Download Equilibrium output

Equilibrium output
• The economic equilibrium is when aggregate demand =
aggregate supply.
• In the short run, equilibrium occurs when aggregate demand
equals short run aggregate supply.
• In the classical model where wages are completely flexible the
economy will be in long run equilibrium at full employment.
• In the Keynesian model a rise in aggregate in demand will be
purely inflationary if the economy is at full employment, but
will lead to an increase in output if the economy is below full
employment.
• A rise in LRAS in the classical model will both increase output
and reduce prices.
• Keynesians would agree with this in general but would argue
that an increase in aggregate supply will have no effect on
output or prices if the economy is in a slump.
• Factors which affect aggregate demand may well affect
aggregate supply and vice versa although this may occur over
different time periods. For instance an increase in investment is
likely to increase both aggregate demand and aggregate supply.
Equilibrium output in the short run
• Both Keynesian and classical economics
believe that in the short run the aggregate
demand curve is downward sloping while the
aggregate supply curve is upward sloping.
• The equilibrium level of output in the short
run occurs at the intersection of the AD and
AS supply curves.
Price level
AS
P
The equilibrium level of
income and output is 0Q.
The equilibrium level of
price is 0P.
AD
0
Q
Real output
Price level
An increase in aggregate demand
will shift the demand curve to the
right.
SRAS
P1
Aggregate demand is made up of
consumption, investment,
government spending and exports –
imports.
Increase in aggregate demand will
result from an increase in one of
these components:
P
AD1
AD
0
Q
Q1 Real output
A rise in aggregate demand shifts the SRAD curve
AD:AD1. Equilibrium output rises 0Q:0Q1 while
price level rise 0P:0P1.
• Fall in interest rates will raise
both consumption and
investment.
• A fall in the exchange rate will
boost exports and reduce
imports.
• A lowering of income tax will
raise consumption because
households will now have higher
disposable income.
Price level
A fall in short run aggregate supply
will shift the SRAS curve upwards
and to the left.
SRAS1
SRAS
P1
P
AD
0
Q1
Q
Real output
A fall in aggregate supply shifts the SRAS curve
SRAS:SRAS1. Equilibrium real output falls 0Q:0Q1
while price levels rise 0P:0P1.
A variety of factors could bring
about a fall in SRAS:
• Wages of workers might rise
• Raw material prices may go up.
• Taxes on goods and services
might be raised by the
government.
A fall in short run aggregate supply
therefore leads to a fall in output
but a rise in price level in the short
run.
A rise in aggregate supply would
lead to an increase in equilibrium
output and a decrease in the price
level.
Equilibrium output in the long run
LRAS
Price level
• In the long run the
impact of changes in
aggregate demand
are affected by the
shape of the long
run aggregate supply
curve.
• Classical economists
argue that in the
long run the
aggregate supply
curve is vertical
SRAS
P
AD
0
Q
Real output
Equilibrium output in the long run
LRAS
Price level
• Long run equilibrium occurs
where the LRAS curve
intersects with the
aggregate demand curve.
• Hence equilibrium output is
0Q and the equilibrium
price level is 0P.
• Associated with the long
run equilibrium price level
is a short run aggregate
supply curve (SRAS) which
passes through the point
where LRAS = AD.
• The LRAS shows the supply
curve for the economy at
full employment . Hence
there can be no
unemployment in the long
run according to classical
economists.
SRAS
P
AD
0
Q
Real output
Price level
LRAS
P
AD
0
Q R
Real output
• Keynesian economists argue
that the economy is at full
employment where the
LRAS curve is vertical at
output 0R – same as classical
view.
• However the economy can
be in equilibrium at less than
full employment.
• In this curve the equilibrium
level of output is 0Q where
the AD curve cuts the LRAS
curve.
• The key point of
disagreement between
classical and Keynesian
economists is the extent to
which workers react to
unemployment by accepting
real wage cuts.
Price level
LRAS
P
AD
0
Q R
Real output
• Classical economists argue that
a rise in unemployment will
lead rapidly to cuts n real
wages.
• These cuts will increase the
demand for labour and reduce
its supply returning the
economy to full employment
quickly and automatically.
• Keynesian economists on the
other hand argue that money
wages are sticky downwards.
