MACROECONOMIC EQUILIBRIUM Economics - A Course Companion Blink & Dorton , 2007. p186-200

1. MACROECONOMIC EQUILIBRIUM Economics - A Course Companion Blink & Dorton, 2007. p186-200

2. Introduction to Macroeconomic Equilibrium • Remember that national income is equivalent to the national output that a country produces. • The actual level of output and its corresponding price level and determined by the interaction between aggregate demand and aggregate supply.

3. Introduction to Macroeconomic Equilibrium What is the equilibrium level of national income? • The equilibrium level of national income is where aggregate demand is equal to aggregate supply. • There is short run and long run macroeconomic equilibrium.

4. Short-Run Equilibrium Output • The economy is in short-run equilibrium where aggregate demand equals short run aggregate supply (SRAS) • As aggregate demand is equal to aggregate supply, there is no upward or downward pressure on the price level. • As long as nothing changes to influence AD or AS, the economy rests at this equilibrium.

5. SHORT RUN EQUILIBRIUM OUTPUT The economy is in short-run equilibrium where aggregate demand equals short run aggregate supply, producing at output level of Y at the price level of P. The output produced by the economy is exactly equal to the total demand in the economy and so there no reason for producers to change their levels of output.

6. Long Run Equilibrium Output • The long-run equilibrium is where aggregate demand is equal to long run aggregate supply. • Given that there is disagreement among economists as to the shape of the long run aggregate supply curve, it is necessary to distinguish between the Keynesian long-run equilibrium output and neo-classical long-run equilibrium output.

7. Short-Run Equilibrium OutputKeynesian Perspective • According to Keynesian economists, the equilibrium level of output may occur at different levels. • Significantly they believe the economy may be in a long run equilibrium at a level of output below the full employment level of national income (Yf)

8. LONG RUN EQUILIBRIUM OUTPUT: KEYNESIAN The economy may be in a long run equilibrium at a level of output below the full employment level of national income (Yf). This will be the case if the economy is operating at a level where there is spare capacity. In this view the equilibrium level of output depends mainly on the level of aggregate demand in the economy. Equilibrium will occur at a real output level of Y, with a price level of P.

9. Long Run Equilibrium below Full Employment Level of Output: Keynes • Aggregate supply can be perfectly elastic because of the existence of spare capacity, where high levels of unused factors of production such as unemployed workers and or underutilised capital. • The equilibrium level of output is below the full employment level of output.

10. Long Run Equilibrium below Full Employment Level of Output: Keynes Deflationary Gap (p187) • A deflationary gap exists when the level of aggregate demand in the economy is not sufficient to buy up the potential output that could be produced by the economy at the full employment level of output.

11. A DEFLATIONARY GAP OR OUTPUT GAP There is a deflationary gap whereby the level of aggregate demand in the economy is not sufficient to buy up the potential output that could be produced by the economy at the full employment level of output. This may also be referred to as an output gap. It is not easily measureable. However, it could be shown as the distance from a point inside a country’s hypothetical production possibility curve to a point on the curve.

12. INCREASE IN REAL OUTPUT WITHOUT INCREASE IN THE PRICE LEVEL In the Keynesian view, aggregate demand can increase and this will lead to a rise in the level of real output. However, there is no increase in the price level and this shown in this graph. If there is an increase in aggregate demand from AD1 to AD2, then there will be an increase in real output from Y1 to Y2 but no change in the price level. Producers can employ the unused factors of production to increase output with no increase in costs. Thus there is no inflationary pressure.

13. WHEN DO INFLATIONARY PRESSURES BECOME A PROBLEM? If aggregate demand increases further to AD3 as shown in this graph, then the economy starts to experience inflationary pressure, as available factors of production become scarcer and their prices bid up. The price level rises from P1 to P2 to compensate producers for their higher costs.

