Contents
What’s it: Long-run macroeconomic equilibrium occurs when the aggregate demand curve intersects the short-run aggregate supply curve at the point of the long-run aggregate supply curve. In other words, the short-run macroeconomic equilibrium lies at the point of the long-run aggregate supply curve.
However, the short-run macroeconomic equilibrium often deviates from the long-run aggregate supply curve. As a result, changes in aggregate demand and short-run aggregate supply cause the economy’s output to fluctuate around the potential output. And those fluctuations make up what we know as the business cycle.
Characteristics of long-run equilibrium
When the economy is in long-run equilibrium, the short-run equilibrium is at the point of the long-run aggregate supply curve. Short-run equilibrium is reached when the short-run aggregate supply curve intersects the aggregate demand curve. The intersection may occur on the right or left of the long-run aggregate supply curve. When the intersection occurs at the point of the long-run aggregate supply curve, the long-run macroeconomic equilibrium is reached.
When it reaches long-run equilibrium, the economy operates at full capacity, fully utilizing productive capacity and available resources.
Then, real GDP equals potential GDP because the economy operates at full capacity. Potential GDP represents the maximum output an economy can achieve when all capacities and resources are fully utilized.
No one is unemployed, including labor, when productive resources are fully utilized. Therefore, we also say the economy operates at full employment, and the unemployment rate is at its natural level.
When full employment is achieved, it does not mean that unemployment is equal to zero. On the contrary, unemployment will continue to exist due to structural or frictional problems.
Long story short, when the economy is in long-run equilibrium, then:
- The short-run equilibrium is at the point of the long-run aggregate supply curve
- The economy operates at full capacity
- Real GDP equals potential GDP
- The unemployment rate is at its natural rate
- Full employment achieved
- Unemployment comprises only structural and frictional unemployment
How does the economy reach long-run equilibrium?
Changes in aggregate demand cause the macroeconomic equilibrium to change. For example, the economy is in long-run equilibrium. Then, if aggregate demand increases, it shifts its curve to the right, prompting the economy to produce more output at a higher price level. As a result, the short-run equilibrium moves to the right and lies to the right of the long-run aggregate supply curve, resulting in a long-run disequilibrium.
Real wages fall as the price level rises, forcing workers to demand higher nominal wages. Finally, higher nominal wages increase production costs and force producers to cut output. As a result, the economy returns to a new long-run equilibrium with lower aggregate output but a higher price level. This explanation represents the view of Neoclassical economists.
In contrast, Keynesian economists argue that an increase in aggregate demand does not necessarily result in an increase in the price level. According to them, the economy may still have spare capacity. Thus, the economy will increase production by utilizing this capacity when aggregate demand increases. As a result, aggregate output increases without causing inflation (the price level does not change).
Then, the long-run equilibrium also changes when there is a change in productive capacity. For example, technological advances have shifted the long-run aggregate supply to the right. As a result, the economy has a higher potential output. Thus, when aggregate demand increases, the economy can meet it by increasing short-run output without generating upward pressure on the price level.
Changes in the long-run equilibrium in the Neoclassical model
To explain further, let’s assume the economy operates at full employment (at potential output). Then, short-run aggregate supply changes in response to changes in aggregate demand, causing changes in the price level. Changes in the price level affect business profits, prompting them to respond by changing their output level.
Increase in aggregate demand
Let’s say the economy operates at full employment, and long-run equilibrium is reached at point C. Assume the central bank lowers interest rates.
A decrease in interest rates drives up aggregate demand. The curve shifts to the right from AD0 to AD1. As a result, the short-run equilibrium is to the right of the LRAS (at point D), resulting in a higher price level (from P2 to P0). In addition, real GDP exceeds potential GDP, resulting in a positive output gap (also known as the expansionary gap).
Now, the economy is producing above its full capacity, which causes costs to increase dramatically. An increase in the price level causes the inflation rate to increase, causing real wages to fall (the increase in inflation exceeds the increase in nominal wages). As a result, workers will demand higher nominal wages to offset the decline in purchasing power caused by higher inflation, and wages will rise.
Wage increases reduce profitability. Businesses can no longer increase output any further to make a profit and compensate for the increase in wages because they are already operating at maximum capacity. At the same time, wages continue to rise due to rising inflation. As a result, they face profitability pressures.
