Figure Natural Employment and Long-Run Aggregate Supply

When the economy achieves its natural level of employment, as shown in Panel (a) at the intersection of the demand and supply curves for labor, it achieves its potential output, as shown in Panel (b) by the vertical long-run aggregate supply curve LRAS at Y _P.

In Panel (b) we see price levels ranging from P ₁ to P ₄. Higher price levels would require higher nominal wages to create a real wage of ω_e, and flexible nominal wages would achieve that in the long run.

In the long run, then, the economy can achieve its natural level of employment and potential output at any price level. This conclusion gives us our LRAS curve. With only one level of output at any price level, the LRAS curve is a vertical line at the economy’s potential level of output of Y _P.

Equilibrium Levels of Price and Output in the Long Run

The intersection of the economy’s AD curve and the LRAS curve determines its equilibrium real GDP and price level in the long run. Figure Long-Run Equilibrium depicts an economy in long-run equilibrium. With aggregate demand at AD ₁ and the LRAS curve as shown, real GDP is $12,000 billion per year and the price level is 1.14. If aggregate demand increases to AD ₂, long-run equilibrium will be reestablished at real GDP of $12,000 billion per year, but at a higher price level of 1.18. If aggregate demand decreases to AD ₃, long-run equilibrium will still be at real GDP of $12,000 billion per year, but with the now lower price level of 1.10.

Figure Long-Run Equilibrium

Long-run equilibrium occurs at the intersection of the AD curve and the LRAS curve. For the three AD curves shown, long-run equilibrium occurs at three different price levels, but always at an output level of $12,000 billion per year, which corresponds to potential output.

The Short Run

Analysis of the macroeconomy in the short run—a period in which stickiness of wages and prices may prevent the economy from operating at potential output—helps explain how deviations of real GDP from potential output can and do occur. We will explore the effects of changes in aggregate demand and in short-run aggregate supply in this section.

Short-Run Aggregate Supply SRAS

Figure Deriving the SRAS Curve

 

The economy shown here is in long-run equilibrium at the intersection of AD ₁with the SRAS curve. If aggregate demand increases to AD ₂, in the short run, both real GDP and the price level rise. If aggregate demand decreases to AD ₃, in the short run, both real GDP and the price level fall. A line drawn through points A, B, and C traces out the SRAS curve.

The model of AD and LRAS predicts that the economy will eventually move toward its potential output. To see how nominal wage and price stickiness can cause real GDP to be either above or below potential in the short run, consider the response of the economy to a change in AD. Figure ‘Deriving the SRAS Curve’ shows an economy that has been operating at potential output of $12,000 billion and a price level of 1.14. This occurs at the intersection of AD ₁ with the SRAS curve at point B. Now suppose that the AD curve shifts to the right (to AD ₂). This could occur as a result of an increase in exports. (The shift from AD ₁ to AD ₂ includes the multiplied effect of the increase in exports.) At the price level of 1.14, there is now excess demand and pressure on prices to rise. If all prices in the economy adjusted quickly, the economy would quickly settle at potential output of $12,000 billion, but at a higher price level (1.18 in this case).