Macroeconomic Equilibrium (DP IB Economics)
Revision Note
Short-run Equilibrium
Real national output equilibrium occurs where aggregate demand (AD) intersects with short-run aggregate supply (SRAS)
A diagram showing the Classical short-run equilibrium in an economy resulting in an equilibrium price of AP1 and real output of Y1
According to classical theory, this economy is in short run equilibrium at AP1Y1
Any changes to the components of AD will cause the AD curve to shift left or right creating a new short-run equilibrium
Any changes to the non-price determinants of SRAS will shift the SRAS curve left or right creating a new short-run equilibrium
Long-run Equilibrium in the Monetarist/New Classical Model
Classical and Keynesian economists have different views on the long-run equilibrium of real national output
Classical economists believe that the economy will always return to its full potential level of output and all that will change in the long-run, is the average price level
YFE is considered to be equal to the natural rate of unemployment in an economy
A diagram that shows the Classical view of long-run equilibrium which occurs at the intersection of long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) and aggregate demand (AD)
Diagram Analysis
The LRAS curve demonstrates the maximum possible output of an economy using all of its scarce resources
The SRAS intersects with AD at the LRAS curve
This economy is producing at the full employment level of output (YFE)
The average price level at YFE is AP1
The Classical Adjustment Process (Self-correcting)
Classical economists believe that in the long run the economy will always return to its full potential level of output and all that will change is the average price level
This is the also referred to as the self-correcting mechanism
Automatic adjustment from a deflationary output gap
A deflationary (recessionary) output gap occurs when the real GDP is less than the potential real GDP
Aggregate demand (AD) has shifted left causing a deflationary gap, which in the long-run will self-correct to YFE but at a lower average price level (AP2)
Correction Process
Initial long-run equilibrium is at AP YFE
AD shifts left from AD → AD1, possibly due to the onset of a recession
Output falls from YFE → Y1 and price levels fall from AP → AP1
Due to the fall in output, firms lay off workers
Unemployed workers are now willing to work for lower wages and this reduces the costs of production which causes the SRAS curve to shift right from SRAS1 → SRAS2
A new long-run equilibrium is formed at AP2 YFE
The economy is back to the full employment level of output (YFE), but at a lower average price
Automatic adjustment from an inflationary output gap
An inflationary output gap occurs when real GDP is greater than the potential real GDP
Aggregate demand (AD) has shifted right causing an inflationary gap, which in the long-run will self-correct to YFE but at a higher average price level (AP2)
Correction Process
Initial long-run equilibrium is at AP YFE
AD shifts right from AD1 → AD2, possibly due to raid expansion of the money supply
Output rises from YFE → Y1 and price levels rise from AP → AP1
Due to the increase in average prices (inflation), workers demand higher wages
Higher wages increase the costs of production which causes the SRAS curve to shift left from SRAS1 → SRAS2
A new long-run equilibrium is formed at AP2 YFE
The economy is back to the full employment level of output (YFE), but at a higher average price
Equilibrium in the Keynesian Model
Keynesian economists believe that the economy can be in long term equilibrium at any level of output
The Keynesian view believes that an economy will not always self-correct and return to the full employment level of output (YFE)
It can get stuck at an equilibrium well below the full employment level of output e.g. Great Depression
The Keynesian view believes that there is role for the government to increase its expenditure so as to shift aggregate demand and change the negative 'animal spirits' in the economy
A diagram that shows the Keynesian View of aggregate supply (AS) with a vertical aggregate supply curve at the full employment level of output (YFE) becoming more elastic at lower levels of output
Diagram Analysis
Using all available factors of production, the long-term output of this economy occurs at YFE
The economy is initially in equilibrium at the intersection of AD1 and AS (AP1YFE)
A slowdown reduces aggregate demand from AD1→AD2 and creates a recessionary gap equal to YFE - Y1
The economy may reach a point where average prices stop falling (AP2), but output continues to fall
Prices may be blocked from falling further due to minimum wage laws, the existence of trade unions, or long-term employment contracts preventing wage decreases
This economy may not self-correct to YFE for years
The low output leads to high unemployment and low confidence in the economy
This stops further investment and further reduces consumption
Keynes argued that this was where governments needed to intervene with significant expenditure e.g. Roosevelt's New Deal; response to financial crisis of 2008
Assumptions & Implications of the two Models
Each model has strengths and weaknesses
It has been said that free market fans like Classical thinking when an economy is doing well but very quickly switch to a Keynesian way of thought during severe recessions as they seek government bail outs
The Economist Mariana Mazzucato sums it up with the phrase, 'Capitalists like to privatise their profits and socialise their losses'
The Assumptions & Implications of Classical Thinking
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Wages are flexible |
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Any deviation from YFE is temporary |
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Demand-side policies are less effective than supply-side policies in generating economic growth |
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The Assumptions & Implications of Keynesian Thinking
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'In the long-run we are all dead' |
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Wages can be inflexible 'sticky' downwards |
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Governments have to intervene to break the 'negative animal spirits' |
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