MAcro CHAPTER 3.5:

CHAPTER SUMMARY

Just like with supply & demand, the market will generally settle at an equilibrium where aggregate demand = aggregate supply. This will determine the overall price level in the economy and the Real GDP that the economy will produce. This is known as a short-run aggregate equilibrium.

Also similar to supply & demand, if the price level is higher than the equilibrium, the economy will face a surplus in GDP (producing more stuff than people want to buy), and if the price level is lower than the equilibrium, the economy will face a shortage in GDP (consumers want to buy stuff, but not enough is being produced).

In an ideal economic situation, there would be no supply or shortage, and the economy would be producing at its maximum potential at full employment. To achieve this, the equilibrium Real GDP determined by AD and SRAS needs to be equal to the LRAS. This is known as long-run aggregate equilibrium, and looks like this:

However, sometimes, in the short-run, unemployment is actually too low, and the economy temporarily produces more than its PPC because not enough people are changing jobs and choosing not to work. In this economic environment, firms often start paying too much for workers (marginal cost > marginal product) and people and firms invest in projects that are unlikely to be successful. This all results in a situation where the short-run aggregate equilibrium Real GDP is higher than the LRAS. This eventually drives up prices, so the difference between the LRAS and the short-run aggregate equilibrium is known as an inflationary gap.

Similarly, if unemployment is high, and the economy is not producing to its full potential, the short-run aggregate equilibrium will be less than the LRAS. This results in a recessionary gap, meaning that the economy is not producing up to its full potential. The three charts below show a recessionary gap, long-run aggregate equilibrium, and an inflationary gap.

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