LONG RUN AGGREGATE SUPPLY the amount of

LONG RUN AGGREGATE SUPPLY • the amount of real output • the economy is able to supply • at different price levels • if the economy is at Natural Real GDP Transparency 6 -1

NATURAL REAL GDP • the amount of output • the economy could produce • if it operated at full employment • called Qn or Qf Transparency 6 -2

LONG RUN AGGREAGATE SUPPLY LRAS • vertical line • at full employment Real GDP • Qn = Qf Transparency 6 -3

THREE POSSIBLE STATES OF THE ECONOMY • Full employment equilibrium • Recessionary gap • Inflationary gap Transparency 6 -4

FULL EMPLOYMENT EQUILIBRIUM The intersection of SRAS and AD is equal to the Natural Real GDP Transparency 6 -5

FULL EMPLOYMENT OUTPUT (other terms) • Potential GDP • the Natural Rate of Employment • the Natural Rate of Unemployment • QF or QN Transparency 6 -6

FULL EMPLOYMENT EQUILIBRIUM PRICE LEVEL LRAS SRAS AD Qn Transparency 6 -7 REAL GDP

RECESSIONARY GAP • Short run equilibrium output is less than full employment • People are not spending enough to purchase all that has been produced (inventories increase) • unemployment is a concern Transparency 6 -8

RECESSIONARY GAP LRAS PRICE LEVEL SRAS AD Q 1 Transparency 6 -9 Qn REAL GDP

POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY • Recessionary gaps are eliminated by decreases in wages and other input prices • Graphically this is an increase in SRAS Transparency 6 -10

Self-Regulating Economy Price Level Exhibit 2 (1 of 2) Part (a) SRAS 1 The economy is in a recessionary gap at point 1. 1 P 1 AD 1 0 5, 200 6, 000 Unemployment rate is higher at $5, 200 billion than at $6, 000 Transparency 6 -11 billion Suppose this is Natural Real GDP (billions of base-year dollars)

Self-Regulating Economy. Exhibit 2 (2 of 2) Transparency 6 -12

INFLATIONARY GAP • Equilibrium output is greater than full employment output • People are spending more than businesses anticipated and inventories are being drawn down • Inflation is a major concern Transparency 6 -13

INFLATIONARY GAP Price Level LRAS Short-run equilibrium Long-run equilibrium AD 0 Transparency 6 -14 QN Natural Real GDP

POLICY IMPLICATIONS OF A SELF REGULATING ECONOMY • Inflationary gaps are eliminated by increases in wages and input prices • Graphically, this is a decrease in SRAS Transparency 6 -15

Self-Regulating Economy: Removing an Inflationary Gap Price Level Exhibit 3 (1 of 2) Part (a) SRAS 1 1 P 1 The economy is in an inflationary gap at point 1. AD 1 0 6, 000 Suppose this is Transparency 6 -16 Natural Real GDP 6, 500 Real GDP (billions of base-year dollars) Unemployment rate is lower at $6, 500 billion than at $6, 000 billion

Self-Regulating Economy: Removing an Inflationary Gap Exhibit 3 (2 of 2) Transparency 6 -17

CLASSICAL ECONOMIC REASONING • Inflationary and. Recessionary gaps will be automatically eliminated due to – flexible prices – flexible wages – flexible interest rates Transparency 6 -18

CLASSICAL VIEW OF THE PRODUCT MARKET Transparency 6 -19

SAY’S LAW SUPPLY CREATES ITS OWN DEMAND Transparency 6 -20

REASONING BEHIND SAY’S LAW • People don’t work just to earn money. They work for the things that money can buy. • People don’t save just to hold the money. They save in order to invest. • All that is earned will be spent. Transparency 6 -21