16 Macroeconomic equilibrium

If economy operating at full employment and there is increase in AD then outcome

"purely inflationary". There is no increase in output and the only change is an increase in price level. Because impossible for economy to produce any further increase in ouput in the long run, given existing factors of production.

Important about New classical perspective

that the lnog run equilibrium is equal to full employment level of income and that the economy will move towards this equilibrium without government intervention as a result of free market forces. increase in AD, inflationary in the long run and thus there is no role for the government to play trying to steer the eocnomy towards full employment.

If government planning to intervene to try to fill in deflationary gap,

-it must try to estimate the gap between equilibrium output and full employment output. -it must have some estimate of the value of the multiplier so as to be able to judge the suitable increase in AD that is necessary to inject into the economy in order to fill the gap The difficulties in estimating both, illustrates one of the limitations of government fiscal policy aimed at managing AD in the economy

Changes in the long run aggregate supply

A country's LRAS is based on the quantity and quality of its factors of production and that these change. Therefore, the full employment level also changes. As economic growth occurs, the LRAS curve shifts to the right. This represent an increase in the potential output of the economy. A country seeking to increase the rate of the economic growth and the full employment level of real output will use supply side policies to increase the quantity or improve the quality of its FOP. The impact of these policies depends to a large extent on the view of the economy that one takes.

Long run equilibrium output

AD=LRAS Keynesian and new classical equilibrium output

KEYNESIAN PERSPECTIVE LONG RUN EQUILIBRIUM OUTPUT

AD=LRAS. This equilibrium will happen at different levels. They believe that the economy may be in long run equilibrium at a level of output below full employment. This will be the case if economy is operating at a level where there is spare capacity. In this view, the equilibrium evel of output, depends on the level of AD. If AD is at the level shown in, then equilibrium will occur at level of output Y. with price level of P. AS can be perfectly elastic due to spare capacity, with high level of unused FOP such as unemployed workers. DEFLATIONARY GAP. AD is not sufficient to buy the potential output gap and though not easily measurable.

HL the multiplier effect

If a government decides to fill a deflationary gap by increasing its own spending, the final increase in AD will actually be greater than the amount of spending. Any increase in AD, will lead to increase in national income. Necessary to understand leakages and injections. Government spending and investment are injections to the circular flow of income, and any injections are multiplied through the economy as people receive a share of the income and then spend a part of what they receive.

new classical perspective showing a combination of short run and long run

Initially economy is at its long run equilibrium at Yf. If increase in AD1-Ad2, due to changes in the components of aggregate demand, then in the short run, increase in output Yf-Y1. Economy will be experiencing inflationary gap, where the economy is in an equilibrium level above the full employment level. However, according to new classical, this is only possible in short run. It is possible for output to increase along the short run AS by paying existing workers overtime wages as a short term solution. But as the economy is originally at the full employment level of output, there are no unemployed resources. In their effort to increase increase output, firms are competing for increasingly scarce labour and capital.

Another simpler example of the Multiplier effect

The government spends 100$ million in an economy. The behaviour -20% goes to taxes -10% saved -10% used for imported goods and services. The remaining income 60%, is spent on domestic goods and services. MARGINAL PROPENSITY TO CONSUME (MPC) and is expressed as decimal In this particular economy, MPC is 0,6. The finnal addition to national income, when all the money has been spent and re-spent, amounts to 250$million, 2.5 times the original government spending. In this example the multiplier effect is equivalent to the value 2.5

example of a multiplier effect

a government spends 100 million $ on a school building project. This money goes to a vast number of people for the FOP they provide. It goes as income for the labour provided by arquitects and stuff. The providers of the capiital and raw materials, such as concrete, steel and stuff also receive a share of this money. So the money ends up as income of the people who provide FOP. What do people do with this income? -some goes back to gov as taxes(leakages) -some saved(leakages) -some spend on foreign goods and services(leakages) -rest is spent on domestic goods and sercives. The money that is spent goes to another number of recipients who behave the same way. During each round, some income is withdrawn from the circular flow and some stays re spent.

