession, negative GDP gap, and the attendant high unemployment by

 

using fiscal policy and monetary policy to increase aggregate demand to AD2. But there is a potential

 

policy trap here: An increase in aggregate demand to AD2 will further raise inflation by increasing the

 

price level from P2 to P3 (a move from point b to point c).

 

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Suppose the government recognizes this policy trap and decides not to increase aggregate demand from

 

AD1 to AD2 (you can now disregard the dashed AD2 curve) and instead decides to allow a cost?push?

 

caused recession to run its course. How will that happen? Widespread layoffs, plant shutdowns, and

 

business failures eventually occur. At some point the demand for oil, labor, and other inputs will decline

 

so much that oil prices and nominal wages will decline. When that happens, the initial leftward shift of the short?run aggregate supply curve will reverse itself. That is, the declining per?unit production costs

 

caused by the recession will shift the short?run aggregate supply curve rightward from AS2 to AS1. The

 

price level will return to P1, and the full?employment level of output will be restored at Qf (point a on the

 

long?run aggregate supply curve ASLR).

 

This analysis yields two generalizations:

 

If the government attempts to maintain full employment when cost?push inflation occurs, even

 

more inflation will occur.

 

If the government takes a hands?off approach to cost?push inflation, the recession will linger.

 

Although falling input prices will eventually undo the initial rise in per?unit production costs, the

 

economy in the meantime will experience high unemployment and a loss of real output.

 

QUESTION: ?Why do you think it is so difficult politically for Congress or even the Federal

 

Reserve to let cost?push inflation burn itself out for lack of aggregate demand fuel?

 

APPLYING THE ANALYSIS Recession in the Long?Run AD?AS Model

 

What does the long?run AD?AS model inform us about recession (or depression)? Will recessions caused

 

by decreases in aggregate demand eventually self?correct?

 

Suppose in Figure 19.5 that aggregate demand initially is AD1 and that the short?run and long?run

 

aggregate supply curves are AS1 and ASLR, respectively. Therefore, as shown by point a, the price level

 

is P1 and output is Qf. Now suppose that investment spending declines dramatically, reducing aggregate

 

demand to AD2. Observe that real output declines from Qf to Q1, indicating that a recession has

 

occurred. But if we make the controversial assumption that prices and wages are flexible downward, the

 

price level falls from P1 to P2. With the economy producing below potential output at point b, demand

 

for inputs will be weak. Eventually, nominal wages themselves fall to restore the previous real wage?

 

when that happens, the short?run aggregate supply curve shifts rightward from AS1 to AS2. The negative

 

GDP gap evaporates without the need for expansionary fiscal or monetary policy, since real output

 

expands from Q1 (point b) back to full?employment real output Qf (point c). The economy is again

 

located on its long?run aggregate supply curve ASLR, but now at the lower price level P3. FIGURE 19.5

 

Recession in the long?run AD?AS model.A recession occurs when aggregate demand shifts leftward, as

 

from AD1 to AD2. If prices and wages are downwardly flexible, the price level falls from P1 to P2 as the

 

economy moves from point a to point b. With the economy in recession at point b, wages eventually fall,

 

shifting the short?run aggregate supply curve from AS1 to AS2. The price level declines to P3, and real

 

output returns to Qf. The economy moves in steps from point a to b to c.

 

Page 464

 

There is considerable disagreement as to whether this hypothetical scenario bears any resemblance to

 

reality. The key point of dispute resolves around the degree to which both input and output prices are

 

downwardly flexible and how long it would take in the actual economy for the necessary downward price

 

and wage adjustments to occur to regain the full?employment level of output. Most economists believe

 

that if such adjustments are forthcoming, they will occur only after the economy has experienced a

 

relatively long?lasting recession with its accompanying high unemployment and large loss of output. The

 

severity and length of the major recession of 2007?2009 has strengthened this view. Also, they point out

 

that it is better to use fiscal and monetary policy to try to halt the decline in real GDP and increase in

 

unemployment than simply to wait and hope that the hypothesized adjustments in the long?run AD?AS

 

model are actually forthcoming. Following such advice, the federal government and Federal Reserve

 

used aggressive fiscal and monetary policy to try to halt and reverse the decline in aggregate demand

 

occurring during the recessionary year 2008. A second, more massive dose of fiscal policy was

 

prescribed for 2009, as the recession continued.

 

QUESTION: ?Why are wages so sticky downward, even during recessions?

 

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