AP_Krugman_Textbook

196 section 4 National Income and Price Determination

figure 19.6

Short -Run Versus

Long -Run Effects

of a Positive

Demand Shock

Starting at E 1 , a positive de-

mand shock shifts AD 1 right-

ward to AD 2 , and the economy

moves to E 2 in the short run.

This results in an inflationary

gap as aggregate output rises

fromY 1 toY 2 , the aggregate

price level rises from P 1 toP 2 ,

and unemployment falls to a

low level. In the long run, SRAS 1

shifts leftward to SRAS 2 as

nominal wages rise in response

to low unemployment at Y 2. Ag-

gregate output falls back to Y 1 ,

the aggregate price level rises

again to P 3 , and the economy

self -corrects as it returns to

long -run macro economic equi-

librium at E 3.

Y 1 Y 2 Real GDP

P 3

Aggregate

price

level

E 3

E 1

E 2

P 1

P 2

SRAS 2

SRAS 1

LRAS

AD 2

AD 1

Inflationary gap

3. ...until an eventual rise in nominal
   wages in the long run reduces short-run
   aggregate supply and moves the


4. An initial positive economy back to potential output.
   demand shock...


5. ...increases the
   aggregate price level
   and aggregate output
   and reduces unemployment
   in the short run...

Potential

output

produce this higher level of aggregate output. When this happens, the economy experi-

ences an inflationary gap.As in the case of a recessionary gap, this isn’t the end of the

story. In the face of low unemployment, nominal wages will rise, as will other sticky

prices. An inflationary gap causes the short -run aggregate supply curve to shift gradu-

ally to the left as producers reduce output in the face of rising nominal wages. This

process continues until SRAS 1 reaches its new position at SRAS 2 , bringing the economy

into 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, but at a

higher price level, P 3 , reflecting a long -run rise in the aggregate price level. Again, the

economy is self -correcting in the long run.

To summarize the analysis of how the economy responds to recessionary and infla-

tionary gaps, we can focus on the output gap,the percentage difference between actual

aggregate output and potential output. The output gap is calculated as follows:

(19-1) Output gap =× 100

Our analysis says that the output gap always tends toward zero.

If there is a recessionary gap, so that the output gap is negative, nominal wages eventu-

ally fall, moving the economy back to potential output and bringing the output gap back

to zero. If there is an inflationary gap, so that the output gap is positive, nominal wages

eventually rise, also moving the economy back to potential output and again bringing the

output gap back to zero. So in the long run the economy is self -correcting:shocks to ag-

gregate demand affect aggregate output in the short run but not in the long run.

Actual aggregate output −Potential output

Potential output

There is an inflationary gapwhen
aggregate output is above potential output.

Theoutput gapis the percentage difference
between actual aggregate output and
potential output.

The economy is self -correctingwhen
shocks to aggregate demand affect
aggregate output in the short run, but not the
long run.