Equilibrium in the short and long run

Full employment output

=potential output=output where cyclical unemployment is zero, and unemployment equals the natural rate, occurring when the economy is at long run equilibrium

Changes in long-run equilibrium

In the monetarist/new classical model, long-run equilibrium can change: -With constant LRAS and potential output, leading to changes only in the price level (cause inflation)[can influence GDP only in the short run] -With changing LRAS, leading to increasing potential output (economic growth) or decreasing potential output (negative growth)

Conclusions arising from the Keynesian model

- Since resource prices and product prices are inflexible downward, the economy cannot move into the long run. This means that the economy can remain indefinitely stuck in a deflationary (recessionary) gap, caused by insufficient aggregate demand, and therefore requires expansionary demand-side policies to come out of recession. -Whereas in the monetarist/new classical model expansionary policies are always inflationary (leading to a higher PL due to the upward sloping SRAS curve and the vertical LRAS curve), in the Keynesian model expansionary policies do not lead to any increase in the price level when the economy is in recession (the horizontal part of the curve). Increases in AD become inflationary only as the economy approaches full employment output.

Equilibrium in the Keynesian model

Equilibrium in this model is given by the intersection of the AD and Keynesian AS curves. There are three possible equilibrium positions Full employment equilibrium: Potential output (Yp) equals to the economy's actual output (Ye) Recessionary (Deflationary) gap: AD intersects the AS curve in its horizontal section, determining the Ye, which is less than Yp (potential GDP) -> unemployment greater than the natural rate Inflationary gap: Potential output (Yp) < the economy's actual output (Ye) -> unemployment falls below the natural rate, as the economy approaches its maximum capacity the PL increases

[LRAS] Long run aggregate supply

In the long run, the AS curve [LRAS] is vertical at the level of potential output, Yp (=full employment output), because in the long run, resource prices change along with the price level, therefore in real terms resource prices remain constant. Thus, as the price level increases or decreases, firm profitability is constant, and firms face no incentive to change the quantity of output they produce. ->Quantity of output produced in the long run is independent of the price level Long-run equilibrium occurs at the level of potential output, Yp, or full employment output, where AD and SRAS intersect on the LRAS curve

Monetarist/ new classical model

In this model, fluctuations of output occur only in the short run. In the long run, the economy automatically returns to long-run equilibrium and full employment (potential) output because of the assumption of full wage-price flexibility. Therefore, long-run equilibrium always occurs at full employment output.

Deflationary (recessionary) gap

Occurs when short-run equilibrium GDP (Ye) is less than potential GDP (Yp) due to insufficient aggregate demand. A deflationary gap can only persist in the short run. In the long run, the economy will return to potential output (=full employment output). Suppose the economy is initially at point x at long-run equilibrium producing Yp. Due to a decrease in AD (AD->AD2) it moves to point y where the price level has fallen, real GDP is lower at Ye and there is a deflationary gap. The economy can remain at y only in the short run. In the long run wages and other resource prices will fall to match the fall in the price level -> SRAS increases, shifts right from SRAS1 to SRAS2 where the economy is at point z, back at long-run equilibrium. In the long run, the only effect of a fall in AD is to cause a fall in the price level, with no effect on real GDP. (Stagflation-recession(with unemployment) and rising price level)

Inflationary gap

Occurs when short-run equilibrium GDP(Ye) is greater than potential GDP (Yp) due to excess aggregate demand. An inflationary gap can only persist in the short run. In the long run the economy will return to potential output (=full employment output) Suppose the economy is initially at point x at long-run equilibrium producing output Yp. Due to an increase in AD (AD1->AD2) it moves to point y where the price level is higher, real GDP is greater at Ye and there is an inflationary gap. The economy can remain at y only in the short run. In the long run wages and other resource prices rise to match the increase in the price level -> SRAS decreases, shifts left from SRAS1 to SRAS2, and the economy is at point z at long run equilibrium once again In the long run, the only effect of an increase in AD is to cause an increase in the price level, with no effect on real GDP

Shifts in aggregate supply over the long term and economic growth

Over the long term (a long period of time) the LRAS and the Keynesian AS curves can shift, indicating that potential output, Yp, changes. Usually these shifts are to the right, indicating economic growth (=growth in real GDP). Factors shifting the curve include: -Increases in quantity of factors of production [ex.: an increase in the amount of labor] -Improvements in quality of factors of production [ex: improvement in labor quality due to more education] -Technological changes -Improvements in efficiency (making better use of scarce resources and lower costs of production] -Reductions in the natural rate of unemployment -Institutional changes [ex.: reduction in bureaucracy] -Reductions in the natural rate of unemployment (unemployment that is 'natural' for an economy when it's producing its 'full employment' level of output - includes unemployed people who are: in between jobs, training etc) If the opposite of the above occur, the AS curve shifts to the left, indicating negative economic growth

Keynesian model

This model is based on the assumption that there is no long run, because wages (and other resource prices) as well as the price level do not fall easily Three sections of the Keynesian AS curve 1)The horizontal section occurs because of two factors: - Wage-price downward inflexibility [wages don't fall easily because of wage contracts, minimum wages, and unpopularity of wage cuts; price level doesn't fall easily because if wages don't fall, a drop in product prices would cut firms' profits, which firms wish to avoid] -Spare capacity when the economy is in recession [at low levels of output, when the economy is in the recession, there's unemployment of labor and other resources; if firms decide to increase output and demand more resources, there is no upward pressure on wages and the price level, therefore they don't increase] 2)The upward sloping section occurs because of resource bottlenecks (shortages) [appear as output increases and approaches full employment of potential output, Yp, causing resource prices to increase. As firms' costs of production rise, firms raise product prices so the price level begins to rise 3)The vertical section occurs because maximum capacity output (Ym) is reached [meaning that all resources are employed to their maximum extent, and it is therefore not possible for output to increase further. Any effort to increase output beyond this point results only in increases in the price level]

[SRAS] Short run aggregate supply

in the short run AS has an upward slope: there is a positive relationship between Price Level and Real GDP due to firm profitability: * if the PL increases (with wages and all other factor prices held constant) firms' profit increase-> firms' increase quantity of output produced -> upward movement along the SRAS curve *if the PL decreases (with wages and all other factor prices held constant) firms' profit decrease-> firms decrease q. of output produced-> downward movement along the SRAS curve A rightward shift from SRAS1 to SRAS1 - short-run aggregate supply increases: for any PL, firms produce a larger quantity of real GDP A leftward shift from SRAS1 to SRAS3 - short-run aggregate supply decreases: for any PL, firms produce a smaller quantity of real GDP Causes by changes in: - Costs of production (wages, land, labour, capital, entrepreneurship) - Business taxes [taxes on firms' profits-treated like costs of production] - Subsidies offered to businesses - Supply shocks

Short run in macroeconomics

the period of time when all resource prices (incl. wages) are constant

Long run in macroeconomics

the period of time when all resource prices (incl. wages) change