• Workers will refuse to take
money wage cuts and will
fiercely resists cuts in their
wages.
• The labour market therefore
will not clear except perhaps
over a very long period of time,
so long that it is possibly even
not worth considering.
A rise in aggregate demand
• Assume that there is arise in aggregate
demand in the economy with long run
aggregate supply initially unchanged.
• For example there may be an increase in the
wages of public sector employees or there
may be a fall in the propensity to save and rise
in the propensity to consume.
Price level
• A rise in aggregate
demand will push
the AD curve to the
right.
• What would a
classical economist
conclude from this?
• A rise aggregate
demand would lead
to rise in price level
but no change in real
output in the long
run.
LRAS
SRAS
P1
P
AD
0
Q
AD1
Real output
Price level
• The aggregate demand
curve shifts to the right
AD:AD1.
• This could be caused by
a fall in interest rates for
example.
• The equilibrium price
level rises from 0P:0P1.
• Equilibrium output stays
the same at 0Q
• In the classical model no
amount of extra demand
will raise long run
equilibrium output. This
is because the LRAS
curve shows the
economy at maximum
productivity at that
point in time.
LRAS
SRAS
P1
P
AD
0
Q
AD1
Real output
Price level
• The movement from one
equilibrium point to
another can also be
shown on the AD/AS
diagram.
• Assume there is a rise in
aggregate demand
(AD:AD1).
• In the short run this will
result in a movement up
the SRAS curve. We can
see that output rises
0L:0M this is
accompanied by a small
rise in the price level
0N:0P.
• This will move the
economy from A to B.
• However there is a
problem………
LRAS
R
SRAS1
SRAS
C
P
N
B
A
AD
0
L
M
AD1
Real output
Price level
• The economic is now
long run disequilibrium.
• The full employment
level of output is 0L
shown by the position of
the LRAS curve.
• The economy is now
operating in LR
overemployment.
• Firms will find it difficult
to recruit labour, buy
raw materials, find new
offices or factory space.
• Firms will respond by
putting up wages and
other costs.
LRAS
R
SRAS1
SRAS
C
P
N
B
A
AD
0
L
M
AD1
Real output
Price level
• The SRAS is drawn on
the assumption that
wages rates and other
costs remain constant.
• A rise in wage rates will
shift the SRAS curve
upwards.
• SR equilibrium output
will now fall and prices
will keep rising.
• The economy will only
return to LR equilibrium
when the SRAS curve
have shifted upwards
from SRAS:SRAS1 so that
aggregate demand once
again equals LRAS at C.
LRAS
R
SRAS1
SRAS
C
P
N
B
A
AD
0
L
M
AD1
Real output
Price level
• The classical model
argues that increases in
AD will initially increase
both prices and output
(A:B).
• Over time prices will
continue to rise but
output will fall as the
economy moves back
towards LR equilibrium
(B:C).
• In the long run an
increase in AD will only
lead to an increase in
the price level (A:C).
• There will be no effect
on equilibrium output.
• Increases in AD without
any change in LRAS are
purely inflationary.
LRAS
R
SRAS1
SRAS
C
P
N
B
A
AD
0
L
M
AD1
Real output
Price level
The Keynesian model
•
LRAS
•
AD5
P
AD4
AD3
•
AD2
AD1
•
A
0
B
C D
Real output
•
Keynesians would agree with the classical
model that an increase in AD from
AD4:AD5 would be purely inflationary. Is
the economy is already at full
employment 0D.
But if the economy is in a deep
depression an increase in aggregate
demand will lead to a rise in output
without an increase in prices.
This shift in aggregate demand from
AD1:AD2 will increase equilibrium output
from 0A:0B without raising the price level
from 0Pas there are unused resources
available.
There is also the possibility that the
economy is a little below full employment
for instance 0C.
Then a rise in AD from AD3:AD4 will
increase both equilibrium output and
prices.
In the Keynesian model increase in AD may or may not be effective in raising equilibrium
output. It depends upon whether the economy is below or at full employment.
A rise in LRAS
• A rise in LRAS means that the potential output
of an economy has increased – there has been
economic growth.
• Rises in LRAS which are unlikely to shift the
aggregate demand curve might occur if, for
instance, incentives to work increased or there
was a change in technology.
