MAcro CHAPTER 3.7:

CHAPTER SUMMARY

In the long-run, the AD-AS model should return to a long-run aggregate equilibrium, where the equilibrium Real GDP is equal to the LRAS. There are many ways that can occur. First, we will look at scenarios where the LRAS itself might change.

1) If business investment increases, this should shift the AD curve to the right because of the increase in investment spending. In the short-run, this leads to an inflationary gap. However, in the long-run, the investment should increase firms' production capacity, shifting the LRAS itself to the right. This can lead to a new, long-run equilibrium at a higher Real GDP.

2) If there is a change in supply due to a supply shock, this could shift both the SRAS and the LRAS. This would only be true in a situation where there is no way for firms to adapt to the changes caused by the supply shock, permanently affecting the economy's PPC.

In many cases, though, a short-run change in AD or AS does not have any significant impact on LRAS. As a result, following the invisible hand, the economy will naturally self-adjust back to an equilibrium Real GDP equal to the LRAS in the long-run. Here are some ways that can happen:

1) If AD rises, the equilibrium will shift to point B, causing an increase in prices and Real GDP. However, in the long-run, if prices rise, workers will demand higher wages in order to afford the higher price levels, causing the SRAS curve to shift to the left because wages are a cost of production. This will bring us back to a new equilibrium at point C, where Real GDP is the same, but the price level is higher.

2) The exact opposite sequence occurs when AD falls, with prices and wages falling, causing SRAS to shift to the right, leading to a new equilibrium at a lower price level.

3) If SRAS decreases, the equilibrium will shift to point B, causing an increase in prices (inflation) and decrease in Real GDP (recessionary gap). In order to survive this environment, businesses will have to lower wages, decreasing their costs, shifting the SRAS curve back to its original place.

Note: This is not something that economists agree about, because real people are rarely willing to take a pay cut. We will accept the theory for the purpose of this class, but this does not seem to work out in real life. In reality, what often happens is that businesses have to fire workers because they will not take pay cuts, further shifting the SRAS to the left and decreasing AD as well since people now have less income to spend. This can lead to a recession that lasts for a long time.

4) Similarly, if the SRAS increases, the equilibrium price falls and equilibrium Real GDP rises, but the increase in productive efficiency means companies will have to pay their workers more, shifting SRAS back to its original place.

Note: This also turns out to not be very true in real life. In capitalism, when companies achieve increased productive efficiency, they usually seek to pass on as much as possible to shareholders and as little as possible to their workers, meaning that workers' wages often do not increase much even when they become more productive.

It can be pretty hard to remember all these different changes, but really all you need to remember is this: according to the theory that economies will self-adjust back to LRAS, the SRAS curve will always shift back to the original equilibrium quantity because of a change in wages. That's all you really need to remember for the exam!

CHAPTER VIDEOS

CHAPTER READINGS

CHAPTER PRACTICE

EXTENSION