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Lecture 34

Lecture 34-Inflationary-Recessionary Gap (LRAS)

5 Pages
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Department
Economics
Course Code
ECO102H1
Professor
Jack Carr

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Tuesday, March 2nd, 2010.
Yp: output when factors of production are utilized at normal rates
Short-Run Equilibrium: Alternative Cases
1. Y < Yp Recessionary gap
2. Y > Yp Inflationary gap
3. Y = Yp Full-employment (real GDP = potential GDP)
What will happen, in the long run, to:
1) The wage rate? FALLS (due to high unemployment)
2) The price level? FALLS (as SRAS shifts right)
3) Aggregate Demand? INCREASES (as price level falls)
4) Real GDP (Y)? INCREASES (to Yp)
Price Level
SRAS
Real GDP
AD
Y
Yp
Inflationary output gap
Price Level
SRAS
Real GDP
AD
Y
Yp
Recessionary output gap
www.notesolution.com
Recessionary Gap: Self-Correction (in Long Run)
1. Yp ± Y0 = Recessionary Gap
2. Real GDP < Potential GDP =>
8QHPSOR\PHQW9
Wage rate ;HYHQWXDOO\
3. :DJH5DWH; !65$60 shifts right to SRAS1
(As costs of production fall, firms expand output)
4. Long-Run Equilibrium occurs at Yp
Summary
Short-Run
AD and SRAS determine real GDP
Time frame: say one year
Remember: factor prices are assumed to be a constant
Long-Run
Real GDP = LRAS (Potential GDP)
Time frame: several years or more
Implications
1. $'³VKRFNFKDQJHUHDO*'3LQshort-run, but not in long-run
2. Fiscal policy (for example) has different short-run and long-run impacts on real GDP
Example
Government increases expenditure (G) by $20 million.
SRAS0
AD
Y0
Yp
LRAS
SRAS1
(w1 < w0)
Y< Yp
www.notesolution.com

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Description
Tuesday, March 2nd, 2010. Yp: output when factors of production are utilized at normal rates Short-Run Equilibrium: Alternative Cases 1. Y < Yp Recessionary gap 2. Y > Yp Inflationary gap 3. Y = Yp Full-employment (real GDP = potential GDP) What will happen, in the long run, to: 1) The wage rate? FALLS (due to high unemployment) 2) The price level? FALLS (as SRAS shifts right) 3) Aggregate Demand? INCREASES (as price level falls) 4) Real GDP (Y)? INCREASES (to Yp) Price Level SRAS Real GDP AD Y Yp Inflationary output gap Price Level SRAS Real GDP AD Y Yp Recessionary output gap Y< Yp www.notesolution.com Recessionary Gap: Self-Correction (in Long Run) 1. Yp ± Y0 = Recessionary Gap 2. Real GDP < Potential GDP => 8QHPSOR\PHQW9 Wage rate ;HYHQWXDOO\ 3. :DJH5DWH; !65$60 shifts right to SRAS1 (As costs of production fall, firms expand output) 4. Long-Run Equilibrium occurs at Yp Summary Short-Run AD and SRAS determine real GDP Time frame: say one year Remember: factor prices are assumed to be a constant Long-Run Real GDP = LRAS (Potential GDP) Time frame: several years or more Implications 1. $'³VKRFNV´FKDQJHUHDO*'3LQshort-run, but not in long-run 2. Fiscal policy (for example) has different short-run and long-run impacts on real GDP Example Government increases expenditure (G) by $20 million. SRAS0 AD Y0 Yp LRAS SRAS1 (w1 < w0) Y< Yp www.notesolution.com What happens, in the long run, to: 1) Real GDP (Y)? 2) The price level? Shift in Demand and Long-Run Equilibrium 1. Long-Run Equilibrium (AD0 shifts to AD1) Y= Yp (Full Employment) Ù No change in real GDP P0 rises to P1 2. How does this occur? Adjustments to Long-Run Equilibrium 1. AD ± SRAS Intersection always determines equilibrium => SRAS0 ± AD0 intersection also occurs at Yp (Note: Not Shown in prior diagram) 2. AD 0 -> AD0 => P > P0 and Y0 > Yp (Inflationary Gap) Along SRAS0: firms increase output as prices rise (and wages remain unchanged) p0 LRAS Real GDP p1 Yp AD0 AD1 p0 p1 Yp Y1 SRAS0 SRAS1 LRAS AD1 AD0 www.notesolution.com 3. In long run, wages also rise, thereby shifting SRAS0 leftward to SRAS1 4. Long Run Equilibrium is established at Y = Yp and P = P1 Economic Facts Year Unemployment Rate Recessionary Gap 1991 11.0% Full-Employment 2000 6.8% Remember: intersection of AD and SRAS always determines Y Policy Issues: Recession of 1991-1992 Should federal government: A) Allow self-correcting forces to (slowly) return the economy to full-employment? B) Use expansionary fiscal policy ± higher G and/or lower T ± to shift the AD curve to the right and thus expand real GDP? SRAS AD Y Yp LRAS 1991 Recessionary Gap SRAS AD Yp =Y LRAS 2000 www.notesolution.com Recessionary Gap: Policy Intervention 1. Yp ± Y0 = Recessionary Gap 2. *9DQGRU7;Ù increase in autonomous expenditure Ö AD shifts right to AD1 Potential Limitations of Policy Intervention 1. Difficult to forecast future course of economy 2. Lags in impact of policy Ù might destabilize economy 3. *9DQGRU7;LQFUHDVHVJRYHUQPHQWDOdeficit Prices Model Purpose is to study All Prices are Fixed AE Model Aggregate Expenditure and multiplier Prices of Factors of AD-SRAS Determination of real Production only are Model GDP and price level fixed All Prices are AD-LRAS Long-run properties of flexible Model economy Ù AD-Yp Model SRAS0 AD Y0 Yp LRAS AD1 www.notesolution.comnd Tuesday, March 2 , 2010. Y p output when factors of production are utilized at normal rates Short-Run Equilibrium: Alternative Cases 1. Y < Y pecessionary gap 2. Y > Y pnflationary gap 3. Y = Y pull-employment (real GDP = potential GDP) SRAS Price Level AD Y Y Real GDP p Recessionary output gap SRAS Price Level AD Yp Y Real GDP Inflationary output gap Y< Y p What will happen, in the long run, to: 1) The wage rate? FALLS (due to high unemployment) 2) The price level? FALLS (as SRAS shifts right) 3) Aggregate Demand? INCREASES (as price level falls) 4) Real GDP (Y)? INCREASES (to Y ) p www.notesolution.com
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