The Classical model
•
•
•
•
In the classical model an
increase in LRAS will lead to
both higher output and
lower prices.
A shift in the AS curve from
LRAS to LRAS1 will increase
equilibrium output from
0L:0M.
Equilibrium prices will also
fall from 0N:0P.
Contrast this to what
happens when AD is
increased in the classical
model – a rise in prices with
no increase in output.
Therefore it is not surprising
that classical economists
are strongly in favour or
supply side policies – this is
why they are sometimes
referred to as supply side
economists.
LRAS LRAS1
Price level
•
N
P
AD
0
Q
Real output
Price level
The Keynesian model
P
Yd
0
• In the Keynesian model an
LRAS LRAS1
increase in AS will both
increase output and
reduce prices if the
AD1
economy is at full
employment.
AD2
• With aggregate demand at
AD3
AD1 a shift in the
aggregate supply curve
from LRAS:LRAS1
Ye Yf
increases full employment
Real output
equilibrium Ye:Yf.
Price level
The Keynesian model
LRAS
P
AD3
Yd
0
• If the economy is at
LRAS1
slightly less than full
employment, with an AD
curve of AD2 then the shift
AD1
to the right of the LRAS
AD2
will still be beneficial to
the economy increasing
output and reducing
prices.
Ye Yf
Real output
Price level
The Keynesian model
P
Yd
0
• Keynesians however
disagree with classical
LRAS LRAS1
economists that supply side
measures can be effective in
a depression.
AD1 • If the AD curve is AD3 an
increase in aggregate supply
AD2
has no effect on equilibrium
AD3
output. It remains stuck ay
Yd.
• Only an increase in
aggregate demand will more
Ye Yf
the economy out of a
Real output
depression.
This is controversial
• During the 1930s classical economists argued that the only way to
put the millions of unemployed during the great depression back to
work was to adopt supply side policies such as cutting tax rates,
reducing trade union power and cutting government spending and
unemployment benefits.
• Keynes attacked this solution by suggesting that the depression was
caused by a lack of demand and that it was the government
responsibility to increase the level of aggregate demand.
• The same debate happened in the UK in the 1980’s only this time it
was the other way around.
• Keynesians suggested that the only quick way to get millions of
people back to work was to expand aggregate demand .
• In the budget of 1981 the government did exactly the opposite and
cut its projected budget deficit reducing aggregate demand arguing
that the only way to cure unemployment was to improve the supply
side of the economy.
Increasing AD & AS
• In microeconomics the factors that shift the
demand curve do not shift the supply curve as
well.
• For example an increase in the costs of
production shifts the supply curve but doe not
shift the demand curve, although there will be
movement along the demand curve as a
result.
• In macroeconomics things are a little different.
Increasing AD & AS
• In macroeconomic aggregate demand and supply
analysis factors that shift one curve may well shift
the other curve as well.
• For example assume that firms increase their
planned investment, this will lead to an increased
level of aggregate demand and in the long run it
will also increase the level of aggregate supply.
• An increase in investment will increase the level
of capital stock in the economy therefore the
productive potential of the economy will rise.
• An increase in
investment in the
classical model will
initially shift the AD
curve to the right form
AD:AD1.
• There will be a
movement along the
short run AS curve from
A:B.
• There is now LR
disequilibrium.
• How this will be
resolved depends upon
the speed with which
the investment is
brought in line and
starts to produce goods
and services.
LRAS
LRAS 1
SRAS
SRAS1
B
A
C
AD1
AD
• Lets assume that an
investment starts to
take effect pretty
quickly:
– The LRAS will shift to
the right LRAS:LRAS1
– Long run equilibrium
will be restored at C.
– Output has increased
and the price level
fallen slightly.
– There will be a new
SRAS curve SRAS1.
– It is below the original
SRAS curve because it
is assumed that
investment has
reduced costs or
production.
LRAS
LRAS1
SRAS
SRAS1
B
A
C
AD1
AD
• Not all investment results in increased
production.
• For example fitting out a new shop which goes
into receivership within a few months will
increase AD but not LRAS.
• The LRAS curve will therefore not shift and the
increased investment will only be inflationary.
• Equally investment may be poorly directed.
• The increase in AD might be greater than the
increase in LRAS, hence there will be an
increase in equilibrium output but there will
also be an increase in prices.