Hey everyone, I'm Mr. Willis and you will love economics. We've discussed economic indicators and measuring economic performance. We've analyzed graphs like the business cycle. and the production possibilities curve that visualize performance.
Now, let me show you one graph that shows us almost everything we need to know about how an economy is performing now compared to where it would like to be. From price level to real GDP output, from the unemployment rate to the standard of living, it's all here on the aggregate demand aggregate supply graph. The economy seen here on the aggregate demand aggregate supply graph is at long-run equilibrium. Aggregate equilibrium is the condition in an economy where aggregate quantity supplied equals aggregate quantity demanded at an optimal price level.
And the aggregate economy is producing its potential real GDP output given the full employment of its resources. Let's break it down. This is an economy at long-run equilibrium. This economy is currently producing its full potential of real GDP output, and the aggregate price level is optimal. But hey, wait a second.
How do we know all that? Let me show you by breaking down the graph. First, the Long Run Aggregate Supply Curve represents the quantity of real GDP that the economy has the potential to produce with the full employment of its available resources. This tells us the output that this economy would like to produce under perfect circumstances, and therefore where it would like to be. This output is labeled as quantity full employment, or QF.
Next, Short-run equilibrium at the intersection of the aggregate demand and short-run aggregate supply curves indicates the quantity of real GDP that the economy is currently producing with the available resources at a current price level. Voluntary exchange between all participants in the aggregate economy results in a short-run equilibrium where the quantity of real GDP output demanded by consumers, firms, government, and foreign participants equals the quantity of real GDP output supplied by domestic firms at a certain price level. Ultimately, this tells us where the economy is producing right now, and this output will be compared to the optimal real GDP output that the economy would like to produce at quantity full employment. In the short run, the economy depicted in this graph is currently producing the quantity of real GDP output that they are capable of producing at full employment. As a result, this economy is at long-run equilibrium.
So wait, one question you might be asking right now is, How do we know that this price level is optimal? At a price of P1 across the aggregate economy, the quantity demanded by consumers, firms, government, and foreign consumers equals the quantity supplied by domestic firms. If price levels were to change above or below P1 for some other reason besides a fundamental change in aggregate demand or aggregate supply, this will cause a disequilibrium in the aggregate economy. There are two types of disequilibrium.
GDP Surplus and GDP Shortage GDP surplus is the condition in an aggregate economy where price levels have risen too high, causing aggregate quantity supply to be greater than aggregate quantity demanded. As price levels increase in the economy, the quantity of real GDP output demanded by consumers, firms, government, and foreign consumers decreases because they are less willing or less able to consume goods and services due to the real balances, interest rate, and foreign trade effects. At the same time, domestic firms will increase the quantity of real GDP output supplied as they seek to earn greater profits as inflation occurs.
The result is a surplus of GDP output in the domestic economy. But the economy should return to equilibrium on its own through natural market forces. With an excess of goods and services, firms will feel the pressure to lower prices in order to avoid losses. Lower prices will lead to an increase in aggregate real GDP output demanded.
and the GDP surplus will become smaller. Eventually, as price levels continue to deflate, real GDP output demanded will increase and real GDP output supplied will decrease until price level reaches a point where the aggregate quantity demanded equals the aggregate quantity supplied and the economy returns to equilibrium. For example, at a price level of P2, prices in the aggregate economy are too high above equilibrium.
Aggregate consumers are less willing and able to purchase goods and services, and therefore decrease their real GDP demanded to $100 billion. At the same time, firms increase their real GDP supply to $500 billion. This creates an excess of GDP output, or a GDP surplus of $400 billion. Filling the pressure to avoid losses, firms will lower prices in order to sell more goods and services.
Consumers will increase their real GDP demanded to $200 billion. and domestic firms will reduce their output. This causes the GDP surplus to shrink to $200 billion.
Eventually, natural market forces will continue to push price back towards equilibrium, and at a price of P4, the real GDP demanded and real GDP supplied in the aggregate economy equals $300 billion. GDP shortage is the condition in an aggregate economy where price levels have fallen too low, causing aggregate quantity demanded to be greater than aggregate quantity supplied. As price levels decrease in the economy, the quantity of real GDP output demanded by consumers, firms, government, and foreign consumers increases because they are more willing or more able to consume goods and services due to the real balances, interest rate, and foreign trade effects.
