AP_Krugman_Textbook

module 19 Equilibrium in the Aggregate Demand–Aggregate Supply Model 195

Section 4 National Income and Price Determination

U.S. economy experienced in 1929–1933: a falling aggregate price level and falling ag-
gregate output.
Aggregate output in this new short -run equilibrium, E 2 , is below potential output.
When this happens, the economy faces a recessionary gap.A recessionary gap inflicts
a great deal of pain because it corresponds to high unemployment. The large recession-
ary gap that had opened up in the United States by 1933 caused intense social and po-
litical turmoil. And the devastating recessionary gap that opened up in Germany at the
same time played an important role in Hitler’s rise to power.
But this isn’t the end of the story. In the face of high unemployment, nominal wages
eventually fall, as do any other sticky prices, ultimately leading producers to increase
output. As a result, a recessionary gap causes the short -run aggregate supply curve to
gradually shift to the right. This process continues until SRAS 1 reaches its new position
atSRAS 2 , bringing the economy to equilibrium at E 3 , where AD 2 ,SRAS 2 , and LRASall
intersect. At E 3 , the economy is back in long -run macroeconomic equilibrium; it is
back at potential output Y 1 but at a lower aggregate price level, P 3 , reflecting a long -run
fall in the aggregate price level. The economy is self -correctingin the long run.
What if, instead, there was an increase in aggregate demand? The results are shown
in Figure 19.6 on the next page, where we again assume that the initial aggregate de-
mand curve is AD 1 and the initial short -run aggregate supply curve is SRAS 1 , so that
the initial macroeconomic equilibrium, at E 1 , lies on the long -run aggregate supply
curve, LRAS.Initially, then, the economy is in long -run macroeconomic equilibrium.
Now suppose that aggregate demand rises, and the ADcurve shifts rightward to
AD 2. This results in a higher aggregate price level, at P 2 , and a higher aggregate output
level, at Y 2 , as the economy settles in the short run at E 2. Aggregate output in this new
short -run equilibrium is above potential output, and unemployment is low in order to

figure 19.5

Short -Run Versus

Long -Run Effects

of a Negative

Demand Shock

In the long run the economy is

self -correcting: demand shocks

have only a short -run effect on

aggregate output. Starting at

E 1 , a negative demand shock

shiftsAD 1 leftward to AD 2. In

the short run the economy

moves to E 2 and a recessionary

gap arises: the aggregate price

level declines from P 1 toP 2 ,

aggregate output declines from

Y 1 toY 2 , and unemployment

rises. But in the long run nomi-

nal wages fall in response to

high unemployment at Y 2 , and

SRAS 1 shifts rightward to

SRAS 2. Aggregate output rises

fromY 2 toY 1 , and the aggre-

gate price level declines again,

fromP 2 toP 3. Long -run macro-

economic equilibrium is even-

tually restored at E 3.

Y 2 Y 1 Real GDP

P 1

Aggregate

price

level

E 1

E 3

E 2

P 3

P 2

SRAS 1

SRAS 2

LRAS

AD 1

AD 2

Recessionary gap

3. ...until an eventual
   fall in nominal wages
   in the long run increases
   short-run aggregate supply
   and moves the economy
   back to potential output.


4. ...reduces the aggregate
   price level and aggregate
   output and leads to higher
   unemployment in the short
   run...


5. An initial
   negative
   demand shock...

Potential

output

There is a recessionary gapwhen

aggregate output is below potential output.