Transcript Macroeconomic Equilibrium File

MACROECONOMIC
EQUILIBRIUM
Economics - A Course Companion
Blink & Dorton, 2007. p186-200
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.
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.
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.
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.
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.
Short-Run Equilibrium Output
Keynesian 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)
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.
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.
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.
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.
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.
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.
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.
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.
DEMAND SIDE POLICIES
Keynesian 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.
DEMAND SIDE POLICIES
Keynesian 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.
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.
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.
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.
Short Run vs Long Run
Neo 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.
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 neoclassical 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.
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.
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.
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.
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 Yf at 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 longrun equilibrium at the full employment
level of output, at a lower price level.
Summary of the
Neo-Classical Approach
• The most important conclusion is that the longrun 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
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.
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.
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.
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.
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.
AN INCREASE IN LRAS:
CLASSICAL VIEW
An increase in the long run
aggregate supply from a neoclassical 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.
Summary: How is the Keynesian
Perspective different to Neo-Classical?
Keynesian School
Neo-Classical School
Long Run Equilibrium is achieved at the full
employment level and is also possible
below the full employment level of output.
Long Run Equilibrium can only be achieved
at the full employment level.
The LRAS cure is flat below the full
employment level and begins to curve and
become a vertical line with inflationary
pressures.
The LRAS curve is always vertical.
Government Intervention (more spending) is Government Intervention to stimulate
useful to stimulate demand and achieve the demand should be avoided. The economy
full employment level of output.
will automatically more towards the full
employment level in the long term.
Governments can use supply side policies to
increase LRAS, but government intervention
may still be necessary to stimulate demand
Government should use supply side policies
(eg: more flexible labor laws) to increase
LRAS.
EXAMINATION QUESTIONS
Short Response Questions (10 marks each)
1. 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.
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.
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.