At the same time, domestic firms will decrease the quantity of real GDP output supplied as they see a smaller chance for earning larger profits in the short run as price levels fall. This results in a shortage of GDP output. in the domestic economy. But the economy should return to equilibrium on its own through natural market forces. With too few goods and services, consumers will feel the pressure to pay higher prices in order to purchase economic goods to satisfy their utility.
Higher prices will lead to an increase in aggregate real GDP output supply, and the GDP shortage should become smaller. Eventually, as prices continue to inflate, real GDP output supply will increase, and real GDP output demanded will decrease. until price levels reach a point where the aggregate quantity demanded equals the aggregate quantity supplied, and the economy returns to equilibrium. For example, at a price of P2, prices are too far below equilibrium, and because of a lesser chance for profits, firms will reduce the real GDP supply to $200 billion, while at the same time, aggregate consumers across the economy will increase their real GDP demanded to $600 billion, leading to a GDP shortage of $400 billion. Because goods and services are hard to find, consumers will feel pressure to pay higher prices in order to purchase them.
As the price level rises to P3, real GDP demanded by all consumers will decrease to $500 billion, and domestic firms will increase the real GDP output supplied to $300 billion, causing the GDP shortage to shrink to $200 billion. Eventually, prices will continue to rise and reach an equilibrium price of P4, where the real GDP output demanded equals real GDP output supplied, at $400 billion. Changes in the determinants of aggregate demand and aggregate supply can cause fundamental changes in economic conditions, which can create what are known as GDP gaps.
GDP gaps exist when an economy is producing a real GDP output at short-run equilibrium that is either lesser or greater than the real GDP output they should be producing at full employment. These gaps affect economic conditions for all participants in the aggregate economy, including the unemployment rate, income levels, consumption levels, and the standard of living. Let's take a closer look.
In the short run, when an economy produces a greater real GDP output than they are capable of producing at full employment, this opens a positive GDP gap, also known as an inflationary gap. An inflationary gap indicates that an aggregate economy is producing real GDP output at a rate that is too fast and therefore is unsustainable, which can cause the economy to eventually overheat. This will drive prices up and eventually decrease consumer purchasing power and consumption, causing economic contraction. An inflationary gap is the equivalent of an aggregate economy producing a level of real GDP output above the growth trendline on the business cycle.
In the short run, when an economy produces a lesser real GDP output than they are capable at full employment, it opens up a negative GDP gap, also known as a recessionary gap. A recessionary gap indicates that the aggregate economy is producing a level of real GDP output that is slower than they are capable, which means the economy could be producing more than it currently is. A recessionary gap is the equivalent of an economy producing a level of real GDP output below the growth trend line on the business cycle.
So, to most, this just looks like a bunch of lines and labels, and not much else. But this graph is visualizing economic conditions for an aggregate economy. including the unemployment rate, income levels, consumption levels, and the standard of living.
Let me teach you how to read these important economic indicators on the aggregate supply and aggregate demand graph. First, the unemployment rate. QF represents the quantity of real GDP that the aggregate economy can produce at the full employment of its resources. Full employment means that an economy is experiencing 4-6% of unavoidable, frictional, and structural unemployment. and no cyclical unemployment.
As a result, we can conclude that any economy producing at long-run equilibrium is experiencing an unemployment rate of 4-6%. If real GDP is less than QF, an economy is in a recessionary gap, and that economy is producing less than it could be, meaning it is wasting a portion of its labor, leading to cyclical unemployment. Workers have lost their jobs due to domestic firms scaling back production, causing the unemployment rate to increase. As a result, we can conclude that the unemployment rate is above 6% when real GDP output is less than quantity full employment. If real GDP is greater than QF.
The economy is in an inflationary gap, and the economy is producing more than it should be, meaning it is using many workers who are willing and able to work, including some who would be categorized as frictionally and structurally unemployed. Firms hire workers in order to produce a greater quantity of products, and, as a result, we can conclude that the unemployment rate is below 4% when real GDP output is greater than quantity full employment. Next, the national income level. Income level refers to the aggregate quantity of income earned by all members of the workforce who are currently employed. If more workers are employed and earning income for their labor, then the national income level increases.
