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Long run and short run equilibrium the as ad

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Long run and short run equilibrium
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The AS-AD (aggregate supply-aggregate demand) model . 31 Inflation ( ) 0 Output ( Y ) AD (aggregate demand) SRAS (short run aggregate supply) LRAS (long run aggregate supply) Y* Y Short run equilibrium
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The AS-AD (aggregate supply-aggregate demand) model . 32 Inflation ( ) 0 Output ( Y ) AD (aggregate demand) SRAS (short run aggregate supply) LRAS (long run aggregate supply) Y* Y Short run equilibrium
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Inflation: what influences the inflation rate? and therefore the position of SRAS Short run: Inflation ‘sticky’ – fairly stable over time, ‘inflationary expectations’ influenced by current inflation rate reinforced by wage/price contracts. Long run: Inflation adjusts in response to ….. 1) The size of the output gap ( Y*- Y ) 2) Shocks to the cost of inputs 3) Shocks to potential output ( Y *) 33
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1) The size of the output gap: no output gap (Y = Y*) . 34 Inflation ( ) 0 Output ( Y ) AD SRAS LRAS Y = Y* Y = Y*, no incentive to change relative prices => no change in inflation rate ( AD = SRAS = LRAS )
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35 1) The size of the output gap: R ecessionary gap (Y < Y*) . Inflation ( ) 0 Output ( Y ) AD SRAS LRAS Y* Y
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Recessionary gap (Y < Y*) Excess supply of goods and services; decrease relative prices (prices rise by less than costs) Cyclical unemployment, unemployment is above the natural rate; excess supply of labour => wages rise by less than the current inflation rate inflation falls ( SRAS shifts down) => move along AD (output increases as RBA follows policy reaction function) Y increases, until Y = Y * (and cyclical unemployment falls until unemployment reaches natural rate) AD = SRAS = LRAS 36
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37 1) The size of the output gap: recessionary gap (Y < Y*) . Inflation ( ) 0 Output ( Y ) AD SRAS LRAS Y* Y
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38 1) The size of the output gap: recessionary gap (Y < Y*) . Inflation ( ) 0 Output ( Y ) AD SRAS LRAS Y* Y
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1) The size of the output gap: expansionary gap (Y > Y*) . 39 Inflation ( ) 0 Output ( Y ) AD LRAS Y* Y SRAS
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40 Expansionary gap (Y > Y*) Excess demand for goods and services; increase relative prices (by more than costs) Unemployment is below the natural rate; excess demand for labour => wages rise by more than current inflation rate inflation rises ( SRAS shifts up) => move along AD (output falls as RBA follows policy reaction function) Y falls, until Y = Y * (and unemployment rises until it reaches natural rate) AD = SRAS = LRAS ** SUGGESTS A SOURCE OF INFLATION IS EXCESSIVE DEMAND (AD SHIFT RIGHT)
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1) The size of the output gap: expansionary gap (Y > Y*) . 41 Inflation ( ) 0 Output ( Y ) AD LRAS Y* Y SRAS
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1) The size of the output gap: expansionary gap (Y > Y*) . 42 Inflation ( ) 0 Output ( Y ) AD LRAS Y* Y SRAS
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43 Excessive demand leads to an expansionary gap and inflation . Inflation ( ) 0 Output ( Y ) AD LRAS Y* SRAS AD’
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44 Excessive demand leads to an expansionary gap and inflation . Inflation ( ) 0 Output ( Y ) AD LRAS Y* SRAS AD’ Y
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45 Excessive demand leads to an expansionary gap and inflation . Inflation ( ) 0 Output ( Y ) AD LRAS Y* SRAS AD’ Y New equilibrium with higher inflation SRAS’
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Suggests economy self corrects in the long run In long run output gaps eliminated without stabilisation policies (other than RBA’s policy reaction function) Recessionary gap - self correction requires wages/prices to fall -> depends on:
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