ECON 2105 1nd Edition Lecture 15 Outline of Current Lecture I. Short-run Equilibrium II. Long-run Equilibrium Current LectureModule 19 Equilibrium in the Aggregate Demand-Aggregate Supply I. Short-run Equilibrium- The difference between short-run and long-run macroeconomic equilibrium o The causes and effects of demand shocks and supply shocks o How to determine if an economy is experiencing a recessionary or an inflationary gap and how to calculate the size of output gaps - If price level is too low, supply would not be enough. (Shortage) we have excess demand. There is not enough production to accommodate for the amount demanded. The economy will fix itself by raising the prices of things. - Short-run equilibrium aggregate price level and Short-run equilibrium output result in short run macroeconomic equilibrium - Assume initially we are at equilibrium; 14 trillion, no shortage and no surplus o Then we have a negative demand shock, quantity demand goes to 13 trillion o How will the market adjust? o There will be a surplus so…o Unplanned inventory spending, inventories will go up, production for next period will go down by the amount that is in the inventorieso Prices? – the prices will decrease because there is not enough demand These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- A negative demand shock leads to a lower aggregate price level and lower aggregate output. - Negative demand shocks? o Lower expected future income o Decrease in wealth due to a significant collapse in housing market,collapse in stock market o Government spending falls o Income tax rises o Loss of confidence (optimism goes down) o Money supply goes down o Interest rates rise o Recession in china o Consumer spending goes down - If output falls unemployment will go up - Positive demand shock- leads to higher aggregate price levels and higher aggregate output o Initial shortage, prices will rise and companies will increase supplies until we reach new equilibrium o Prices go upo GDP goes up o Increase in wealth o Market boomo Increase in govt spendingo High demand coming from overseas - Positive Supply Shock- leads to higher aggregate output and lower aggregate prices o Increase in productivity o Commodity prices lower o Wages go down o Oil prices go down o Taxes on firms go down o Labor goes up o Capital goes up o Technology gets better o Consumer spending goes up - Negative supply shock- leads to lower aggregate output and higher aggregate prices o Causes stagflation o Decrease in productivity o Wages go up o Labor goes downo Capital goes down - Government shutdown, is it a shock to aggregate demand or aggregate supply? o Aggregate negative demand shock o Some claim that uncertainties  negative demand shock - When facing lower prices, why not lower the wages and keep producing the same amount at lower prices? o Wages are downward sticky. - Assume initially we are at equilibrium, 14 trillion o But the economy is working under full capacity, potential output level is 15 trilliono What happens?? o Wages will go down o Rents will go down o SRAS curve will shift to the right o We are in recession II. Long-run Equilibrium - The economy is in long-run macroeconomic equilibrium when the point ofshort-run macroeconomic equilibrium is on the long-run aggregate supplycurve.- We have no pressures on wages or prices - Short-run effects of a negative demand shock o An initial negative demand shocko Causes a recessionary gap: aggregate output below potential output o Reduces aggregate price level and aggregate output and leads to higher unemployment in the short-run - Short-run positive demand shock o Initial positive demand shock o increases the aggregate price level and aggregate output and leads to lower unemployment in the short run- What happens next? Are we stuck in a gap forever?o The economy may correct itself in the long run if wages and pricesfully adjust.- Inflationary gap: aggregate output above potential output - Output gap: percentage difference between actual aggregate output and potential output - Short-run vs long-run effects on positive demand shock o Initial demand shocko Increases aggregate price level and aggregate output, reduces unemployment in the short runo Until a rise in nominal wages in the long run reduces short-run aggregate supply and moves the economy back to potential outputo The demand shock creates the supply shock - Short run vs long run effects on negative demand shock o Initial negative demand shock o reduces the aggregate price level and aggregate output and leads to higher unemployment in the short runo until a fall in nominal wages in the long run increases short-run aggregate supply and moves the economy back to potential output- responding to supply shocks o Negative supply shocks pose a policy dilemma: o To stabilize aggregate output requires increasing aggregate demand. This will lead to inflation. o But to stabilize prices requires reducing aggregate demand. This will deepen the output slump.- Output goes down, prices go up  negative supply shock - Prices go down and output goes up  shift to the right of supply - Output goes up and prices go up  positive demand