Page 336 - Economics

CONFIRMING PAGES

PART FIVE
288
Long-Run Perspectives and Macroeconomic Debates
FIGURE 15.2 Equilibrium in the extended Applying the Extended
AD-AS model. The long-run equilibrium price level P 1 and
level of real output Q f occur at the intersection of the aggregate AD-AS Model
demand curve AD 1 , the long-run aggregate supply curve AS LR ,
The extended AD-AS model helps clarify the long-run
and the short-run aggregate supply curve AS 1.
aspects of demand-pull inflation, cost-push inflation, and
AS LR recession.
Demand-Pull Inflation in the
AS 1
Extended AD-AS Model
Price level Recall that demand-pull inflation occurs when an increase in

aggregate demand pulls up the price level. Earlier, we depicted
a this inflation by shifting an aggregate demand curve right-
P 1
ward along a stable aggregate supply curve (see Figure 10.7).
In our more complex version of aggregate supply,
however, an increase in the price level eventually leads to
AD 1
an increase in nominal wages and thus a leftward shift of
0 Q f
the short-run aggregate supply curve. This is shown
Real domestic output
in Figure 15.3 , where we initially suppose the price level is
with “extended” referring to the inclusion of both the short- P at the intersection of aggregate demand curve AD ,
1
1
run and the long-run aggregate supply curves.) short-run supply curve AS , and long-run aggregate supply
1
In the short run, equilibrium occurs wherever the curve AS . Observe that the economy is achieving its
LR
downsloping aggregate demand curve and upsloping full-employment real output Q at point a.
f
short-run aggregate supply curve intersect. Now consider the effects of an increase in aggregate
This can be at any level of output, not sim- demand as represented by the rightward shift from AD to
1
ply the full-employment level. Either a AD . This shift might result from any one of a number of
2
negative GDP or a positive GDP gap is factors, including an increase in investment spending and
possible in the short run. a rise in net exports. Whatever its cause, the increase in
But in the long run, the short-run ag- aggregate demand boosts the price level from P to P and
G 15.1 1 2
gregate supply curve adjusts as we just de- expands real output from Q to Q at point b . There, a pos-
Extended AD-AS f 2
f
model scribed. After those adjustments, long-run itive GDP gap of Q Q occurs.
2
equilibrium occurs where the aggregate de- So far, none of this is new to you. But now the distinction
mand curve, vertical long-run aggregate supply curve, and between short-run aggregate supply and long-run aggregate
short-run aggregate supply curve all intersect. Figure 15.2 supply becomes important. Once workers have realized that
shows the long-run outcome. Equilibrium occurs at point a , their real wages have declined and their existing contracts
where AD intersects both AS and AS , and the economy have expired, nominal wages will rise. As they do, the short-
1
LR
1
achieves its full-employment (or potential) output, Q . At run aggregate supply curve will ultimately shift leftward such
f
1
long-run equilibrium price level P and output level Q , there that it intersects long-run aggregate supply at point c. There;
1
f
is neither a negative GDP gap nor a positive GDP gap. the economy has reestablished long-run equilibrium, with
the price level and real output now P and Q , respectively.
3
f
Only at point c does the new aggregate demand curve AD
QUICK REVIEW 15.1 2
intersect both the short-run aggregate supply curve AS and
2
• The short-run aggregate supply curve has a positive slope the long-run aggregate supply curve AS .
LR
because nominal wages do not respond to the price-level
changes. 1 We say “ultimately” because the initial leftward shift in short-run aggre-
• The long-run aggregate supply curve is vertical, because gate supply will intersect the long-run aggregate supply curve AS LR at
nominal wages eventually change by the same relative price level P 2 (review Figure 15.1b). But the intersection of AD 2 and this
amount as changes in the price level. new short-run aggregate supply curve (not shown) will produce a price
• The long-run equilibrium GDP and price level occur at the level above P 2 . (You may want to pencil this in to make sure that you un-
intersection of the aggregate demand curve, the long-run derstand this point.) Again nominal wages will rise, shifting the short-run
aggregate supply curve, and the short-run aggregate supply aggregate supply curve farther leftward. The process will continue until
curve. the economy moves to point c, where the short-run aggregate supply curve
is AS 2 , the price level is P 3 , and real output is Q f .
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