Contents
What’s it: A short-run macroeconomic equilibrium occurs when the aggregate demand curve and the short-run aggregate supply curve intersect. It determines the actual output (real GDP) and the price level in the economy.
Equilibrium may be below, at, or above potential output (potential GDP), represented by the long-run aggregate supply curve. When equilibrium is below potential output, there is a negative output gap (or recessionary gap). On the other hand, suppose it is at a point on the long-run aggregate supply curve. In that case, real GDP equals potential GDP – economists call the economy at full employment. Meanwhile, if it is above potential output, there is a positive output gap (or expansionary gap).
Shifts in the aggregate demand curve and the short-run aggregate supply curve cause short-run fluctuations. As a result, the short-run equilibrium moves around the potential output, resulting in what we call the business cycle.
Highlighting the difference between short-run and long-run equilibria
Changes in aggregate demand and short-run aggregate supply determine the short-run macroeconomic equilibrium, which determines the economy’s actual output. If the two curves intersect, short-run equilibrium results.
At one point, equilibrium may be at a point on the long-run aggregate supply curve. In other words, the aggregate demand curve intersects the short-run aggregate supply curve at a point on the long-run aggregate supply curve. This situation is what we call the long-run macroeconomic equilibrium.
Thus, if a long-run macroeconomic equilibrium is reached, actual output equals potential output, and real GDP equals potential GDP. However, the short-run equilibrium usually deviates from the long-run aggregate supply, perhaps above or below (in the graph, it is on the right or left).
Short-run fluctuations and business cycles
In actual conditions, the short-run macroeconomic equilibrium is rarely exactly at a point on the long-run aggregate supply curve. Instead, the short-run aggregate supply curve and the aggregate demand curve often shift to the right and left, resulting in a short-run equilibrium fluctuating around the long-run aggregate supply curve. In plain language, real GDP rarely equals potential GDP. These deviations create the business cycle.
Real GDP is less than potential GDP.
Real GDP may be lower than potential GDP. We all this situation a negative output gap. It is also called the recessionary gap because the economy’s output falls below its full capacity. As a result, some resources in the economy are idle.
It is also called the deflationary gap because the price level tends to be pushed downwards. In this case, deflationary does not necessarily mean deflation is occurring. Instead, the economy may experience disinflation, wherein the inflation rate weakens by a lower percentage than before.
Real GDP equals potential GDP
Because real GDP equals potential GDP, the economy produces output at its full capacity. In other words, the economy operates at full employment.
In this situation, the unemployment rate is at its natural level. The labor market leaves only structural and frictional unemployment, which will never be zero even when the economy is operating at full capacity.
Real GDP exceeds potential GDP
Shifts in the short-run aggregate supply and the aggregate demand curves may cause real GDP to be higher than the potential GDP. This is referred to as a positive output gap because the economy produces more than its full capacity. Under these conditions, businesses operate production facilities well above their most efficient capacity.
The positive output gap is also known as the expansionary gap because the economy is in an expansion phase. We also call it the inflationary gap because inflationary pressures increase.
Because it operates beyond its production capacity, the economy faces a tight labor market. The unemployment rate is low and below its natural rate. A further decline in the unemployment rate will put further pressure on inflation.
Impacts of shifts on short-run equilibrium
As noted earlier, the short-run macroeconomic equilibrium often deviates from potential output. The aggregate demand curve and the short-run aggregate supply curve shift to the right or to the left due to external stimuli. As a result, the short-run macroeconomic equilibrium also changes. So how does the shift of the two curves affect the short-run macroeconomic equilibrium and the economy? Let’s discuss the following four scenarios:
- Aggregate demand decreases
- Aggregate demand increases
- Short-run aggregate supply decreases
- Short-run aggregate supply increases
For discussion, assume the economy is at its full capacity. Thus, real GDP equals potential GDP.
Decrease in aggregate demand
Aggregate demand decreases for several reasons, such as:
- Tight monetary policy. For example, the central bank raises interest rates or reserve requirement ratio.
- Tight fiscal policy. For example, the government raises taxes or cuts spending.
- Consumer confidence falls. As a result, they reduce consumption expenditures.
- Exchange rate appreciation makes foreign goods cheaper for domestic buyers, encouraging imports. On the other hand, domestic goods become more expensive to buyers abroad, lowering exports.
- Global recession. As a result, exports decrease as demand in international markets falls.
The above factors cause the aggregate demand curve to shift to the left. As a result, the short-run equilibrium is to the left of the long-run aggregate supply curve. And the economy is operating below its full capacity, resulting in less real GDP than potential GDP.
A decrease in aggregate demand causes downward pressure on the price level. Businesses face weaker profit prospects, which prompts them to cut output.
At first, businesses may not lay off employees right away. Instead, they simply stop hiring while taking efficiency measures. Thus, the unemployment rate may not have decreased significantly. In addition, the economy may only experience disinflation, and the inflation rate is lower than before.
However, if aggregate demand falls further, the pressure on profitability increases. Eventually, the business reduced production further and began to reduce the workforce. As a result, the unemployment rate increased.
