Macro Project 2 Important Final Assignment $ Any Takers?

Handout MACRO - #20P

Three States of the Economy

Too Hot, Too Cold, Just Right

In the short run, aggregate supply slopes upward to the right showing the positive relationship between price level and quantity supplied of real GDP. In the long run, aggregate supply is simply the level of potential real GDP produced at full employment or when the unemployment rate is at its natural level.

The economy can be in any of three states: a recessionary gap, an inflationary gap, or in long-run equilibrium.

· A recessionary gap occurs when, at its short run equilibrium, the economy is producing less than the natural real GDP.

In a recessionary gap, the quantity of real GDP being produced is below the full employment level of output, which means that unemployment is higher than its natural rate. There is a surplus of labor in the labor market.

· An inflationary gap occurs when, at its short run equilibrium, the economy is producing more than the natural real GDP.

In an inflationary gap, the quantity of real GDP being produced is above the full employment level of output, which means that unemployment is lower than its natural rate. There is a shortage in the labor market.

· Long run equilibrium occurs when, at its short run equilibrium, the economy is producing the same level of output as the natural real GDP.

In long run equilibrium, the quantity of real GDP being produced is the same as the full employment level of output (potential GDP), which means that unemployment is at its natural rate. The labor market is also in equilibrium.

Price Level

LRAS

QN

Natural Real GDP at full employment

(Potential GDP)

AD

Real GDP

Long run equilibrium

SRAS

Pe

Price Level

LRAS

Qe

AD

Real GDP

Short run equilibrium

SRAS

< QN

U>UN

Pe

Real Wage

Labor Demand (Businesses)

At QN

Labor Hours

Labor Supply (Households)

Surplus of Labor

We1

We

Too High Now

Labor Demand1 (Businesses)

At Qe<QN

QL1

Less than

QN Full Employment

U<UN

QLe

At

QN Full Employment

U=UN

LRAS

Price Level

Qe

AD

Real GDP

Short run equilibrium

SRAS

QN <

U<UN

Pe

Real Wage

Labor Demand (Businesses)

At QN

Labor Hours

Labor Supply (Households)

Shortage of Labor

We1

Labor Demand1 (Businesses)

At Qe>QN

QL1

Greater than

QN Full Employment

U<UN

QLe

At

QN Full Employment

U=UN

We

Too Low Now

Price Level

LRAS

Qe

AD

Real GDP

Short & long run equilibrium

SRAS

QN =

U=UN

Pe

Real Wage

Labor Demand (Businesses)

At QN

Labor Hours

Labor Supply (Households)

QLe

At

QN Full Employment

U=UN

We