Macroeconomic Equilibrium

Macroeconomic equilibrium Macroeconomic equilibrium occurs where the quantity of real GDP supplied is equal to the quantity of real GDP demanded, i.e., at the intersection of the AS and AD curves. Why is this an equilibrium? Equilibrium occurs at a price level of 115, where the quantity of real GDP supplied = the quantity of real GDP demanded = $9 trillion. If the price level is above 115, say, 130, the quantity of real GDP supplied is $10 trillion at point A. But the quantity of real GDP demanded is less than $10 trillion. Firms are unable to sell all of their output. Therefore, there is an unplanned increase in firms’ inventories. Firms respond by reducing production and cutting prices. The combination of a decrease in output and a decrease in prices means a movement down along the AS curve from point A toward point E. If the price level is below 115, say, 100, the quantity of real GDP supplied is $8 trillion at point B. But the quantity of real GDP demanded is more than $8 trillion. There is an unplanned decrease in firms’ inventories as firms are unable to meet all of their customers’ demands. Firms respond by increasing production and raising prices. The combination of an increase in output and an increase in prices means a movement up along the AS curve from point B toward point E. Macroeconomic equilibrium can occur at full employment, above full employment, or below full employment: Fluctuations in AD cause fluctuations in real GDP around potential GDP. At point E, AD0 intersects AS at potential GDP. Equilibrium real GDP = Potential GDP Equilibrium real GDP is $9 trillion. This is a full employment equilibrium. Now, if AD increases to AD1, firms’ inventories decrease and firms respond by increasing production and raising prices to meet the higher demand. Equilibrium real GDP increases to $10 trillion at point A. Equilibrium real GDP now exceeds potential GDP. This is an above-full employment equilibrium. If AD now decreases to AD2, firms’ inventories increase and firms respond by cutting production and lowering prices in order to sell all of their output. Equilibrium real GDP decreases to $8 trillion at point B. Equilibrium real GDP is now less than potential GDP. This is a below-full employment equilibrium. The business cycle Fluctuations in AD can cause business cycle fluctuations in real GDP. When AD increases from AD0 to AD1, equilibrium real GDP increases from full employment, at $9 trillion, to $10 trillion, which is a business cycle expansion. If AD now decreases back to AD0, equilibrium real GDP decreases again to $9 trillion, the full employment level. If AD decreases further to AD2, equilibrium real GDP decreases to $8 trillion and the economy is in a recession, with equilibrium real GDP below full employment. If AD increases again to AD0, equilibrium real GDP increases back to the full employment level of $9 trillion. The causes of these AD fluctuations are any of the factors we have discussed: changes in expectations, fiscal or monetary policy, or global economic conditions. AS fluctuations Recall that AS can shift either because of a change in potential GDP or because of a change in the nominal price of labor or some other major resource. Potential GDP grows during periods of rapid technological change and capital accumulation. A good example of a change in the price of a major resource is a change in the price of crude oil. Oil is used as an input in the production of many goods and services because oil is used to produce electrical power and fuel for transportation. Assume that the economy is initially in equilibrium at full employment, i.e., equilibrium real GDP = potential GDP. Now, oil prices rise. Firms face higher transportation and energy costs and therefore reduce production. AS decreases from AS0 to AS1: Equilibrium real GDP decreases below potential GDP and the price level rises. The economy is in a recession because real GDP is below full employment. But there is also inflation. A combination of recession and inflation is called stagflation, and occurred in the U.S. and the global economy in the mid-1970s and early 1980s. Starting from the same full employment equilibrium, if oil prices fall, firms’ transportation and energy costs decrease and firms increase production. AS increases from AS0 to AS2: Equilibrium real GDP increases above potential GDP and the price level falls. The economy is in an abovefull employment equilibrium. In the mid-1980s, an economic expansion coincided with slowing inflation. Adjustment to full employment When a shift in AD moves the economy to an equilibrium that is above or below full employment, automatic forces operate to bring the economy back to full employment in the long run. AD increases from AD0 to AD1. Equilibrium real GDP increases above potential GDP. There is now an inflationary gap. This is a gap between actual GDP and full employment GDP that causes prices to rise: The increase in the price level reduces the purchasing power of workers’ wages, while firms’ profits have increased. Workers demand higher wages to compensate them for higher prices, and other input suppliers likewise demand higher prices for their inputs. Firms agree to these demands because they want to maintain their output and employment in the face of strong demand for their products. As nominal wage rates and nominal prices of other inputs rise, AS decreases. The AS curve shifts from AS0 to AS1 and equilibrium real GDP decreases back to potential GDP. Full employment equilibrium is restored: A decrease in AD from AD0 to AD2 causes equilibrium real GDP to decrease below potential GDP. There is now a deflationary gap. This is a gap between actual GDP and full employment GDP that causes prices to fall: The economy is now in recession at an equilibrium level of real GDP that is below full employment, and the price level has fallen. Those workers who are still employed see the purchasing power of their wages rise due to the drop in prices. Firms’ profits decrease and, due to the surplus of unemployed labor, nominal wages fall. As firms reduce output, they purchase fewer inputs, and therefore nominal input prices fall too. As nominal wage rates and nominal prices of other inputs fall, AS increases. The AS curve shifts from AS0 to AS2 and equilibrium real GDP increases back to potential GDP. Full employment equilibrium is again restored: