What’s it: A macroeconomic equilibrium occurs when aggregate supply equals aggregate demand. Aggregate supply represents the total output of goods and services. Meanwhile, aggregate demand represents the total goods and services demanded in the economy. Changes in aggregate supply or aggregate demand affect inflation, real GDP, and the unemployment rate.
The difference between short-run equilibrium and long-run equilibrium
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 it slopes 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.
You can read about it in the aggregate demand curve article.
All right, back to macroeconomic equilibrium.
Economists divide the macroeconomic equilibrium into two:
- Short-run equilibrium is when aggregate demand equals short-run aggregate supply. Shifts in both cause actual real GDP to fluctuate around potential GDP.
- 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.
Alright, let’s discuss one by one.
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. And 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 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.
First, the positive output gap is also called as 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.
Second, the negative output gap is also called the deflationary gap. Sometimes, economists call it the recessionary gap. As the name suggests, this usually occurs during a contraction or recession where there is downward pressure on the price level.
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
Aggregate demand will shift due to changes in:
- Money supply
- Government spending
- Consumer and business confidence
- Exchange rate
- Global economic growth
Meanwhile, several factors shift the short-run aggregate supply, including:
- Nominal wages
- Raw material costs
- Exchange rate
- Business tax
- Expectations of future prices and profits
- Changes in the quantity and quality of production factors
Furthermore, 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.
Let’s take a look at 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 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. That, in turn, increases short-run aggregate supply and returns the economy to full employment (LRAS).
This kind of 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.