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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.
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.
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.
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).
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.
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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