Page 238 - Krugmans Economics for AP Text Book_Neat

figure 19.6

Short -Run Versus Aggregate
Long -Run Effects price 3. …until an eventual rise in nominal
level wages in the long run reduces short-run
of a Positive aggregate supply and moves the
1. An initial positive economy back to potential output.
Demand Shock demand shock… LRAS
Starting at E 1 , a positive de- SRAS 2
mand shock shifts AD 1 right-
ward to AD 2 , and the economy
SRAS 1
moves to E 2 in the short run.
This results in an inflationary E 3
gap as aggregate output rises
P 3
from Y 1 to Y 2 , the aggregate
price level rises from P 1 to P 2 ,
and unemployment falls to a
P 2 E 2
E 1
low level. In the long run, SRAS 1
shifts leftward to SRAS 2 as 2. …increases the
P 1 aggregate price level
nominal wages rise in response
AD 2 and aggregate output
to low unemployment at Y 2 . Ag- and reduces unemployment
gregate output falls back to Y 1 , AD 1 in the short run…
the aggregate price level rises
again to P 3 , and the economy Potential Y 1 Y 2 Real GDP
self -corrects as it returns to output
long -run macro economic equi- Inflationary gap
librium at E 3 .

produce this higher level of aggregate output. When this happens, the economy experi-
There is an inflationary gap when
ences an inflationary gap. As in the case of a recessionary gap, this isn’t the end of the
aggregate output is above potential output.
story. In the face of low unemployment, nominal wages will rise, as will other sticky
The output gap is the percentage difference
prices. An inflationary gap causes the short -run aggregate supply curve to shift gradu-
between actual aggregate output and
ally to the left as producers reduce output in the face of rising nominal wages. This
potential output.
process continues until SRAS 1 reaches its new position at SRAS 2 , bringing the economy
The economy is self -correcting when
into equilibrium at E 3 , where AD 2 , SRAS 2 , and LRAS all intersect. At E 3 , the economy is
shocks to aggregate demand affect
back in long -run macroeconomic equilibrium. It is back at potential output, but at a
aggregate output in the short run, but not the
higher price level, P 3 , reflecting a long -run rise in the aggregate price level. Again, the
long run.
economy is self -correcting in the long run.
To summarize the analysis of how the economy responds to recessionary and infla-
tionary gaps, we can focus on the output gap, the percentage difference between actual
aggregate output and potential output. The output gap is calculated as follows:
(19-1) Output gap = Actual aggregate output − Potential output × 100
Potential output
Our analysis says that the output gap always tends toward zero.
If there is a recessionary gap, so that the output gap is negative, nominal wages eventu-
ally fall, moving the economy back to potential output and bringing the output gap back
to zero. If there is an inflationary gap, so that the output gap is positive, nominal wages
eventually rise, also moving the economy back to potential output and again bringing the
output gap back to zero. So in the long run the economy is self -correcting: shocks to ag-
gregate demand affect aggregate output in the short run but not in the long run.

196 section 4 National Income and Price Determination