Macroeconomic Equilibrium: Short Run Vs. Long Run

What’s it? A macroeconomic equilibrium occurs when aggregate supply equals aggregate demand. Aggregate supply represents the total output of goods and services produced by firms within an economy at a given price level. On the other hand, aggregate demand represents the total amount of goods and services that households, businesses, and the government desire to purchase at a given price level. Imagine a grand economic seesaw: for stability, the total production (supply) needs to be balanced by the total desire to purchase (demand).

Why it matters: Changes in either aggregate supply or aggregate demand can significantly impact key economic indicators. These changes can influence inflation, the level of real GDP (total economic output adjusted for inflation), and the unemployment rate. Understanding macroeconomic equilibrium helps us grasp how these factors interact and influence overall economic stability.

Two types of macroeconomic equilibrium: Short-run and long-run equilibria

Macroeconomics distinguishes between short-run and long-run concepts for aggregate supply. Short-run aggregate supply is the quantity supplied when some costs are variable. However, wages and other input prices remain constant. An increase in price increases the profits of the firms and thus encourages them to increase output. The short-run aggregate supply curve is upward-sloping (positive slope).

Meanwhile, the long-run supply represents the quantity supplied when wages and other input prices are variable. When the price rises, it does not increase profits because wages and other input prices will also increase proportionally. Therefore, an increase in price does not affect the profit and quantity supplied. As a result, the long-run aggregate supply curve is vertical.

Furthermore, the aggregate demand curve is downward sloping (negative slope). Why does it slope downward?

You can trace it from the effects of changes in the price level (inflation) on aggregate demand components such as household consumption, business investment, and net exports.

Take, for example, household consumption. When the price level declines, real wealth increases and encourages households to increase their consumption (wealth effect). The opposite effect also applies when the price level rises.

Economists divide the macroeconomic equilibrium into two:

1. Short-run equilibrium is when aggregate demand equals short-run aggregate supply. Shifts in both cause actual real GDP to fluctuate around potential GDP.
2. Long-run equilibrium occurs when aggregate demand equals short-run aggregate supply at a point on the long-run aggregate supply curve. At this point, actual real GDP equals potential GDP, and the unemployment rate equals its natural rate. Another term for long-run equilibrium is full employment equilibrium.

Let’s discuss this one by one.

Short-run equilibrium

Short-run aggregate supply assumes constant nominal wages. The intersection of short-run aggregate demand and supply determines the economy’s price level and actual real GDP. Because nominal wages do not change to achieve full employment, a short-run equilibrium can occur below, just right, or above potential GDP.

If the price level is above equilibrium, aggregate supply exceeds aggregate demand, causing excess supply. This situation causes inventory to build up, forcing producers to sell their inventory at a lower price.

Classical economists say the lower price level encourages aggregate demand to rise. If the price level falls, it increases real household wealth, pushes interest rates down, and increases exports. As a result, demand from the four main sectors of the economy increases.

This situation continues until the economy reaches its new equilibrium.

Meanwhile, if the price level is below the equilibrium price, there is a shortage in the economy. Producers raise prices to make more profit. At the same time, aggregate demand decreases because of the tendency of the price level to rise. The economy will go to its new equilibrium, and aggregate demand equals aggregate supply.

Long-run equilibrium

Long-run aggregate supply represents the maximum output an economy can produce. Thus, if it reaches long-run equilibrium, the economy operates at potential output (full employment). All resources are fully utilized so that actual real GDP will equal potential GDP.

In fact, real GDP rarely matches potential GDP because aggregate demand and short-run aggregate supply are continually changing. That causes the short-run equilibrium to fluctuate around the long-run aggregate supply curve (potential GDP). The deviation of actual real GDP from potential GDP (known as the output gap) forms the business cycle phase.

Two possible output gaps are a positive output gap and a negative output gap.

Positive output gap

The positive output gap is also called the expansionary gap. In the business cycle, it usually occurs during the last phase of expansion.

In the curve, the positive output gap occurs when the short-run equilibrium point is to the right of the long-run aggregate supply curve. At that time, actual real GDP exceeds potential GDP.

A positive output gap shows you that aggregate demand exceeds long-run aggregate supply. In other words, the economy’s maximum capacity is insufficient to meet aggregate demand. It generates upward pressure on the price level.

To cover aggregate demand, the economy imports goods from abroad. Therefore, during this period, the trade balance will tend to be in deficit due to the high demand for imports.

Negative output gap

The negative output gap is also called the deflationary gap. Sometimes, economists call it the recessionary gap. As the name suggests, it usually occurs during a contraction or recession when downward pressure on the price level occurs.

A negative gap means that actual real GDP is lower than potential GDP. The economy operates below its potential level. Some resources are idle, generating downward pressure on the price level in the economy. During this period, you will see the unemployment rate increase.

Also, the inflation rate slows down (disinflation) or may lead to negative (deflation). As a note to you. Although we call this period the deflationary gap, it does not always result in deflation. Downward pressure on the price level may result in a slower inflation rate (disinflation) than deflation.

Shifts in aggregate demand and aggregate supply

We’ve established that macroeconomic equilibrium exists when total production (aggregate supply) meets total desired purchases (aggregate demand). But this balance isn’t static. Various factors can influence both sides of the equation, causing shifts in aggregate demand (AD) and short-run aggregate supply (SRAS). Let’s explore these factors to understand how they can disrupt or restore equilibrium, impacting inflation, real GDP, and unemployment.

