Question

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

Short answer

In the AD/AS model, an economy might not achieve equilibrium at potential output due to demand-side factors such as insufficient aggregate demand or contractionary fiscal and monetary policies, and supply-side factors like productivity shocks or resource constraints. During the Great Recession, for example, a significant drop in aggregate demand, coupled with contractionary policies, led to a large output gap and high unemployment.

Step-by-step solution

1. Understand Potential Output

Potential output refers to the level of output that an economy can produce when all its resources, including labor and capital, are employed at their maximum efficiency. When the economy is operating at potential output, it is considered to be at full employment, with the actual output equal to its potential output.

2. Review the AD/AS Model

In the AD/AS model, the Aggregate Demand curve shows the relationship between the overall price level in the economy and the quantity of goods and services demanded. The Aggregate Supply curve indicates the relationship between the overall price level and the quantity of goods and services supplied. The intersection of the AD and AS curves determines the equilibrium level of output (Y) and the price level (P).

3. Factors that Prevent Equilibrium at Potential Output

There are several factors that can cause an economy not to achieve equilibrium at its potential output. These factors can be divided into two broad categories: demand-side factors and supply-side factors. a) Demand-side factors: These factors are related to the Aggregate Demand curve. If the AD curve does not intersect the AS curve at the potential output level, the economy will not be in equilibrium at potential output. Some possible demand-side factors include: - Insufficient aggregate demand: If consumers and businesses do not have enough purchasing power, the economy may not reach its potential output. This can be due to a lack of consumer confidence, high unemployment, or a tight monetary policy. - Fiscal and monetary policy: Contractionary fiscal or monetary policy can reduce aggregate demand, causing the AD curve to shift to the left, away from potential output. This can occur if the government decides to reduce spending, increase taxes, or if the central bank raises interest rates. b) Supply-side factors: These factors are related to the Aggregate Supply curve and might cause the AS curve to shift away from potential output. Some possible supply-side factors include: - Productivity shocks: Unforeseen events, such as natural disasters, can disrupt the production process, causing the AS curve to shift to the left. This can reduce the potential output level of the economy. - Resource constraints: An economy might face resource constraints, such as labor shortages or insufficient access to capital, which can prevent it from reaching potential output. In this case, the AS curve may not intersect the AD curve at potential output.

4. Real-World Example: The Great Recession

The Great Recession (2007-2009) serves as an example of an economy not achieving potential output. During this period, the U.S. and many other countries experienced a significant drop in aggregate demand due to financial market disruptions, leading to high unemployment and a large output gap (the difference between actual and potential output). Contractionary monetary and fiscal policies further exacerbated the situation, causing the aggregate demand curve to shift even further away from potential output. In summary, various factors can prevent an economy from achieving equilibrium at its potential output in the AD/AS model. These factors can include demand-side issues such as insufficient aggregate demand, contractionary fiscal and monetary policies, or supply-side factors such as productivity shocks or resource constraints.