14. WHEN AN INCREASE IN AGGREGATE DEMAND IS “PURELY INFLATIONARY”. If the economy is operating at full employment and there is an increase in aggregate demand, then the outcome will be “purely inflationary”. That is, there is no increase in output and the only change in an increase in the price level. This is because it is impossible for the economy to produce any further increase in output in the long run, given the existing factors of production. An increase in aggregate demand from AD1 to AD2 results in no change in output as the economy cannot produce output beyond the full employment level of output. The only impact is an increase in the price level from P1 to P2. We say there is an inflationary gap, whereby the level of aggregate demand cannot be satisfied given the existing resources.

15. Inflationary Gap • There is an inflationary gap, when the level of aggregate demand cannot be satisfied given the existing resources. • As a result, the price level rises to allocate the scarce resources among the competing components of aggregate demand. (eg: consumers, producers, the government and the foreign sector.

16. DEMAND SIDE POLICIESKeynesian approach for Government • It is important to note that the long-run equilibrium level of output is not necessarily equal to the full employment level of income and the economy can rest in equilibrium at level of output below full employment. • This has significant implications for the role of government in the economy. • Governments seeking to intervene to steer the economy towards full employment will use demand-side or demand management policies.

17. DEMAND SIDE POLICIESKeynesian approach for Government • Demand side or demand management policies includes fiscal and monetary policy. • Expansionary policies are used in order to stimulate aggregate demand and to increase the equilibrium level of output. • Increasing the level of output implies an increase in the demand for labour and so such policies are designed to reduce unemployment. • Contractionary policies are used to decrease aggregate demand and reduce inflationary pressures that are caused when the price level rises.

20. NEO CLASSICAL PERSPECTIVE • According to the neo-classical economists, the economy will always move towards its long-run equilibrium at the full employment level of output.

21. NEO CLASSICAL PERSPECTIVE-LONG RUN EQUILIBRIUM Long-run equilibrium is where the aggregate demand curve meets the vertical long run aggregate supply curve as shown in this graph.

22. AN INCREASE IN AGGREGATE DEMAND IN THE LONG RUN The impact of any changes in aggregate demand will be on the price level only. This is shown in this graph. The increase in aggregate demand from AD1 to AD2 results in an increase in the price level from P1 to P2 without any increase in the level of real output.

23. Short Run vs Long RunNeo Classical & Keynes • It is valuable to look at the adjustment from the short run to the long run in order to understand the neo-classical perspective. • The Keynesians and neo-classical economists agree on the shape of the short run aggregate supply curve, the neo classical economists argue that the economy will always move automatically to its long run-equilibrium.

24. Long Run Equilibrium is achieved without government interference • The expression `automatically more to long run equilibrium` means without government intervention. • This emphasizes the importance the neo-classical economists place on free markets. • In their view, there may be a short run increase in output if there is an increase in aggregate demand, but the economy will always return to its long run equilibrium.

25. NEO CLASSICAL PERSPECTIVE: COMBINATION OF SHORT RUN AND LONG RUN Initially the economy is in long run equilibrium at Yf. If there is an increase in aggregate demand from AD1 to AD2, due to changes in any of the components of aggregate demand, then in the short run, there will be an increase in output from Yf to Y1. According to neo classical economists this is only possible in the short run. It is possible for output to increase along the short run aggregate supply curve by paying existing workers overtime wages as a short term solution. However, as the economy is at is originally at the full employment level of output, there are no unemployed resources. In their effort to increase their output, the firms in the economy are competing for increasing scarce labour and capital and as result prices increase from P1 to P2.

26. Short Term Increases in Output beyond the Full Employment Level • Due to the payment of overtime and shortages of workers, higher wages must be paid, which results in higher costs overall. • The increase in the average price level means that on average, all prices in the economy have risen as the firms bid up the prices of the factors of production in order to increase their output. • The rise in the price level means an increase in costs to firms as the prices of the factors of production (eg: labour, raw materials and capital) haven risen.

