equilibrium (ad

MACROECONOMIC EQUILIBRIUM (AD/AS)

PREPARED BY :

UMAIR

MACROECONOMIC EQUILIBRIUM

The interaction of aggregate demand and aggregate supply determines macroeconomic equilibrium, and understanding macroeconomic equilibrium provides insight into changes in real GDP and the price level.

In considering determination of real GDP and the price level, however, we must distinguish between the short run and the long run.

SHORT-RUN MACROECONOMIC EQUILIBRIUM

Short-run macroeconomic equilibrium occurs (geometrically) at the intersection of the short-run aggregate supply curve (SRAS) and the aggregate demand curve (AD).

This intersection indicates the price level at which the aggregate quantity of final goods and services supplied in the economy is equal to the aggregate quantity demanded, and indicates as well the corresponding level of real GDP.


To see that this point of intersection is an equilibrium point, consider first a situation where the price level is below that corresponding to the short-run equilibrium.

At this price level, the quantity of real GDP that will be supplied by firms will be less than the quantity of real GDP that will be demanded by households, business firms, government, and net foreign demand.

With firms unable to meet demand, inventories decline and back orders become the rule.

In order to meet the strong demand, firms will begin to increase production; and in so doing will incur additional resource costs that will result in price increases (i.e., there will be a movement up along the SAS curve).

As prices increase, this will lead to a moderating of demand (movement up along the AD curve). These movements will continue until quantity supplied equals quantity demanded -- at the point of intersection of the SAS and AD curves.


Similarly, if the price level is greater than the equilibrium level, the quantity of real GDP supplied will exceed the quantity demanded.

In this case, inventories will accumulate, goods and services will go unsold, and eventually firms will lay off workers, cut production, and reduce prices in order to sell their output.

This translates into a movement down along the SAS curve, and as prices fall there will be a corresponding movement down along the AD curve.

These movements will continue until equilibrium is reached.

LONG-RUN MACROECONOMIC EQUILIBRIUM

Long-run macroeconomic equilibrium requires that real GDP be equal to potential GDP, and corresponds to a situation of full employment.

That is, long-run macroeconomic equilibrium entails the economy being on its vertical long-run supply curve.

This contrasts with the short-run equilibrium situation, in which real GDP may be less than or greater than (or equal to) potential GDP.

Let's take a look at the different possible short-run situations vis-à-vis long-run equilibrium


Consider first the case where there is a short-run equilibrium at a real GDP below the level of potential GDP.

This is called a below full-employment equilibrium, and the difference between potential GDP and real GDP is called a recessionary gap.

A recessionary gap is associated with a business cycle contraction.

In any case, the most obvious manifestation of a recessionary gap is the presence of high unemployment.

RECESSIONARY GAP

RECESSIONARY GAP

If real GDP < Potential real GDP (full employment GDP), then a recessionary gap exist.

At the same time: Unemployment rate > natural rate of unemployment.

Since more job seekers are in the market, they tend to settle with a lower wage.

Lower wage will lower the AS curve (increase AS) and causing the price to decrease.

Lower price will increase consumption. This process will continue until the economy reaches the

long run equilibrium (potential real GDP).


Short-run equilibrium at a real GDP in excess of potential GDP is called an above full-employment equilibrium.

The excess of real GDP over potential GDP is called an inflationary gap.

That is, this gap creates inflationary pressure.

INFLATIONARY GAP

INFLATIONARY GAP

If real GDP > Potential real GDP (full employment GDP), then an inflationary gap exist.

At the same time: Unemployment rate < natural rate of unemployment.

Since job seekers are less than job openings in the market, employers are forced to raise the wage to attract new workers.

High wage will decrease the AS (upward shift), and raise the price.

Higher price will lower consumption. This process will repeat until the long run equilibrium is

reached.

FULL-EMPLOYMENT EQUILIBRIUM

The third possibility is with a short-run equilibrium at a real GDP just equal to potential GDP.

This is a full-employment equilibrium, and is the only case where we have long-run equilibrium as well as short-run equilibrium.

FULL-EMPLOYMENT EQUILIBRIUM

CHANGES IN AD

First consider the consequences of an increase in aggregate demand, as might occur in response to increases in expected future incomes, profits,

or inflation; in response to a lower exchange rate or higher foreign

incomes; in response to fiscal policy increasing government spending

or transfer payments, or decreasing taxes; or in response to expansionary monetary policy (increasing

the money supply) or lowering of interest rates.

CHANGES IN AD

Increased aggregate demand will result in a new short-run macroeconomic equilibrium, with a higher price level and a higher level of real GDP.

This results in demand-pull inflation. As AD rises, output rises, and unemployment falls.

CHANGES IN AD

CHANGES IN AS

Similarly, changes in SAS can result in fluctuations in real GDP around potential GDP.

For example, a leftward shift of the SAS curve (as would occur with an increase in factor prices) will bring about a new short-run macroeconomic equilibrium, with higher prices and lower real GDP than prior to the shift.

It results in cost-push inflation. This combination of higher prices and reduced output is

known as stagflation.

CHANGES IN AS

equilibrium (ad

Entertainment & Humor