The situation forces businesses to reduce output and pass wage increases to selling prices to maintain profitability. As a result, the short-run aggregate supply falls and shifts its curve to the left (from SRAS0 to SRAS1). The economy returns to its long-run equilibrium (at point A) but at a higher price level (from P0 to P1).
Decrease in aggregate demand
Assume the central bank raises interest rates to dampen inflation. And at the same time, the economy is at full employment where the long-run equilibrium is at point A.
An increase in interest rates causes aggregate demand to decrease. The curve shifts to the left, from AD1 to AD0. As a result, the short-run equilibrium is to the left of the LRAS curve (point B), decreasing output and the price level. Now, real GDP (GDP2) is less than potential GDP, resulting in a negative output gap (also known as the deflationary or recessionary gap). In addition, the price level falls from P1 to P0 (inflationary pressures decrease).
Note: The deflationary gap does not necessarily lead to deflation. Declining inflationary pressures may only result in disinflation in which the inflation rate slows.
A negative output gap indicates the economy is below full capacity. Some resources, including labor, are idle. As a result, the unemployment rate is higher. So, theoretically, nominal wages will fall.
A decrease in the price level causes real wages to rise. Instead, businesses face pressure on their profitability due to falling price levels. They operate below capacity and try to lower nominal wages to reduce pressure on profitability. Workers should receive lower nominal wages – real wages do not change much because nominal wages fall less rapidly than the price level declines).
Decreasing nominal wages reduces production costs. That then encourages businesses to operate at higher capacities. As a result, short-run aggregate supply rises and shifts its curve to the right (from SRAS1 to SRAS0), driving the economy toward a new equilibrium (at point C). As a result, aggregate output increases (from GDP2 to potential GDP) at a lower price level (from P0 to P2).
Changes in the long-run equilibrium in the Keynesian model
In the Keynesian model, an increase or decrease in aggregate demand does not necessarily result in an increase in the price level, as Neoclassical economists argue. For example, the economy has spare capacity when operating at GDP0. Thus, an increase in aggregate demand (e.g., from AD0 to AD1) causes aggregate output to rise from GDP0 to GDP1. And the increase in output is not accompanied by an increase in the price level (still at P0).
However, a further increase in aggregate demand will bring the economy closer to full capacity (close to the vertical line). Thus, if aggregate demand increases from AD1 to AD2, aggregate output increases from GDP1 to GDP2, accompanied by a slight increase in the price level (from P0 to P1).
Then, as it gets closer to the vertical section, a further increase in aggregate demand will put pressure on the price level even higher. For example, when aggregate demand increases and shifts the curve from AD2 to AD3, aggregate output increases from GDP2 to potential GDP. This situation indicates the economy operates at full capacity.
When already operating at full capacity (real GDP equals potential GDP)—shown from the vertical line—further increases in aggregate demand will only result in inflationary pressures. Meanwhile, aggregate output does not increase further because the economy is already fully using the available resources.
Changes in long-run aggregate supply (LRAS)
The long-run aggregate supply curve can shift to the right or to the left due to changes in factors of production. For example, increasing the number of workers and their productivity allows the economy to increase its potential output. Likewise, the economy can increase potential output when more capital accumulates.
Additionally, technology also plays a role in increasing potential output. Advances in technology make labor and capital more productive. Thus, they can produce more output using existing inputs. For example, computers allow us to produce more articles than a typewriter, even if only done by one person.
Technological progress shifts the long-run aggregate supply curve to the right (from LRAS1 to LRAS2). As a result, the economy can produce more output, becoming a potential GDP2. So how is the new long-run macroeconomic equilibrium achieved? It depends on aggregate demand.
Say aggregate demand is still at AD1 while long-run aggregate supply is already at LRAS2. This situation indicates the economy operates below its full capacity, and the short-run equilibrium (point A) is to the left of the LRAS2 curve. There is idle capacity. In this situation, policymakers should take expansionary policies to stimulate aggregate demand, for example, by cutting interest rates.
A cut in the interest rate increases aggregate demand and shifts its curve to the right, from AD1 to AD2. Although aggregate demand increases, the price level does not increase because the economy operates below its new capacity. Thus, the economy can increase output and shift the short-run aggregate supply curve to the right. As a result, real GDP equals potential GDP2, and the price level remains at P0. And a new long-run macroeconomic equilibrium is reached.