Factors affecting aggregate demand (AD) to shift

Aggregate demand will shift due to changes in:

• Money supply: If the central bank increases the money supply, consumers and businesses have more money to spend, which increases AD. Conversely, a decrease in money supply reduces spending and lowers AD.
• Tax: A decrease in taxes leaves more money in people’s pockets, boosting consumption and AD. Conversely, higher taxes lead to less spending and lower AD.
• Government spending: Increased government spending directly injects money into the economy, raising AD. Conversely, decreased government spending reduces AD.
• Consumer and business confidence: When consumers and businesses are optimistic about the future, they are more likely to spend and invest, increasing AD. Conversely, low confidence leads to less spending and investment, lowering AD.
• Exchange rate: A depreciation (weakening) of a country’s currency makes exports cheaper and imports more expensive. This can increase AD for domestically produced goods. Conversely, an appreciation (strengthening) of the currency can decrease AD.
• Global economic growth: A strong global economy can lead to higher demand for a country’s exports, boosting AD. Conversely, a weak global economy can decrease export demand and lower AD.

Factors affecting aggregate supply (SRAS) to shift

Several factors shift the short-run aggregate supply, including:

• Nominal wages: In the short run, wages may be fixed by contracts. If prices rise but wages stay the same, businesses become more willing to produce, shifting SRAS to the right. Conversely, if wages rise faster than prices, production costs increase, and SRAS shifts left.
• Raw material costs: A rise in raw material costs increases production costs, causing businesses to reduce supply, shifting SRAS left. Conversely, a decrease in raw material costs allows businesses to produce more at the same price level, shifting SRAS right.
• Exchange rate: Similar to AD, a depreciation of the currency can make exports more profitable, incentivizing businesses to produce more and potentially shifting SRAS right. Conversely, an appreciation can make exports less profitable and may cause a shift left on the SRAS curve.
• Business tax: An increase in business taxes reduces profits and discourages production, shifting SRAS left. Conversely, a decrease in business taxes can incentivize production and shift SRAS right.
• Subsidy: Government subsidies to businesses can lower production costs, encouraging them to produce more and shifting SRAS right. The opposite is true when subsidies are reduced.
• Expectations of future prices and profits: If businesses expect future prices or profits to rise, they may be more willing to produce now, shifting SRAS right in anticipation. Conversely, if they expect prices or profits to fall, they may be less willing to produce, shifting SRAS left.
• Changes in the quantity and quality of production factors: An increase in the quantity or quality of labor, capital, or natural resources can improve production efficiency and allow businesses to produce more at a given price level, shifting SRAS right. Conversely, a decrease in these factors can have the opposite effect.

Note: Long-run aggregate supply occurs to change only because of changes in production factors’ quantity and quality. It will increase when the amount of labor, natural resources, and capital increases. Also, the quality of human capital and technology contributes to increasing long-term aggregate supply by increasing economic productivity.

Economic Shocks and Macroeconomic Equilibrium

Economic shocks can affect either the aggregate supply (AS) or aggregate demand (AD) curve, causing them to shift. For example, an oil price hike (supply shock) can shift the AS curve leftward, leading to higher prices and lower output. Conversely, a surge in consumer confidence (demand shock) can shift the AD curve rightward, increasing both output and prices.

Macroeconomic equilibrium ideally occurs at potential output, the level of production when the economy utilizes its resources efficiently. Shocks can push the economy away from this equilibrium. For instance, a natural disaster (negative shock) might reduce production capacity, lowering output below potential. Conversely, a technological breakthrough (positive shock) could increase efficiency, pushing output above potential.

Governments and central banks often implement policies to mitigate the effects of shocks and steer the economy back towards equilibrium. For example, after a negative demand shock, the government might increase spending (fiscal policy) or the central bank might lower interest rates (monetary policy) to stimulate aggregate demand.

The severity and duration of the disequilibrium caused by shocks depend on several factors:

• Type of shock: Supply shocks are generally considered more persistent than demand shocks, as they often take longer to resolve. For example, rebuilding infrastructure after an earthquake takes time.
• Flexibility of the economy: Economies with greater flexibility in wages, prices, and resource allocation can adapt faster to shocks and return to equilibrium quicker.
• Policy effectiveness: The success of government and central bank policies in mitigating the impact of shocks plays a crucial role in restoring equilibrium.

Restoring equilibrium: Self-correction vs. Policy intervention

Let’s examine the curve above. Assume government spending is reduced. A fall in government spending lowers aggregate demand and shifts the curve to AD2.

A fall in aggregate demand pushes down real output (GDP2) and the price level (P2). As a result, the new short-run equilibrium is below the potential output (the deflationary gap). Then, how does real GDP return to its potential level? Economists have two explanations.

The first is through the self-correcting mechanism. Rising unemployment forces workers to compete more closely for available jobs. They tend to be willing to accept lower wages to maintain income. It is better to receive a lower salary than not to receive it at all. Lower nominal wages reduce production costs, increasing short-run aggregate supply and returning the economy to full employment (LRAS). This argument is popularized by classical economists.

The second is through economic policy. As Keynesian economists believe, policymakers can adopt expansionary policies to increase aggregate demand. It can be through fiscal policy or monetary policy. The options are:

• Increasing government spending
• Lowering taxes
• Cutting the policy rate
• Lowering the reserve requirement ratio
• Open market operations by purchasing government securities

This policy stimulates aggregate demand. An increase in aggregate demand then shifts the curve to the right (from AD2 to AD0) and returns real GDP to its potential level.