Question

In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?

Short answer

In the AD/AS model, several factors can prevent the economy from achieving equilibrium at potential output, including economic shocks, sticky prices and wages, inflationary or deflationary gaps, and monetary and fiscal policies. These factors can cause fluctuations in output and price levels, as well as shifts in the AD and AS curves. However, over time, automatic stabilizing mechanisms and government intervention might help the economy adjust and reach equilibrium at potential output.

Step-by-step solution

Understanding the AD/AS model

In the AD/AS model, there are two main components: Aggregate Demand (AD) and Aggregate Supply (AS). AD represents the total demand for goods and services in an economy, while AS represents the total supply of goods and services. The intersection of the AD and AS curves determines the equilibrium level of output and the price level.

Potential output

Potential output, also known as full employment output, is a macroeconomic concept that refers to the level of output that the economy can produce when the labor and capital resources are fully employed. In the AD/AS model, this is represented by the level of output corresponding to the Long-Run Aggregate Supply (LRAS) curve, which is a vertical line indicating that in the long run, the economy's output is determined by its resources, technology, and productivity, irrespective of the price level.

Factors preventing equilibrium at potential output

For the economy to achieve equilibrium at potential output, the AD and AS curves must intersect precisely at the LRAS curve. However, several factors can prevent this from happening: 1. Economic shocks: Unanticipated events such as natural disasters, political instability, or technological changes can cause sudden and unpredicted changes in AD or AS, leading to fluctuations in output and the price level. 2. Sticky prices and wages: In reality, wages and prices do not adjust immediately to changes in economic conditions. This "stickiness" can cause short-run fluctuations in output, preventing the equilibrium from being reached instantly. 3. Inflationary or deflationary gaps: If the economy is operating below potential output with high unemployment (deflationary gap) or above potential output with high inflation (inflationary gap), the AD and AS curves will not intersect at the LRAS curve. The economy may take time to adjust to these gaps with shifts in demand or supply. 4. Monetary and fiscal policies: Government policies such as interest rate changes or government spending can affect AD and AS, sometimes preventing the equilibrium from being reached at potential output.

Achieving equilibrium through adjustments

The economy might eventually achieve equilibrium at potential output through automatic stabilizing mechanisms and government policies. If there is a deflationary gap, the lower price level may encourage consumption and investment, increasing aggregate demand and pushing output back towards potential. Similarly, if there is an inflationary gap, the higher price level could discourage spending, reducing aggregate demand, and pushing the output back down towards potential. In summary, various factors such as economic shocks, sticky prices and wages, inflationary or deflationary gaps, and monetary and fiscal policies can prevent the economy from achieving equilibrium at potential output in the AD/AS model. Nonetheless, over time, the economy might adjust and reach equilibrium through automatic stabilizing mechanisms and government intervention.