Macroeconomic Equilibrium (Cambridge (CIE) A Level Economics): Revision Note

Short-run macroeconomic equilibrium

• Real national output equilibrium occurs where aggregate demand (AD) intersects with short-run aggregate supply (SRAS)

Diagram analysis

• 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 determinants of SRAS will shift the SRAS curve left or right, creating a new short-run equilibrium

• The level of employment in the economy is determined by the equilibrium level of output - at Y1, firms require a corresponding level of workers to produce that output

  • If equilibrium output rises, employment rises; if equilibrium output falls, employment falls

Long-run macroeconomic equilibrium

• Free market economists believe that the economy will always return to its normal capacity level of output

  • In the short-run, there will be fluctuations around this capacity level of output

  • In the long-run, the economy will return to this normal capacity level of output, but perhaps at a different average price level

• It is important to understand the long-run macroeconomic equilibrium as it is used to identify positive and negative output gaps in an economy (this is covered in more detail later on)

Diagram analysis

• The LRAS curve demonstrates the normal capacity level of output of the 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 (Y_FE)

• The average price level at Y_FE is AP₁

Keynesian long-run equilibrium

• The Keynesian view challenges the classical assumption that the economy will always return to full employment output

• In the Keynesian model, the economy can settle in long-run equilibrium below full employment - where AD intersects the elastic section of the Keynesian LRAS

  • At this point, there is significant spare capacity and unemployment in the economy

  • The price level is stable because spare resources can be brought into production without bidding up factor prices

  • The economy will not automatically self-correct - without government intervention it may remain at this low output equilibrium indefinitely

Diagram analysis

• The economy is initially in equilibrium at P₁Y_FE - at the full employment level of output on the vertical section of the Keynesian LRAS

  • A fall in AD causes the AD curve to shift left from AD₁ to AD₂

  • The new equilibrium is at P₂Y₁ - below the full employment level of output Y_FE

  • There is now a negative output gap equal to Y₁Y_FE - the economy is producing below its potential

• The price level has fallen from P₁ to P₂ - the economy is on the upward-sloping section of the Keynesian LRAS where both output and price level changes occur

• Unlike the classical model, the economy will not automatically return to Y_FE - wages and prices are sticky downwards and the self-correction mechanism breaks down at low levels of output

• This provides the Keynesian justification for government intervention - an increase in AD via expansionary fiscal policy can shift AD₂ back rightward, raising output and employment back towards Y_FE

Aggregate demand and supply analysis

1. An increase in aggregate demand (AD)

Diagram analysis

• The initial equilibrium level of output was at AP₁Y₁

• An increase in one of the components of AD (e.g. consumption) causes the AD to increase AD₁→AD₂

• Average prices in the economy rise to AP₂ and the real level of output increases to Y₂

• The new short-run equilibrium is at AP₂Y₂

• As output rises from Y₁ to Y₂, firms require more workers to meet higher demand - employment rises; conversely a fall in AD would reduce output and employment

2. An increase in short run aggregate supply (SRAS)

Diagram analysis

• The initial equilibrium level of output was at AP₁Y₁

  • This equilibrium represents a negative output gap equal to Y₁Y_FE

• An increase in one of the determinants of SRAS (e.g. productivity) causes the SRAS to increase SRAS₁→SRAS₂

• Average prices in the economy fall to AP₂ and the real level of output increases to Y₂

• The new short-run equilibrium is at AP₂Y₂

• There is still a negative output gap but it is smaller (Y₂Y_FE)

• As output rises from Y₁ to Y₂, more workers are needed in production - employment rises and the negative output gap narrows, meaning unemployment falls though it does not return to zero until YFE is reached