ECON10003 Lecture Notes - Lecture 15: Unemployment, Potential Output, Output Gap
19 Jun 2018
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MACROECONOMICS LECTURE 15
The AD- Aggregate supply framework and Fluctuations in the Economy
Aggregate supply curve: shows actual rate of inflation occurring at different levels of output and output gap. OR
how actual rate of inflation will vary (due to behaviour) as output deviates from potential output.
Aggregate demand curve: shows demand for goods and services in total at each rate of inflation
Short run equilibrium occurs at a point of intersection between AD and AS. Here, actual rate of inflation has
adjusted to the level of output and the output gap and, at that rate of inflation, aggregate demand is equal to that output
level.
Long run equilibrium occurs when the level of output is equal to potential output and so firms have no reason to
adjust inflation rate. i.e. actual inflation = expected inflation
Sources of economic fluctuations:
1. Demand shocks (shifts on the AD curve): AD shifts left. PAE < at each rate of inflation. In short run, firms
adjust output to meet demand. A (negative) contractionary gap appears causing decrease in actual rate of
inflation i.e. actual rate of inflation responds to output gap. As contractionary - firms selling less than they
want therefore reduce rate that the price is increased in order to reduce relative price so sell more. As this
happens, actual rate of inflation decreases rather than relative prices changing. Point where AD2 meets AS is
considered short-run equilibrium as there is still an output gap as actual output < potential output. Because of
output gap, actual inflation decreases. There is also positive cyclical unemployment or actual unemployment
rate > natural rate at short-run equ. In long-run actual rate of inflation will further decrease as firms reduce
rate at which they increase prices. w/ lower inflation, AD increases and new equ. at AD2=AS2. AS shifts to
AS2 as expected rate goes down as actual rate goes down. This is a long run movement. Output = potential
output, unemployment rate = natural rate and actual rate of inflation = expected rate.
If AD shifts right. PAE > output at each rate of inflation. Assume firms adjust output to meet demand and now
there is an expansionary gap. Causes an increase in the rate of inflation in current period and economy meets
short-run equilibrium where AS=AD2. Output (expansionary) gap exists as actual output > potential output.
Actual rate unemployment < natural rate so -ve cyclical unemployment. Expansionary gap causes increase in
actual rate of inflation, occurs because firms raise the rate at which they are increasing prices to increase
product’s relative price due to excess demand for product. As all firms act this was, actual rate of inflation
increases rather than the change in relative price. In the long run this will cause the expected rate of inflation
will also rise. AS shifts to AS2 because actual rate has increased. Long-run equilibrium at AS2=AD2, actual
output=potential output, actual inflation= expected inflation, actual unemployment= natural rate of
unemployment.
Low rates of inflation normally associated with high unemployment and vice versa.
2. Inflation shock shifting AS: -ve ( AS shifts up/left) or +ve (down/right). Sees an increase in the actual rate of
inflation that occurs due to a factor included in the random error term. In the example of a -ve shock: actual
rate of inflation initially increases and is initially in excess of expected rate until after a one period time lag,
the expected rate increases to a new higher annual rate to AD=AS2 (short run equ.). There is a decrease in AD
due to the increased rate of inflation, output falls below potential output and firms reduce the rate at which
they are increasing prices. Where AD=AS2, there is a -ve output gap(contractionary), actual output < potential
output and +ve cyclical unemployment since measured or actual rate of unemployment > natural rate. As
contractionary, firms raise prices at a lower rate to decrease relative prices as output < potential output and
firms selling < desired. As all firms behave in this way, actual rate of inflation decreases rather than a
decrease in firm’s relative price occurring. As actual rate of inflation falling, expected rate will also fall. It is
this last fall which causes AS to shift back to its original position and economy returns to AS=AD.
3. A shock to Potential Output: Output which results when all productive resources are being used at their
“normal” rates of utilisation or the level of output when the economy is producing an output level consistent
with its long run growth output. Inflation shocks may be sufficient to reduce level of potential output. Firms
may choose to no longer use less-efficient and more expensive to operate capital equipment that is intensive in
its use of energy. With less capital being used, potential output falls. Using the effect of the oil price shock on
potential output: immediately following decrease in potential output, at initial rate of inflation is an
expansionary output gap because actual output is now greater than potential output. In the presence of an
expansionary output gap, actual inflation and in turn expected inflation will increase. In response, AS shifts up
to AS2. This generates a new long-run equilibrium at AS2=AD
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Document Summary
The ad- aggregate supply framework and fluctuations in the economy. Aggregate supply curve: shows actual rate of inflation occurring at different levels of output and output gap. Or how actual rate of inflation will vary (due to behaviour) as output deviates from potential output. Aggregate demand curve: shows demand for goods and services in total at each rate of inflation. Short run equilibrium occurs at a point of intersection between ad and as. Here, actual rate of inflation has adjusted to the level of output and the output gap and, at that rate of inflation, aggregate demand is equal to that output level. Long run equilibrium occurs when the level of output is equal to potential output and so firms have no reason to adjust inflation rate. i. e. actual inflation = expected inflation. Sources of economic fluctuations: demand shocks (shifts on the ad curve): ad shifts left. In short run, firms adjust output to meet demand.
