ECO102 Lecture 08

Completed Notes Status

Central objective: Understand the long-run adjustment process for the AS/AD model following fiscal, foreign, and supply shocks, emphasizing that the long-run multiplier is zero.
Key concepts:
- Output Gap Adjustment Process: Shocks that push actual GDP ( $Y$ ) away from potential GDP ( $y^{*}$ ) create either an Inflationary Gap or a Recessionary Gap. Wage adjustments ( $w$ ) eventually shift the Short-Run Aggregate Supply curve to restore long-run equilibrium.
- Fiscal Policy: Demand-side shocks (like $Δ G$ or $Δ N X$ ) shift AD, temporarily changing output and prices. In the long run, wages adjust, negating the output change and leaving the economy with a permanently changed price level.
- Aggregate Supply Shocks: Exogenous supply shocks move output and prices in opposite directions. The long-run self-correction mechanism alters nominal wages to reverse the shift entirely, meaning neither the long-run price level nor output changes permanently.
Connections:
- The lecture connects the Solow Model (which determines long-run potential output, $y^{*}$ ) to the Keynesian AD/AS framework. The intersection of AD and AS determines short-run fluctuations, while $y^{*}$ anchors the Long-Run Aggregate Supply.

#tk: flashcard this and line above (referencing Solow model and vertical LRAS)
- Answer: Created standalone flashcards verifying that the Solow model determines equilibrium $y^{*}$ and that LRAS is vertical at $y^{*}$ .
#tk: fix the graph, professors notes on the graph are not good and nonsensical curve which don't match the points.
- Answer: The algebraic derivation of the budget balance is $B = 0.25 Y - 20$ . At $Y = 80$ , $B = 0$ , which correctly intersects the x-axis. Review the specific slope in Desmos to ensure it matches the 0.25 multiplier.
#tk: graph below (missing NX and Savings graphs)
- If not answerable: Requires referring back to lecture slides or personal notes to accurately plot $N X$ and $S$ shifts. Action plan updated.
#tk: go to office hours tomorrow
- Answer: Logged in immediate review actions. Ensure you ask about the contradictory algebra around $p^{*} = 30$ versus $p^{*} = 50$ in the Foreign Shock example.
#tk: how do we get this (referencing $A D_{0} = 200 - 2 p$ )
- Answer: Derive AD by setting $Y = A E$ . Given $A E = 100 + 0.5 Y - p$ , substituting yields $Y = 100 + 0.5 Y - p ⟹ 0.5 Y = 100 - p ⟹ Y = 200 - 2 p$ .
#tk: flashcard this (supply shock variable change)
- Answer: Created flashcard verifying that in a supply shock, only the nominal wage ( $w$ ) changes permanently in the long run.
#tk: exam question (AS rotation)
- Answer: The rotation from $A S = 2 p$ to $A S = 3 p$ represents a slope change. Identified as a challenging concept below.

Remember/Understand:
- What happens to the nominal wage when the economy is in a recessionary gap?
- Why is the long-run aggregate supply curve vertical?
- In the long run, what is the value of the fiscal multiplier?
Apply/Analyze:
- If the government increases spending ( $G$ ) while the economy is at $y^{*}$ , trace the sequence of events that returns the economy to its long-run equilibrium.
- Explain why an exogenous shift in the SRAS curve results in no permanent change to the long-run price level.
Evaluate/Create:
- Given an AS rotation shock from $A S = 2 p$ to $A S = 3 p$ , calculate the necessary wage adjustment ( $w$ ) to restore long-run equilibrium if $y^{*} = 100$ and AD is given by $Y = 200 - 2 p$ .

Aggregate Demand Derivation:
- Why it's challenging: Recognizing that the AD curve is derived by enforcing the goods market equilibrium condition ( $Y = A E$ ) and isolating $Y$ as a function of $p$ .
- Study strategy: Practice substituting the given $A E$ equation into $Y = A E$ and solving for $Y$ algebraically every time.
Long-Run Multiplier is Zero:
- Why it's challenging: It is counter-intuitive that a fiscal expansion mathematically increases GDP in the short run but ultimately yields no extra output.
- Study strategy: Remember that the $y^{*}$ ceiling forces wage adjustments. Track the shifts visually: AD moves right, then AS moves left, canceling the real output gains but compounding the price increases.
AS Curve Rotation:
- Why it's challenging: Most shocks are parallel shifts (changes to the intercept). A rotation changes the slope, affecting how severely prices interact with wage adjustments.
- Study strategy: Redraw the $A S = 2 p$ and $A S = 3 p$ curves on a standard $P, Y$ axis. Recall that $P$ is on the y-axis, meaning you must conceptually invert the function to $P (Y)$ to visualize steepness.

Immediate review actions:
- Review all [COMPLETED] insertions and verify with course materials
- Address all #tk items (if any)
- Re-read Lecture Summary and confirm key links
- Go to office hours to clarify the conflicting price level calculations in the Foreign Shocks section ( $P = 30$ vs $P = 50$ ).
- Re-draw the missing $N X$ and Savings ( $S$ ) graphs on paper.
Practice and application:
- Answer Remember/Understand questions
- Answer Apply/Analyze questions
- Attempt Evaluate/Create questions
Deep dive study:
- Focus on Challenging Concepts (above)
- Extend atomic notes only where the new lecture adds content
Verification and integration:
- Cross-reference notes with textbook/slides
- Identify remaining gaps
- Link this lecture to prior/future lecture notes (lecture notes only; no MOCs)