Short-run Equilibrium

• Real national output equilibrium?occurs where?aggregate demand?intersects with?aggregate supply

A diagram showing the Classical short-run equilibrium in an economy resulting in an equilibrium price of AP1?and real output of Y1

• According to?classical theory, this economy is in?short run equilibrium at AP1Y1
• Any changes to the components of?AD?will cause the AD curve to shift left or right?creating a new short-run equilibrium
• Any changes to the?determinants of SRAS?will shift the SRAS curve left or right?creating a new short-run equilibrium

Long-run Equilibrium

• Classical?and?Keynesian?economists have different views on the?long-run equilibrium?of real national output
  • Classical economists?believe that the economy will?always return to its full potential level?of output and all that will change in the long-run, is the?average price level
  • Keynesian economists?believe that the economy can be in?long-run equilibrium at any level of output
    

A diagram that shows the Classical view of long-run equilibrium which occurs at the intersection of long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) & aggregate demand (AD)

Diagram Analysis

• The?LRAS?curve demonstrates the?maximum possible output?of an economy using all of its?scarce resources
• The?SRAS intersects with AD?at the LRAS curve
• This economy is producing at the?full employment level?of output (YFE)
• The?average price level?at YFE?is AP1

A diagram that shows the Keynesian view of long-run equilibrium which occurs at the intersection of long-run aggregate supply (LRAS) & aggregate demand (AD)

Diagram Analysis

• The?vertical portion?of the LRAS curve corresponds to the?classical view?of LRAS
  • The Keynesian view believes there is a?maximum level of possible output
• The?LRAS?curve?becomes elastic?at a certain price level as prices cannot fall further
  • Possibly due to?minimum wage laws, the existence of?trade unions, or long-term?employment contracts?preventing wage decreases
• Real output national equilibrium?can occur at any?level of output
  • In this case equilibrium is at the intersection of?LRAS and AD (AP1Y1)

Changes Using the Classical Approach

1. An Increase in Aggregate Demand (AD)

A diagram showing the Classical representation of an increase in aggregate demand (AD)

Diagram Analysis

• The?initial equilibrium?level of output was at?AP1Y1
• An?increase?in one of the components of?AD?(e.g. consumption) causes the AD to?increase AD1→AD2
• Average prices?in the economy rise to?AP2?and the real level of?output increases to Y2
• The new?short-run equilibrium?is at AP2Y2

2. An increase in short run aggregate supply (SRAS)

A diagram showing the Classical representation of an increase in the short-run aggregate supply (SRAS)

Diagram Analysis

• The?initial equilibrium?level of output was at?AP1Y1
  • This equilibrium represents a?recessionary?or negative output gap equal to?Y1YFE
• An?increase?in one of the determinants of?SRAS?(e.g. productivity) causes the SRAS to?increase SRAS1→SRAS2
• Average prices?in the economy fall to?AP2?and the real level of?output increases to Y2
• The new?short-run equilibrium?is at?AP2Y2
• There is still a negative output gap?but it is smaller?(Y2YFE)

Changes Using the Keynesian Approach

1. Changes to Aggregate Demand (AD)

A diagram that illustrates the Keynesian view of how changes to aggregate demand (AD) have different impacts on the average price level (AP)

Diagram Analysis

• The economy is initially in?equilibrium?at the intersection of?AD1?and LRAS
  • The?price level?is AP1?and the?output?is at Y1
• An?increase?in any component of?AD?(e.g. government spending) causes AD to shift from AD1→AD2
  • As this?increase occurs close to the full employment level?of output, there is a?large increase?in the average?price level (AP1→AP2), but a relatively?small increase?in?real output (Y1→Y2)
• A?decrease?in any component of?AD?(e.g. net exports) causes AD to decrease from?AD1→AD3
  • As this?decrease occurs close to the elastic portion of the LRAS curve, there is a relatively?larger decrease?in the?real output (Y1→Y3) than the decrease in the average price level (AP1→AP3)
• If a further?decrease in AD?were to take place from?AD3→AD4, there would be virtually no impact on the average price level, but the?real output?would fall from?Y3→Y4

Changes to Long-run Aggregate Supply (LRAS)

1. Changes to LRAS in the Classical Model

• Changes to any of the?determinants of LRAS?will change the long-run productive potential of the economy

A diagram showing the Classical view of an increase in the long-run aggregate supply (LRAS) of an economy and how it lowers average price levels

Diagram Analysis

• The?initial potential output?of this economy is seen at?YFE
  • The economy is in?equilibrium?at AP1YFE
• A?change to the education?level in the economy can?increase the quality of labour?and shift the LRAS to the right from?LRAS1→LRAS2
  • There is now an increased level of possible output in the economy?YFE1
• The?extra supply?in the economy?allows prices to fall?and?output to increase?resulting in a new equilibrium at AP2YFE1

2. Changes to LRAS in the Keynesian Model

• As with the Classical model,?changes to any of the?determinants of LRAS?will change the long-run productive potential of the economy

A diagram showing the Keynesian view of an increase in the long-run aggregate supply (LRAS) of an economy and how it changes output without necessarily changing average price levels

Diagram Analysis

• The?initial potential output?of this economy is seen at?YFE
  • The economy is in?equilibrium?at the intersection of AD1?and LRAS (AP1YFE)
• A?change to the immigration policy?can?increase the quantity of labour?and shift the LRAS to the right from?LRAS1→LRAS2
  • There is now an increased level of possible output in the economy?YFE1
  • AD is in the vertical portion?of the LRAS curve so output will increase (YFE→YFE1)?and?average prices will fall (AP1→AP3)
• If the starting point of this economy had been the?equilibrium at AD2Y2,?then according to Keynesian thinking, an increase in LRAS would not?impact?the economy as it is?stuck in a depression?& requires?AD to increase?in order to change national output