If less workers are employed and earning income for their labor, then the national income level decreases. If real GDP is less than QF, then the economy is in a recessionary gap, and the economy is producing less than it could be, and the unemployment rate is higher than 6%. As firms fire workers because they are no longer needed to produce products, the unemployment rate increases and workers are earning less income, causing income levels to fall. If real GDP is greater than QF, the economy is in an inflationary gap, and the economy is producing more than it should be, and the unemployment rate is less than 4%.
As firms hire workers because they are needed to produce more products, the unemployment rate decreases and workers are earning greater income. causing income levels to rise. Consumption levels can also be determined.
Consumption levels refer to the aggregate spending by all domestic consumers who earn disposable income. If more workers are employed and the national income level increases, consumers in the aggregate economy have more disposable income to spend and consumption levels increase. If less workers are employed and the national income level decreases, consumers in the aggregate economy have less disposable income to spend. and consumption levels decrease.
If RUGDP is less than QF, the economy is in a recessionary gap, and the unemployment rate is higher than 6%. As the unemployment rate increases and workers are earning less income, they have less disposable income to spend, causing consumption levels to fall. If RUGDP is greater than QF, the economy is in an inflationary gap, and the unemployment rate falls below 4%.
As the unemployment rate decreases, Workers are earning more income and they have more disposable income to spend causing consumption levels to rise Lastly the standard of living you learned that the standard of living refers to the quality of life in a society And it is best measured by a nation's real GDP per capita Soteros Paribus unless explicitly stated we can assume that the population size of a country does not change meaning changes in real GDP output will directly lead to changes in real GDP per capita. If real GDP is less than QF, and an economy is in a recessionary gap, the real GDP per capita of that country is decreasing, as fewer goods and services are available to satisfy the needs and wants of citizens. This means the standard of living is decreasing. If real GDP is greater than QF, and an economy is in an inflationary gap, the real GDP per capita of that country is increasing. as more goods and services are available to satisfy the needs and wants of citizens.
This causes the standard of living to increase. Let's practice with GDP gaps by using fundamental changes in aggregate supply and demand. Suppose the United States economy is at long-run equilibrium, and Congress reduces income tax rates for all American consumers. Consumers will have more disposable income because they pay less in taxes.
and consumers will purchase greater quantities of real GDP output at every price level. This increase in consumer spending will lead to an increase in aggregate demand in the United States economy. After this fundamental change, the American economy will have a new short-run equilibrium. Prices will increase through demand-pull inflation, and real GDP output will increase as firms boost aggregate quantity supply to meet increased consumer demand. This new output of production means the United States economy is now experiencing an inflationary gap and is producing real GDP at a rate that is greater than its potential.
It also means that the unemployment rate is decreasing and now is below 4%. The national income level is rising as more workers are employed and earning income, and consumption levels are increasing as consumers buy more goods and services with greater disposable income. Lastly, the standard of living is increasing in the United States, as an increase in real GDP leads to an increase in real GDP per capita. Now suppose that the Canadian economy is at long-run equilibrium, and the Canadian Parliament reduces subsidies for domestic firms.
Canadian firms will receive less grant money from the government, making it harder to hire workers and purchase equipment or pay for production costs, leading firms to decrease their production levels. This decrease in corporate subsidies will lead to a decrease in short-run aggregate supply in the Canadian economy. After this fundamental change, the Canadian economy will now have a new short-run equilibrium. Prices will increase through cost push inflation and real GDP output will decrease as consumers reduce aggregate quantity demanded after inflation.
This new output of production means the Canadian economy is now experiencing a recessionary gap and is producing less real GDP than it potentially could produce. It also means that the unemployment rate is increasing and is now above 6% as cyclical unemployment increases. The national income level is falling as fewer workers are employed and earning income, and consumption levels are decreasing as consumers buy less economic goods with their decreased income.
Lastly, the standard of living is decreasing in Canada, as a decrease in real GDP output leads to a decrease in real GDP per capita. And that's aggregate equilibrium. Be sure to subscribe to the channel by hitting the red button below, so you can receive alerts about new videos when they become available.
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