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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.