27. Short Term Increases in Output beyond the Full Employment Level Return to the Original Level at a Higher Price Level Graphical Analysis It is important to remember what happens to short run aggregate supply when the cost of production rises. The result is a shift in the short run aggregate supply from SRAS1 to SRAS2. Although firms were willing to supply a higher level of output due to the higher prices they were receiving in the short run, their higher costs of production result in no real gain so they reduce their output back to Yf. The final result is that output returns to its full employment level, but at a higher price level.

28. FALL IN AGGREGATE DEMAND FROM THE FULL EMPLOYMENT LEVEL Originally the economy is at is long-run equilibrium, where AD1 intersects with SRAS1 at output Yfat a price level P1. A fall in aggregate demand from AD1 to AD2 due to changes in any of the components of aggregate demand, results in a fall in the level of national output from Yf to Y1 and a decrease in the price level from P1 to P2. In the short run, the economy will produce at less than full employment output, but the fall in the price level means that the prices of the economy’s factors of production have fallen. This means that firms’ cost of production fall and this results in a shift in the short run aggregate supply curve from SRAS1 to SRAS2. The economy returns to its long-run equilibrium at the full employment level of output, at a lower price level.

29. Summary of the Neo-Classical Approach • The most important conclusion is that the long-run equilibrium level of output is equal to the full employment level of income and that the economy will move towards this equilibrium without any government intervention as result of free market forces. • According to this model, an increase in aggregate demand will be purely inflationary in the long run, and thus there is no role for the government to play in trying to deliberately steer the economy towards full employment

30. Summary of the Neo-Classical Approach • Although there may be deviations from full employment in the short run, neo-classical economists would not see a role for the government in filling these gaps. • They would recommend leaving the economy to market forces, rather than using demand management.

31. CHANGES IN LONG RUN AGGREGATE SUPPLY • It is important to remember that a country’s long run aggregate supply is based on the quantity and quality of its factors of production and that these change. • Therefore the full employment level of output also changes. • As economic growth occurs, the LRAS curve shifts to the right. This represents an increase in the potential output of the country.

32. CHANGES IN LONG RUN AGGREGATE SUPPLY • A country seeking to increase the rate of economic growth and the full employment level of real output will use supply-side policies to increase the quantity or improve the quality of its factors of production. • The impact of such policies depends on the view of the economy that one takes.

33. CHANGES IN LONG RUN AGGREGATE SUPPLY: KEYNES • For Keynesian economists, the impact of increase in the LRAS depends on the initial position of the economy.

34. INCREASE IN LRAS WHEN ECONOMY IS OPERATING BELOW FULL EMPLOYMENT: KEYNES The economy is initially in equilibrium at Y below full employment. An increase in the long-run aggregate supply increases the potential of the economy to produce at a higher level of output, but the aggregate demand is not sufficient to buy up this potential. The equilibrium will remain at Y. While Keynesian economists certainly do not underestimate the importance of supply-side policies in achieving economic growth, this emphasizes their view that the government must intervene if the economy is operating below full employment.

35. AN INCREASE IN LRAS: CLASSICAL VIEW An increase in the long run aggregate supply from a neo-classical viewpoint will have an entirely favourable impact. There will be an increase in the full employment level of income from Yf1 to Yf2 and a fall in the price level from P1 to P2. This is why such economists are sometimes referred to as supply side economists According to this view, supply-side policies are the most effective way of achieving a country’s macroeconomic goals.

36. Summary: How is the Keynesian Perspective different to Neo-Classical?

37. EXAMINATION QUESTIONS Short Response Questions (10 marks each) With the help of a diagram, explain the difference between the equilibrium level of output and the full employment level of output. 2. With the help of a diagram, explain the effects of an increase in long-run aggregate supply on national income and the price level.

38. EXAMINATION QUESTIONS • Short Response Questions (10 marks each) • 3. With the help of a diagram illustrating the neo-classical perspective, explain how an • increase in aggregate demand will • affect an economy in the short run • and long run.

39. EXAMINATION QUESTIONS Essay Question 1a. Explain the components of aggregate demand (10 marks) 1b. Evaluate the extent to which an increase in aggregate demand is beneficial for an economy.