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:
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.
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.
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.
|achu: Stagflation= recession + inflation.|
|SaeedAlam: This is I believe why Austrian economists are right in supporting gold standard currency, so you eliminate these artificial 'booms' which have done nothing in the long run but destroy wealth without any extra tangible output to show for it.|
|bidisha: This is why supply side economics doesn't work. Read krugman of New York Times a noble prize winner.|
|oneashok: India is heading into stagflation i guess...|