The document summarizes the AD-AS model used to analyze economic fluctuations. It describes how short-run macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves. Demand shocks shift the AD curve and cause output and prices to move together, while supply shocks shift the SRAS curve and cause output and prices to move in opposite directions. In the long run, the economy self-corrects to the intersection of the AD, SRAS, and LRAS curves at potential output.

1. MODULE 19

2.  In the AD-AS model, the aggregate supply
curve and the aggregate demand curve are
used together to analyze economic
fluctuations.
 This is the basic model used to understand
economic fluctuations.

3.  The point where the AD and the SRAS curve
intersect is the short-run macroeconomic
equilibrium.
 This is the point at which the quantity of
aggregate output supplied is equal to the
quantity demanded by domestic
households, businesses, the government, and
the rest of the world.

4.  The aggregate price level at which
macroeconomic equilibrium is reached is the
short-run equilibrium aggregate price
level.
 The level of output at which macroeconomic
equilibrium is reached is the short-run
equilibrium aggregate output.
 The short-run equilibrium aggregate output
and the short-run equilibrium aggregate
price level can change because of shifts in
either the AD or the SRAS curve.

5.  An event that shifts the AD curve, such as a
change in expectations or wealth, the effect
of the size in the existing stock of physical
capital, or the use of fiscal or monetary
policy, is known as a demand shock
 A positive demand shock will increase AD and
shift the AD curve to the right; a negative
demand shock will decrease AD and shift the
AD curve to the left.
 Demand shocks cause aggregate demand
output and aggregate price level to move in
the same direction.

6.  An event that shifts the SRAS curve, such as
a change in commodity prices, nominal
wages, or productivity, is known as a supply
shock.
 A positive demand shock reduces production
costs and increases the quantity supplied at
any given aggregate price level, shifting the
SRAS curve to the right.
 A negative supply shock raises production
costs and reduces the quantity producers are
willing to supply at any given price
level, shifting the SRAS curve to the left.

7.  Supply shocks cause the aggregate price level
and aggregate output to move in opposite
directions.
 The combination of inflation (rising price
level) and falling aggregate output is called
stagflation (stagnation plus inflation).
Falling output leads to rising
unemployment, while the purchasing power
of money decreases due to the rise in prices.
 This situation creates a dilemma for policy-
makers!

8.  Long-run macroeconomic equilibrium is
reached when the short-run macroeconomic
equilibrium is on the long-run aggregate
supply curve.
 We assume that enough time has passed so
that the economy is in short-run
macroeconomic equilibrium and on the long-
run aggregate supply curve.
 So, the long-run macroeconomic equilibrium
is at the intersection of all three curves:
SRAS, AD, and LRAS.

9. LRAS
P SRAS
R
I
C
E
LONG-RUN
MACROECONOMIC
EQUILIBRIUM
L
E
V
E
L
AD
POTENTIAL
REAL GDP
OUTPUT

10.  Changes in short-run macroeconomic can
move the economy away from the long-run
macroeconomic equilibrium.
 However, the economy is self-correcting in
the long run.

11.  If aggregate demand falls for any
reason, aggregate output would be below
potential output; in this case, the economy
faces a recessionary gap.
 In the face of the high unemployment
resulting from a recessionary gap, nominal
wages eventually fall, which will lead
producers to increase output. This process
continues until the economy again attains
potential output, but at a lower aggregate
price level.
 The economy is in long-run macroeconomic
equilibrium once again, see next graph:

13.  Ifaggregate demand were to increase for any
reason, aggregate output would be above
potential output; in this case, the economy
faces an inflationary gap.
 In the face of the low unemployment
resulting from the inflationary gap, nominal
wages will rise, which will lead producers to
reduce output. This process continues until
the economy again attains potential
output, but at a higher aggregate price level.
 The economy is in long-run macroeconomic
equilibrium once again, see the next graph:

16.  If there is a recessionary gap, the output
gap is negative. In this case, nominal wages
eventually fall, moving the economy back to
potential output and bringing the output
gap back to zero.
 If there is an inflationary gap, the output
gap is positive. In this case, nominal wages
eventually rise, moving the economy back
to potential output and bringing the output
gap back to zero.

17.  So in the long run, the economy is self-
correcting: shocks to aggregate demand
affect aggregate output in the short run but
not in the long run.