Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve. If real GDP is below equilibrium GDP, firms increase production and raise prices, and if real GDP is above equilibrium GDP, firms decrease production and lower prices. These changes bring a movement along the SAS curve towards equilibrium.

In short-run equilibrium, real GDP can be greater than or less than potential GDP.

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP - when the economy is on its LAS curve.

Note two things:

• At the price chosen by suppliers (P), the aggregate demand (AD) is exactly equal to the amount suppliers are willing to supply (SAS).
• This equilibrium between SAS and AD coincides with the maximum capacity of the economy, as indicated by the LAS curve. The level of output produced is labeled as Y_f, indicating full employment of resources.

Long-run equilibrium thus occurs where LAS, AD, and SAS coincide.

Economic Growth and Inflation

Economic growth occurs because the quantity of labor grows, capital is accumulated, and technology advances, all of which increase potential GDP and bring a rightward shift of the LAS curve. The following figure illustrates economic growth and inflation.

Inflation occurs because the quantity of money grows faster than potential GDP, which increases aggregate demand by more than long-run aggregate supply. The AD curve shifts rightward faster than the rightward shift of the LAS curve.

The Business Cycle

The business cycle occurs because aggregate demand and short-run aggregate supply fluctuate.

• A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP. The amount by which potential GDP exceeds real GDP is called a recessionary gap.
• Long-run equilibrium is an equilibrium in which potential GDP equals real GDP.
• An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP is called an inflationary gap.

Let's look at the inflation gap.

An economic boom may be the result of an increase in AD. Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward.

The prices of goods and services increase, which in turn induces suppliers to expand output to a level that is unsustainable in the long run (which is why a boom is followed by an economic contraction). That is, firms increase output and prices - a movement along the SRAS curve.

Since prices are currently high (P₁) and the situation is moving into the long run, people will expect prices to continue to be high. There is an inflationary gap.

Stagflation

In the resource market, a supply shock such as a drought or high oil prices is reflected by a leftward shift of the supply curve of resources. The price of resources, and thus the cost of production, increases. Assuming prices in the goods and services markets are unchanged, the higher costs may be one of the factors that contribute to a recession.

As the SAS curve shifts leftward, real GDP decreases and the price level rises. The combination of recession with inflation is called stagflation.

Practice Question 1

In the short run, real GDP ______ potential GDP.

A. is always above
B. can fall below or rise above
C. is always below

Correct Answer: B

Practice Question 2

In long-run equilibrium, ______

A. aggregate demand is vertical.
B. real GDP equals potential GDP.
C. price level is fixed.

Correct Answer: B

Practice Question 3

An increase in aggregate demand ______

A. raises potential output.
B. reduces potential output.
C. does not change potential output.

Correct Answer: C

Potential output is the long-run output level an economy can produce given the quantity of inputs available, the prices of these inputs, and production technology. It depends on supply conditions, not aggregate demand.

Practice Question 4

Refer to the graph below. The potential output curve is best shown by ______.

A. Curve A
B. Curve B
C. Curve C
D. Curve D

Correct Answer: A

The potential output curve is vertical because potential output is unaffected by price level.

Practice Question 5

Refer to the graph below. The economy is in short-run equilibrium at ______.

A. point A
B. point B
C. point C

Correct Answer: A

Short-run equilibrium exists at the point at which the aggregate demand curve intersects the aggregate supply curve.

Practice Question 6

If potential output exceeds aggregate demand, eventually ______

A. input prices will rise and output will fall.
B. both input prices and output will rise.
C. input prices will fall and output will rise.

Correct Answer: C

In a recessionary gap, the demand for inputs is low, causing input prices to fall. As input prices fall, so do output prices; this causes an increase in aggregate demand and output.

Practice Question 7

A recessionary gap is the amount by which ______

A. potential GDP exceeds nominal GDP.
B. nominal GDP exceeds potential GDP.
C. potential GDP exceeds real GDP.
D. real GDP exceeds potential GDP.

Correct Answer: C

Practice Question 8

When the economy experiences a combination of recession and inflation, the situation is called ______.

A. an inflationary/recessionary gap
B. hyperinflation
C. stagflation

Correct Answer: C

Practice Question 9

During an economic boom, the AD/AS model indicates that the real interest rate will ______ and real wage rates will ______.

A. increase; increase
B. increase; decrease
C. decrease; increase

Correct Answer: A

During an economic boom, there is high demand for goods and services and increased demand for resources such as labor. Thus, the price of labor (the real wage rate) will increase. To increase supply, more funds are needed. This increased demand for loanable funds will increase the real interest rate.

Practice Question 10

If an economy is in long-run equilibrium and an unexpected increase in aggregate demand occurs, the temporary output will ______ and the permanent prices will ______.

A. decrease; increase
B. increase; decrease
C. increase; increase

Correct Answer: C

Aggregate demand changes alone cannot permanently change real output. An unexpected increase will, however, cause a temporary economic boom with a temporary increase in output. Aggregate demand changes can cause permanent changes in the price level. Thus, if aggregate demand increases and remains at the higher level, the price level will increase and will remain at the higher level.

Practice Question 11

If the intersection of aggregate demand and short-run aggregate supply is to the right of long-run aggregate supply, in the long run there will be a decrease in ______.

A. output prices
B. resource prices
C. output

Correct Answer: C

The economy is experiencing a temporary economic boom but this cannot last, since the intersection is to the right of long-run aggregate supply. Output and resource prices will rise, but with sufficient time for the adjustment of all prices output will fall back to the level of long-run aggregate supply (due to higher resource prices).

Practice Question 12

If the intersection of aggregate demand and short-run aggregate supply is to the left of long-run aggregate supply and there is no shift in aggregate demand, in the long run resource prices will ______ and short-run aggregate supply will ______.

A. decrease; increase
B. increase; increase
C. decrease; decrease

Correct Answer: A

The economy is in a recession, since its short-run equilibrium is less than its long-run capacity. This will lead to falling resource prices, and thus an outward shift of the short-run aggregate supply curve until full employment output is restored at the intersection of the aggregate demand curve and the long-run aggregate supply curve.

Practice Question 13

A recession is likely to occur if there is a(n) ______.

A. unanticipated decrease in aggregate demand and supply
B. unanticipated decrease in aggregate demand but increased (unplanned) supply
C. decrease in demand only (no matter whether it is anticipated or not)

Correct Answer: A

Recessions occur because prices in the goods and services market are low relative to costs of production. Two reasons are unanticipated reduction in aggregate demand and unfavorable supply shocks.

Practice Question 14

A recessionary gap is more likely to be observed when ______

A. real GDP is above potential GDP.
B. employment is above full-employment equilibrium.
C. real GDP is below potential GDP.

Correct Answer: C

A below full-employment equilibrium is a macro-economic equilibrium in which potential GDP exceeds real GDP. The amount by which potential GDP exceeds real GDP is called the recessionary gap.