An increase in the unemployment rate worsens job and income prospects. Households respond by reducing consumption spending. As a result, aggregate demand falls deeper, which may result in deflation, with the inflation rate in negative territory.
Increase in aggregate demand
An increase in aggregate demand occurs for several reasons, including:
- Loose monetary policy. For example, the central bank cuts interest rates or lowers the reserve requirement ratio.
- Loose fiscal policy. For example, the government cuts taxes or increases spending.
- Strong consumer confidence. As a result, they are optimistic about their income and employment, prompting them to increase consumption expenditures.
- Exchange rate depreciation. Consequently, foreign goods become more expensive for domestic buyers, reducing imports. In contrast, domestic goods become cheaper for overseas buyers, encouraging increased exports.
- Strong global economic growth. As a result, exports increased due to strong international market demand.
An increase in aggregate demand causes its curve to shift to the right, causing the economy to operate above its full capacity. As a result, real GDP exceeds potential GDP. This situation produces upward inflation pressure. And the unemployment rate is lower.
An increase in aggregate demand incentivizes businesses to increase output. This is because they see strong profit prospects, prompting them to increase production to earn more money. They also increase investment by buying machinery or establishing production facilities to meet demand.
In addition to increasing investment, businesses are increasing recruitment and maximizing the existing workforce, for example, by overtime. As a result, the unemployment rate decreased.
On the one hand, a decline in the unemployment rate makes the labor market tighter. The labor supply is becoming more scarce, especially qualified workers. As a result, nominal wages creep up as businesses compete to recruit them.
An increase in nominal wages increases costs. This situation leads businesses to pass the cost increase to the selling price. As a result, inflationary pressures increased.
On the other hand, lower unemployment, overtime, and higher wages improved job and income prospects. Households became more optimistic, increasing consumption expenditures and leading to a further increase in aggregate demand.
Stronger aggregate demand encourages businesses to increase output further. As a result, they increase hiring, making the labor market even tighter. This situation resulted in nominal wages rising further and, in the end, pushing up inflation.
Without government intervention, rising inflation overheats the economy. The inflation rate accelerates, for example, through the wage-price spiral. A spiral occurs when an increase in nominal wages increases inflation and ultimately pushes nominal wages higher. As a result, the inflation rate increases further, continuing the spiral. Usually, the government will adopt stricter economic policies, such as raising interest rates or taxes, to moderate inflationary pressures.
Decrease in short-run aggregate supply
A decrease in short-run aggregate supply shifts its curve to the left. It can be caused by several factors, including:
- Higher wages
- Increase in the input prices, such as energy and raw materials
- Business tax increase
- Production subsidies removed
A decrease in short-run aggregate supply causes the short-run equilibrium to be to the left of the long-run aggregate supply curve. As a result, real GDP falls as the economy operates below its full capacity. And real GDP is below potential output. Assuming aggregate demand does not change, the decline in real GDP causes upward pressure on the price level.
This situation results in a negative output gap in the economy. However, unlike a negative gap due to a decrease in aggregate demand (which results in a decrease in the price level), a negative gap due to a decreased short-run aggregate supply causes an increase in the price level.
In addition, the unemployment rate is also higher because the economy is operating below its full capacity, leaving some resources, including labor, unemployed. As a result, higher inflation accompanies higher unemployment in the short run.
We call this situation stagflation (from the words “stagnation” and “inflation”). In the 1980s, the decline in output was accompanied by high inflation, as in the United States. The surge in oil prices is among the causes commonly cited.
Oil is used in almost all industries, from raw materials to fuel. Thus, the increase will not only cause production costs to rise sharply, but prompting businesses to cut output. But, it also pushes the prices of goods and services to soar.
As the economy’s output falls, policymakers may introduce looser economic policies to boost production, for example, by cutting interest rates. This policy increases aggregate demand and shifts its curve to the right (from AD0 to AD1), driving the economy toward long-run equilibrium. However, this step has other consequences; inflation rises higher. For example, suppose a decreased short-run aggregate supply causes the price level to rise from P0 to P1. In that case, this policy raises the price level higher (to P2).
Increase in short-run aggregate supply
A decrease in wages can cause an increase in short-run aggregate supply, shifting the curve to the right. Since previously, the economy was at full employment, this increase puts it above its full capacity. In other words, real GDP exceeds potential GDP.
In addition to a decrease in wages, the short-run aggregate supply curve shifts to the right because:
- Input price drop
- Business tax cuts
- Production subsidies
These factors lower production costs, prompting businesses to increase their output. Thus, the economy produces more output at a lower price level, assuming constant aggregate demand.
The situation may be temporary. And the economy is back to its long-run equilibrium.
Alternatively, it can be permanent because the short-run aggregate supply curve and the long-run aggregate supply curve shift to the right. Thus, a new long-run macroeconomic equilibrium with higher potential output is reached. How could this happen?
Increased productivity is the reason. For example, the workforce becomes more productive due to improvements in human resources through education and training. Or the economy invests in more sophisticated physical capital. And technological advances are also another key factor.
These factors allow the economy to have a higher production capacity. As a result, the economy can generate more potential output than before. In the short run, increased productivity eventually leads to increased output at lower costs.
