Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the AS curve. If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices. If the quantity of real demand exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices.
Three Types of Macroeconomic Equilibrium: The Recessionary Gap
A full employment equilibrium occurs when equilibrium real GDP equals potential GDP. In this case, AS intersects AD and the Potential GDP at the same equilibrium point. There are no gaps in this case.
A recessionary gap (or below full employment equilibrium ) occurs when real GDP is less than potential GDP and that brings a falling price level. A recessionary gap occurs when the SRAS curve and the AD curve intersect to the left of the potential GDP line. In Figure 6.3, potential GDP is $16 trillion but the actual equilibrium real GDP is $15 trillion. In a recessionary gap, there is a surplus of labor and firms can hire new workers at a lower wage rate. As the money wage rate falls, the SRAS curve shifts rightward and the price level falls and real GDP rises. The money wage rate falls until real GDP equals potential GDP. (20)
An inflationary gap (or above full employment equilibrium ) occurs when real GDP exceeds potential GDP and that brings a rising price level. An inflationary gap occurs when the AS curve and the AD curve intersect to the right of the potential GDP line. In Figure 6.4, potential GDP is $16 trillion but the actual real GDP is $16.5 trillion. In an inflationary gap, there is a shortage of labor and firms must offer higher wage rates to hire the labor they demand. As the money wage rate rises, the AS curve shifts leftward and the price level rises and real GDP falls. The money wage rate rises until real GDP equals potential GDP. (20)
Using the AD/AS Model to Explain Inflation and the Business Cycle
Inflation results when the quantity of money grows at a rate that outpaces the growth of potential GDP. Using the AD/AS model, when the AD curve shifts rightward at a faster rate than the potential GDP curve, inflation occurs.
The business cycle results from fluctuations in aggregate supply and aggregate demand. Aggregate supply fluctuates because labor productivity grows at a variable pace, which brings fluctuations in the growth of potential GDP. A real business cycle results from fluctuations in the pace of growth of labor productivity and potential GDP.
Aggregate demand fluctuations are the main source of the business cycle, since swings in aggregate demand occur more quickly than changes in the money wage rate that change aggregate supply.
Demand-pull inflation is inflation that starts because aggregate demand increases. Demand-pull inflation can be started by any of the factors that increase aggregate demand, but can only be sustained by growth in the quantity of money.
Starting at full employment, an increase in AD increases the price level and real GDP and creates an inflationary gap. The shortage of labor increases the money wage rate, which decreases AS and thereby increases the price level and decreases GDP back to potential GDP. If the quantity of money increases, AD will increase again, creating an inflationary gap. This process repeating itself results in an ongoing demand-pull inflation spiral.
Cost-push inflation is an inflation that begins with an increase in cost. The two main sources of cost increases are increases in the money wage rate and increases in the money prices of raw materials, such as oil. Cost-push inflation can be started by an increase in costs, but can only be sustained by growth in the quantity of money. Starting at full employment, an increase in oil prices decreases the AS, which increases the price level, decreases real GDP, and creates a recessionary gap. When the unemployment rate rises above the natural rate, the Fed increases the quantity of money to restore full employment. AD increases and returns real GDP back to potential GDP, but the price level rises further. Oil producers now see the price of everything else rising, so they raise the price of oil higher, and this process repeats in a cost-push inflation spiral.
The combination of recession (decreasing real GDP) and inflation (rising price level) is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks. Stagflation poses a dilemma for the Fed, because if they fail to increase the quantity of money, the economy remains below full employment, but if they increase the quantity of money it can create a cost-push inflation spiral. (20)