Macroeconomic Equilibrium Review for AP Economics
Review questions for this study guide can be found at:
Main Topics: Equilibrium Real GDP and Price Level, Recessionary and Inflationary Gaps, Shifting AD, The Multiplier Again, Shifting AS
We use supply and demand models to predict changes in the prices and quantities of microeconomic goods and services. Now that we have built a model of aggregate demand and aggregate supply, we use similar analysis to predict changes in real GDP and the average price level.
Equilibrium Real GDP and Price Level
When the quantity of real output demanded is equal to the quantity of real output supplied, the macroeconomy is said to be in equilibrium. Figure 14.6 below illustrates macroeconomic equilibrium at full employment Qf and price level PLf at the intersection of AD and AS.
Recessionary and Inflationary Gaps
When the economy is in equilibrium, but not at the level of GDP that corresponds to full employment (GDPf), the economy is experiencing either a recessionary or an inflationary gap.
As the name implies, a recessionary gap exists when the economy is operating below Qf and the economy is likely experiencing a high unemployment rate. In Figure14.7, the recessionary gap is the difference between GDPf and GDPr, or the amount that GDP must rise to reach GDPf.
An inflationary gap exists when the economy is operating above GDPf. Because production is higher than GDPf, a rising price level is the greatest danger to the economy. In Figure 14.8, the inflationary gap is the difference between GDPi and GDPf, or the amount that GDP must fall to reach GDPf.
"Be able to locate these on a graph." —AP teacher
Since you have mastered the microeconomic tools of supply and demand, you should have little trouble predicting how macroeconomic factors affect real GDP and the price level.
Shifts in AD
The economy is currently in equilibrium but at a very low recessionary level of real GDP. If AD increases from AD0 to AD1 in the nearly horizontal range of SRAS, the price level maybe only slightly increases, while real GDP significantly increases and the unemployment rate falls.
If AD continues to increase to AD2 in the upward sloping range of SRAS, the price level begins to rise and inflation is felt in the economy. This demand-pull inflation is the result of rising consumption from all sectors of AD.
If AD increases much beyond full employment to AD3, inflation is quite significant and real GDP experiences minimal increases. Figures 14.9, 14.10, and 14.11 illustrate how rising AD has different effects on the price level and real GDP in the three stages of shortrun AS.
If aggregate demand weakens, we can expect the opposite effects on price level and real GDP. In fact, one of the most common causes of a recession is falling AD as it lowers real GDP and increases the unemployment rate. Inflation is not typically a problem with this kind of recession as we expect the price level to fall, or deflation, with falling AD. This is seen in Figure 14.12.
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