For new classicals

an increase in LRAS, will have a favourable impact. There will be an increase in the full employment level of income, and a fall in price level. This emphasizes that supply side policies are the most effective way in achieving country's macroecnomic goals

For Keynesians, the impact of supply side policies

an increase in the LRAS depends on the initial equilibrium position of the economy. If below full employment, then the increase in the LRAS, will have no effect in the equilibrium output.

Any change in any of the withdrawals from the circular flow of income will result in a

change in the economy's multiplier. If taxation rate increases, the multiplier effect will fall. if MPM falls, the multiplier effect will increase

If aggregate demand increase further, to AD3, then

economy starts to experience inflationary prssure, as available factors of production become scarcer and their prices bid up. P level rises to compensate producers for their higher costs.

national income

is equivalent to the level of output that a country produces and is a key sign of the economic health of an economy.

Formulas

it can be calculated by using either the MPC, or the value of the marginal propensity to withdraw. The mpw is the value of the marginal propensity save MPS, plus marginal rate of taxation (MRT) plus marginal propensity to import MPM

more new classical perspective

it is important to look at the adjustment from the short run to the long run to understand the new classical perspective. The word automatically move to long run equilibrium at full employment means that without government intervention. In their view, there may be a short run increase in output if there is an increase in aggregate demand, but the economy will always return to its long run equilibrium.

we have a short run and

long run macroeconomic equilibrium

we can use similar analysis to see what happens if AD falls.

originally the economy is at its long run equilibrium where AD1 intersects with SRAS1, at output YF and price level P1. A fall in AD1->AD2, due to changes in components, results in a fall in the level of national output Yf to Y1 and a decrease in price level. Deflationary gap, where economy is in equilibrium at a level of output that is less than the full employment level. In the short run, the economy will produce at less than full employment output, however, this deflationary gap will not persist. The fall in APL, means prices of FOP in the economy have fallen. This means that firms' costs of production fall and this results in shift to the right SRAS1 to SRAS2. The economy will return to full level of employment, at a lower price level.

Demand side policies

the diagrams of the Keynesian view of different possible long run positions of the economy. Important conclusion the long run equilibrium level is not necessarily equal to the full employment level of income, that the economy can become stuck in equilibriumat a level of output that is below full employment. Significant role of the government in the economy. Governments seeking to intervene, to steer the economy towards full employment, will use demand side policies. These involve fiscal and monetary policies from chapter 14. Expansionary policies used to increase AD to increase the equilibrium level of output. Increasing the level of output implies an increase in the demand for labour so such policies are designed to reduce unemployment. Contractionary polcies are used to decrease AD, to reduce inflationary pressure that is caused when price level rises.

short run equilibrium output

the economy is in short run equilibrium where aggregate demand equals short run aggregate supply SRAS. Producing an output level of Y at the price level of P. The output produced is exactly equal to the total demand in the economy and so there is no reason for producers to change their levels of output. There is no inflationary or deflationary pressure.

New classical perspective

the economy will always move towards its long run equilibrium at the full employment level of output. AD=LRAS new classical. The impact of any changes in AD will be on price level only. An increase in AD, will result in an increase in the price level from P1 to P2, without an increase in the level of output.

the new classical perspective of the impact of an increase in AD in the short run and in the long run

the increase in AD1->AD2, results increase in price level P1 to P2. DIAGRAM. Increase average price level means that on average, all prices in the economy have risen as the firms bid up the prices of the factors of production in order to increase output. Rise in Price level, means increase in costs to firms as the prices of the FOP have risen. This leads to a shift in the SRAS1->SRAS2, to the left. Although firms wre willing to supply a higher level of output due to the higher prices they were receiving in the short run, thteir higher costs of production result in no REAL gain, so reduce output to Yf. Output returns to its full employment level but at a higher price.

In keynesian view, AD can increase such that there is an increase in the level of output

without any consequences in the price level.