Question

The aggregate-demand (AD), short-run aggregate supply (AS), and long-run aggregate-supply (AS_LR) schedules are as follows. The schedules show the GDP price deflator (P) versus real GDP (Q), with Q measured in trillions of constant dollars.

P	AD	AS	ASLR
80	30	22	30
90	28	24	30
100	26	26	30
110	24	28	30
120	22	30	30
130	20	32	30

1. GRAPHS: Graph the AD, AS, and AS_LR curves in the same diagram. Be sure to label the curves and the axes. Indicate potential output (Q_f) on the Q axis.

2. SHORT-RUN AND LONG-RUN AGGREGATE SUPPLY, IN GENERAL: Explain the difference in shape between the AS and AS_LR curves in general.

Note: “in general” means not just for this economy but for any economy.

3. SHORT-RUN AND LONG-RUN EQUILIBRIUM, IN GENERAL: State the general conditions for short-run equilibrium and for long-run equilibrium. Which one implies the other?

Note: “general” means not just for this economy but for any economy.

4. SHORT-RUN EQUILIBRUM, THIS ECONOMY: What is the short-run equilibrium price level? Explain your answer. What is the short-run equilibrium Q? Explain your answer. Show this short-run equilibrium price and output on the graph. Suppose that P is initially at 90. This implies that there is either excess demand or excess supply of Q—which one? And what is the amount of this excess demand or excess supply? Then explain the process of eliminating the excess demand or supply, that is, the process to reach short-run equilibrium.

5. LONG-RUN EQUILIBRIUM, THIS ECONOMY: What is long-run equilibrium GDP (Q)? Explain your answer. Assuming that the AD curve does not shift, what is the long-run equilibrium price level (P)? Explain your answer. Show the long-run equilibrium price and output on the graph. Beginning at short‑run equilibrium, describe the process to long-run equilibrium.

Answer 1

2) The difference in LRAS and SRAS is that LRAS is vertically fixed at its potential output (Q_f), whereas SRAS is upward sloping in nature due to stickiness of price and wages and menu costs, etc.

3) Short-Run Equilibrium: SRAS = AD;

    Long-Run Equilibrium: LRAS = AD

   An economy operating at its potential, i.e., at L.R. equilibrium will always be in its S.R. equilibrium.

4) Here, for P = 100, SRAS = AD; and hence this is the S.R. equilibrium, with corresponding Q = 26.

At P = 90, AD = 28 > 24 = AS, i.e., there persists excess demand in the economy. This excess demand implies a decrease in quantity produced against quantity demanded in the economy, boosting up the price levels in the process, until the economy reaches its equilibrium level of prices.

5) Here, for P = 80, LRAS = AD; and hence this is the L.R. equilibrium, with corresponding Q = 30.