Equilibrium

• Equilibrium price and quantity are found where the AD and AS curves intersect.– At any price level above equilibrium sellers

are faced with surpluses and are forced to reduce production and price level.

– At any price level below equilibrium buyers are faced with shortages and are forced to pay more, encouraging suppliers to produce more.

Equilibrium

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply

Aggregatedemand

AEquilibrium price

Equilibrium output

Equilibrium

• In the short run equilibrium may be above or below the full employment rate. In other words AD and AS may not intersect at the LRAS.

• In the long run equilibrium will be at the LRAS, because in the long-run short run AS will have adjusted so that short-run aggregate output is equal to the potential output.

Short-run Equilibrium Below Full Employment Potential Output

(recessionary gap)P

rice

Leve

l

AD

AS

RGDP

LRAS

FEQ1

PL1

Short run Equilibrium Above Full Employment Potential Output

(inflationary gap)P

rice

Leve

l

AD

AS

RGDP

LRAS

FEQ1

PL1

Changes in AD

• Increases in AD cause the price level and the level of output and employment to rise.

• This rise in price level is known as demand-pull inflation.

• Decreases in AD cause the price level and the level of output and employment to fall.

• Increases or decreases in AD are known as Demand Shocks

Increases in ADP

rice

Leve

l

AD

AS

RGDP

LRAS

FEQ1

PL1

,Q2

PL2

AD2

Changes in AS

Increases in AS have a positive effect on both price level and output.

–When AS shifts right, price levels fall or stabilize, but output increases.

Increases in ASP

rice

Leve

l

AD

AS

RGDP

LRAS

FE

PL

AS1

PL1

Q1

Changes in AS

Decreases in AS have a negative effect on both price level and output.

– When AS shifts left, price levels rise, but output falls.

•This is known as cost-push inflation or stagflation.•Any unexpected change in AS whether positive or negative is known as a supply shock.

Decreases in AS(stagflation)

Pric

e Le

vel

AD

AS

RGDP

LRAS

FEQ1

PL1

AS2

PL2

Q2

Self-Correcting Nature of Economy

• In the long-run aggregate supply will shift so that equilibrium will be at the long-run level of output

• This happens as nominal wages and other input prices adjust to meet the current price level

Short run Equilibrium Below Full Employment-Lower price levels lead to lower wages, shifting SRAS right

Pric

e Le

vel

AD

AS

RGDP

LRAS

FEQ1

PL1

,Q2

PL2

AS2

Short run Equilibrium Above Full Employment-Higher price levels lead to higher wages, shifting SRAS left

Pric

e Le

vel

AS

RGDP

LRAS

FE Q1

AS2

AD1

PL1