3.2.5 Macroeconomic 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
  

• 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
• Y_FE 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 (Y_FE)
• The average price level at Y_FE is AP₁

• 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 Y_FE but at a lower average price level (AP₂)

 
Correction Process

1. Initial long-run equilibrium is at AP Y_FE
2. AD shifts left from AD → AD₁, possibly due to the onset of a recession
3. Output falls from Y_FE → Y₁ and price levels fall from AP → AP₁
4. Due to the fall in output, firms lay off workers
5. 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
6. A new long-run equilibrium is formed at AP₂ Y_FE
7. The economy is back to the full employment level of output (Y_FE), 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 Y_FE but at a higher average price level (AP₂)
 

Correction Process

1. Initial long-run equilibrium is at AP Y_FE
2. AD shifts right from AD₁ → AD₂, possibly due to raid expansion of the money supply
3. Output rises from Y_FE → Y₁ and price levels rise from AP → AP₁
4. Due to the increase in average prices (inflation), workers demand higher wages
5. Higher wages increase the costs of production which causes the SRAS curve to shift left from SRAS₁ → SRAS₂
6. A new long-run equilibrium is formed at AP₂ Y_FE
7. The economy is back to the full employment level of output (Y_FE), but at a higher average price

• 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 (Y_FE)
  • 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 (Y_FE) 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 Y_FE
• The economy is initially in equilibrium at the intersection of AD₁ and AS (AP₁Y_FE)
• A slowdown reduces aggregate demand from AD₁→AD₂ and creates a recessionary gap equal to Y_FE - 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 Y_FE 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

• 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

Assumptions	Implications
Wages are flexible	Markets self-correct to YFE in the long run due to the fact that wages can easily rise or fall so as to change costs of production The self-correction is based on automatic short-run supply side changes and there is no need for government intervention
Any deviation from YFE is temporary	There may be short periods of unemployment when a recessionary gap occurs, however markets will return to YFE which corresponds to the natural rate of unemployment (NRU) for an economy
Demand-side policies are less effective than supply-side policies in generating economic growth	Economic growth is generated by increasing the productive capacity of the economy This thinking follows Says' Law Government intervention should focus on increasing the supply-side of an economy

 

The Assumptions & Implications of Keynesian Thinking

Assumptions	Implications
'In the long-run we are all dead'	Keynes explained that the idea of markets self-correcting in the long-run was flawed in that the long-run could be a very long period of time indeed The consequences of severe recessionary gaps and the unemployment they cause can be significant, lasting for generations
Wages can be inflexible 'sticky' downwards	Markets will reach a point where self-correction as a result of falling wages is no longer viable Workers will reach a point where they are no longer willing to accept lower wages Wages may be blocked from falling further due to minimum wage laws, the existence of trade unions, or long-term employment contracts preventing wage decreases
Governments have to intervene to break the 'negative animal spirits'	Animal spirits refers to the human emotions which drive financial decisions during times of uncertainty or market volatility If the emotions are gloomy about the economic outlook, then gloominess will continue This was the situation in the Great Depression and Keynes advocated that Government spending was required to change the mood in the economy and to help rebuild business and consumer confidence Once governments had intervened, the self-correcting mechanism would begin to function again