Chapter 8: ADAS in LongRun and SelfRegulating Economy

1
Chapter 8 AD-AS in Long-Run and Self-Regulating
Economy

• States of Economy--relative positions of Real
  GDP and Natural GDP
• Natural GDP Full-Employment or Potential GDP
• 3 Possible States
• Real GDP lt Natural GDP
• Real GDP gt Natural GDP
• Real GDP Natural GDP

2
Real GDP lt Natural Real GDP (QNatural)
Price Level

• Recessionary Gap
• Buyers Demand less than economy can produce
• Actual Unemployment exceeds Natural
  Unemployment Rate

SRAS1
AD1

• Real GDP

Q1
QNatural
3
Real GDP gt Natural Real GDP (QNatural)
Price Level

• Inflationary Gap
• Buyers Demand more than economy can produce at
  normal output rate
• Actual Unemployment less than Natural
  Unemployment Rate

SRAS1
AD1

• Real GDP

Q1
QNatural
4
Real GDP Natural Real GDP (QNatural)
Price Level

• Long-Run Equilibrium
• Actual Unemployment equals Natural Rate of
  Unemployment

SRAS1
AD1

• Real GDP

QNatural Q1
5
The Self-Regulating Economy

• Recessionary/Inflationary gap only temporary
• Economy self-adjusts to equilibrium at Natural
  Real GDP
• Unnecessary to intervene in economy
• Classical, New Classical, Monetarist schools
  view economy as self-regulating

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Adjustment Process in Recessionary Gap
Price Level

• Unemployment Rate gt Natural Unemploy. Rate
• Excess unemployment causes decrease in wages (
  other input prices)
• Shifts SRAS right. Why?
• This lowers Ps, raising C. Why?
• Continues until equilibrium at QNatural (point 2)

SRAS1
SRAS2

• 1

• 2

AD1

• Real GDP

Q1
QNatural
7
Adjustment Process in Inflationary Gap
Price Level
SRAS2

• Unemployment Rate lt Natural Unemploy. Rate
• Excess employment causes rise in wages (
  other input prices)
• Shifts SRAS left. Why?
• Ps rise, decreasing C. Why?
• Continues until equilibrium at QNatural (point 2)

SRAS1

• 2

• 1

AD1

• Real GDP

Q1
QNatural
8
Long-Run Aggregate Supply Curve (LRAS)
Price Level
Long-Run Equilibrium

• Shows Real GDP economy can supply at different
  Ps
• Assumes wages (input prices) adjust to eliminate
  inflationary/recessionary gaps
• LRAS vertical at QNatural
• Where AD equals LRAS

LRAS
SRAS

Short-Run Equilibrium

AD

• Real GDP

QNatural
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Policy-Implications of Self-Regulating Economy

• Economy self-adjusts to Natural Real GDP
• No need to intervene in economy
• Changes in wages/prices eliminate
  inflationary/recessionary gaps
• Laissez-faire approach
• Policy of No Policy
• Classical, New Classical, Monetarist schools