Lecture Notes: Aggregate Demand and Supply Equilibrium

Introduction

• Understanding equilibrium in the Aggregate Demand (AD) and Aggregate Supply (AS) model.
• Equilibrium occurs when production/output equals consumption/purchasing in the economy.
• Similar concept to the Aggregate Expenditure Model.

Finding Equilibrium

• Graph Representation
  • Horizontal Axis: Real GDP
  • Vertical Axis: Price Level
  • Equilibrium is the intersection point of AD and AS.
• Equilibrium Outcomes
  • Equilibrium Price Level: Point on the vertical axis.
  • Equilibrium Real GDP: Point on the horizontal axis, representing real GDP production.

Potential Real GDP vs. Equilibrium Real GDP

• Potential Real GDP may differ from Equilibrium Real GDP.
• Long Run Aggregate Supply
  • Indicates potential; can be higher or lower than equilibrium.
• GDP Gap
  • Difference between equilibrium real GDP and potential real GDP.
  • Types:
    • Inflationary Gap: Equilibrium GDP > Potential GDP.
    • Recessionary Gap: Equilibrium GDP < Potential GDP.

Addressing the GDP Gap

• Self-Correcting Economy

  • Economy can adjust without government intervention to reach potential GDP.

• Recessionary Gap

  • Low resource demand leads to lower resource prices.
  • Decreasing prices increase aggregate supply, moving equilibrium towards potential GDP.
  • Results in deflation.

• Inflationary Gap

  • High resource demand leads to higher resource prices.
  • Increasing prices decrease aggregate supply, reducing equilibrium GDP towards potential GDP.
  • Results in inflation.

Role of Policies

• Fiscal and Monetary Policies
  • Needed as self-correction can be slow (years or decades).
  • Aim to minimize the time and damage caused by recessionary or inflationary gaps.
  • Government and Federal Reserve may intervene to expedite return to equilibrium.

Conclusion

• The AD-AS model illustrates how economies reach equilibrium and highlights potential gaps.
• Understanding these concepts helps in formulating effective economic policies.