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AS Macroeconomics / International Economy

Macroeconomic Equilibrium

We now put aggregate demand and supply to together to consider the idea of equilibrium for the economy.

In this chapter, we will be using the neo-Keynesian version of the long run aggregate supply curve – which is drawn as a non-linear curve. This shape of the LRAS curve shows that increases in aggregate demand may increase real output and employment in the short term though when SRAS is upward sloping, this may be at the expense of higher inflation.

Macro-economic equilibrium is established when AD intersects with SRAS. This is shown in the diagram below. At price level P1, AD is equal to SRAS – i.e. at this price level, the value of output produced within the economy equates with the level of demand for goods and services.  The output and the general price level in the economy will tend to adjust towards this equilibrium position. If the general price level is too high for example, there will be an excess supply of output and producers will experience an increase in unsold stocks. This is a signal to cut back on production to avoid an excessive level of inventories. If the price level is below equilibrium, there will be excess demand in the short run leading to a run down of stocks – a signal for producers to expand output.

Changes in short-run aggregate supply (SRAS)

Suppose that higher productivity of labour and capital inputs together with lower raw material costs such as cheaper oil and steel causes the short run aggregate supply curve to shift outwards. (Assume that there is no shift in AD). The next diagram shows what is likely to happen. SRAS1 shifts outwards to SRAS3 and a new macroeconomic equilibrium will be established at Y3.

Equilibrium using a linear aggregate supply curve

In the next diagram we see the effects of two inward shifts in AD. This might be caused for example by a decline in business confidence (reducing planned investment demand) and a fall in exports following a global downturn. It might also be caused by a cut in government spending or a rise in interest rates (announced by the Bank of England).

The result of the inward shift of AD is a contraction along the short run aggregate supply curve and a fall in national output (i.e. a recession). This causes downward pressure on the general price level and takes the equilibrium level of national output further away from the full capacity level of national income as indicated by the LRAS curve. We would expect to see a rise in unemployment.

The Output Gap

The output gap (or GDP gap ) is an important concept in macroeconomics. It is defined as the difference between the actual level of national output and its potential level and is usually expressed as a percentage of the level of potential output.

Negative output gap – downward pressure on inflation

The actual level of real GDP is given by the intersection of AD & SRAS – the short run equilibrium. If actual GDP is less than potential GDP (e.g. real output level Y1) then there is a negative output gap. Some factor resources including labour are under-utilised and the main economic problem is likely to be higher than average unemployment. High unemployment indicates an excess supply of labour in the factor market which means there is downward pressure on real wage rates. In the next time period, a fall in wage rates shifts SRAS downwards until actual and potential GDP are identical – assuming labour markets are flexible.

Positive output gap – upward pressure on inflation

If actual GDP is greater than potential GDP i.e. a level of real GDP of Y2 then there is a positive output gap. Some resources including labour are working beyond normal capacity e.g. shift work and overtime. The main economic problem is likely to be demand pull and cost-push inflation. The shortage of labour puts upward pressure on wage rates. In the next time period, a rise in wage rates shifts SRAS upwards until actual and potential GDP are identical – assuming labour markets are flexible.

The last boom in the late 1980s left the UK with a large positive output gap, one of the reasons why we say a sharp acceleration in inflation before the recession of the early 1990s (high inflation required very high interest rates to control it and this squeezed business and consumer confidence and spending). At the end of the recession in 1992 the output gap was negative – allowing the economy to grow for several years without the fear of demand-pull inflationary pressure.

Over the last six or seven years, the output gap has remained close to zero. The Bank of England has managed quite successfully through its interest rate strategy to keep aggregate demand growing more or less in line with the economy’s productive potential. The recent global economic slowdown has hit GDP growth in the UK (leading to weak exports and falling investment) – but the economy continues to operate fairly close to its potential.