Page 236 - Krugmans Economics for AP Text Book_Neat

There’s another important contrast between supply shocks and demand shocks. As
The economy is in long -run
we’ve seen, monetary policy and fiscal policy enable the government to shift the AD
macroeconomic equilibrium when the
curve, meaning that governments are in a position to create the kinds of shocks shown
point of short -run macroeconomic equilibrium
is on the long -run aggregate supply curve. in Figure 19.2. It’s much harder for governments to shift the AS curve. Are there good
policy reasons to shift the AD curve? We’ll turn to that question soon. First, however,
let’s look at the difference between short -run macroeconomic equilibrium and long -
run macroeconomic equilibrium.

Long-Run Macroeconomic Equilibrium
Figure 19.4 combines the aggregate demand curve with both the short -run and long -
run aggregate supply curves. The aggregate demand curve, AD, crosses the short -run
aggregate supply curve, SRAS, at E LR . Here we assume that enough time has elapsed
that the economy is also on the long -run aggregate supply curve, LRAS. As a result, E LR
is at the intersection of all three curves—SRAS, LRAS, and AD. So short -run equilibrium
aggregate output is equal to potential output, Y P . Such a situation, in which the point
of short -run macroeconomic equilibrium is on the long -run aggregate supply curve, is
known as long -run macroeconomic equilibrium.
To see the significance of long -run macroeconomic equilibrium, let’s consider
what happens if a demand shock moves the economy away from long -run macroeco-
nomic equilibrium. In Figure 19.5, we assume that the initial aggregate demand curve
is AD 1 and the initial short -run aggregate supply curve is SRAS 1 . So the initial macro-
economic equilibrium is at E 1 , which lies on the long -run aggregate supply curve,
LRAS. The economy, then, starts from a point of short -run and long -run macroeco-
nomic equilibrium, and short -run equilibrium aggregate output equals potential out-
put at Y 1 .
Now suppose that for some reason—such as a sudden worsening of business and
consumer expectations—aggregate demand falls and the aggregate demand curve
shifts leftward to AD 2 . This results in a lower equilibrium aggregate price level at P 2
and a lower equilibrium aggregate output level at Y 2 as the economy settles in the
short run at E 2 . The short -run effect of such a fall in aggregate demand is what the

figure 19.4

Long -Run Macroeconomic Aggregate
price
Equilibrium level LRAS
Here the point of short -run macroeco- SRAS
nomic equilibrium also lies on the long -
run aggregate supply curve, LRAS. As a
result, short -run equilibrium aggregate
output is equal to potential output, Y P . The
Long-run
economy is in long -run macroeconomic macroeconomic
P E E LR
equilibrium at E LR . equilibrium

AD

Real GDP
Y P
Potential
output

194 section 4 National Income and Price Determination