Short-run macroeconomic equilibrium

Short-run macroeconomic equilibrium occurs when the total quantity of goods and services demanded matches the total supplied at a given price level.

Determining equilibrium output and price level

• Equilibrium real output is found where the aggregate demand (AD) curve intersects with the short-run aggregate supply (SRAS) curve.
• The average price level (APL) is set at this intersection, reflecting the general cost of goods and services across the economy.

Changes in equilibrium from shifts in AD and SRAS

Shifts in either AD or SRAS alter the economy's equilibrium, affecting both output and prices.

Effects of shifts in aggregate demand

• An increase in AD, such as from government spending boosts, shifts the AD curve rightwards.
• This results in higher real output and a higher APL in the short run.
• A decrease in AD shifts the curve leftwards, leading to lower real output and a lower APL.

Effects of shifts in short-run aggregate supply

• A decrease in SRAS, caused by rising production costs like increased commodity prices, shifts the SRAS curve leftwards.
• This leads to a higher APL but lower equilibrium real output.
• An increase in SRAS shifts the curve rightwards, resulting in a lower APL and higher real output.

Long-run macroeconomic equilibrium

In the long run, the economy adjusts to its full potential, where resources are fully utilised.

Key features of long-run equilibrium

• Equilibrium output settles at the potential or full-employment level, regardless of short-term fluctuations.
• Short-run deviations from potential output occur because nominal wages are fixed in the short run.
• In the long run, nominal wages become flexible, adjusting fully to changes in the APL, restoring the economy to its natural capacity.

Deflationary and inflationary gaps

Gaps arise when the economy's actual output diverges from its potential.

Types of economic gaps

• Deflationary gap - Occurs when equilibrium real output falls below the full-employment level, indicating unused resources.
• Inflationary gap - Exists when equilibrium real output exceeds the full-employment level, leading to pressure on resources.

Monetarist and Keynesian views on closing gaps

Different economic schools offer contrasting explanations for how gaps are resolved, focusing on market mechanisms versus government action.

Monetarist perspective on gap closure

• Market forces naturally eliminate both deflationary and inflationary gaps through adjustments in nominal wages.
• No government intervention is required, as the economy self-corrects over time.
• The adjustment process may take a considerable period, reflecting the "long run" nature of these changes.

Keynesian perspective on gap closure

• Unlike Monetarists, Keynesians argue there is no automatic mechanism to close gaps, potentially leaving the economy stuck below full employment.
• Nominal wages are "sticky downwards," meaning they rise easily but resist falling, prolonging deflationary gaps.
• AD drives the equilibrium level of activity, so a fall in AD can trap the economy in a deflationary gap.
• Government intervention is essential, using expansionary fiscal policy (e.g., increased spending) or loose monetary policy (e.g., lower interest rates) to boost AD and restore full employment.
• At full employment, further AD increases cause inflation without output growth.
• Keynesians define full employment as zero unemployment, differing from Monetarists who include a natural rate of unemployment.