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Lecture 16. Oct. 28 - Ch. 10, part 2

Macroeconomic equilibrium
The interaction of aggregate demand and aggregate supply determines macroeconomic equilibrium, and understanding macroeconomic equilibrium provides insight into changes in real GDP and the price level. In considering determination of real GDP and the price level, however, we must distinguish between the short run and the long run.
Short-run macroeconomic equilibrium occurs (geometrically) at the intersection of the short-run aggregate supply curve (SAS) and the aggregate demand curve (AD). This intersection indicates the price level at which the aggregate quantity of final goods and services supplied in the economy is equal to the aggregate quantity demanded, and indicates as well the coresponding level of real GDP.


To see that this point of intersection is an equilibrium point, consider first a situation where the price level is below that corresponding to the short-run equilibrium. At this price level, the quantity of real GDP that will be supplied by firms will be less than the quantity of real GDP that will be demanded by households, business firms, government, and net foreign demand. With firms unable to meet demand, inventories decline and back orders become the rule. In order to meet the strong demand, firms will begin to increase production; and in so doing will incur additional resource costs that will result in price increases (i.e., there will be a movement up along the SAS curve). As prices increase, this will lead to a moderating of demand (movement up along the AD curve). These movements will continue until quantity supplied equals quantity demanded -- at the point of intersection of the SAS and AD curves.
Similarly, if the price level is greater than the equilibrium level, the quantity of real GDP supplied will exceed the quantity demanded. In this case, inventories will accumulate, goods and services will go unsold, and eventually firms will lay off workers, cut production, and reduce prices in order to sell theor output. This translates into a movement down along the SAS curve, and as prices fall there will be a corresponding movement down along the AD curve. These movements will continue until equilibrium is reached.
Long-run macroeconomic equilibrium requires that real GDP be equal to potential GDP, and corresponds to a situation of full employment. That is, long-run macroeconomic equilibrium entails the economy being on its vertical long-run supply curve. This contrasts with the short-run equilibrium situation, in which real GDP may be less than or greater than (or equal to) potential GDP. Let's take a look at the different possible short-run situations vis-à-vis long-run equilibrium.
Consider first the case where there is a short-run equlibrium at a real GDP below the level of potential GDP. This is called a below full-employment equilibrium, and the difference between potential GDP and real GDP is called a recessionary gap. Note that this situation may correspond to a recession, but this will not necessarily be the case: if potential GDP has grown faster than real GDP recently, a recessionary gap may exist even with continued (slow) real GDP growth. In any case, the most obvious manifestation of a recessionary gap is the presence of high unemployment.


Short-run equilibrium at a real GDP in excess of potential GDP is called an above full-employment equilibrium. The excess of real GDP over potential GDP is called an inflationary gap. That is, this gap creates inflationary pressure. Unemployment in this situation would be below the full-employment level of unemployment.


The third possibility is with a short-run equilibrium at a real GDP just equal to potential GDP. This is a full-employment equilibrium, and is the only case where we have long-run equilibrium as well as short-run equilibrium.


Which of these three possibilities corresponds to the situation in which the U.S. economy presently may be found? Parkin notes that we experienced an inflationary gap in 1988-90, recessionary gaps in the early 80s and again in the early 90s, and he suggests that the economy was at full employment in mid-1994. What about now?
Fluctuations in real GDP around its long-term upward trend (reflecting increases in potential GDP) may stem from either fluctuations in aggregate demand or in aggregate supply. First consider the consequences of an increase in aggregate demand, as might occur in response to increases in expected future incomes, profits, or inflation; in response to a lower exchange rate or higher foreign incomes; in response to fiscal policy increasing government spending or transfer payments, or decreasing taxes; or in response to expansionary monetary policy (increasing the money supply) or lowering of interest rates.
Increased aggregate demand will result in a new short-run macroeconomic equilibrium, with a higher price level and a higher level of real GDP.


However, workers will now be receiving a lower real wage (since, by assumption, movements up along the SAS curve entail increases in output prices while wages and other factor prices remain constant), and profits of firms will have increased. In these circumstances, workers will seek wage increases and firms, eager to maintain employment and output levels, will grant such increases (without wage increases, firms risk losing workers).
But increased wages will shift the short-run aggregate supply curve to the left. This shift will cause a movement up along the aggregate demand curve, raising the price level and reducing the level of real GDP.


Note that we're looking at secondary effects of the increase in AD, and it will take time for the secondary effects to develop.
Similarly, changes in SAS can result in fluctuations in real GDP around potential GDP. For example, as we've just seen, a leftward shift of the SAS curve (as would occur with an increase in factor prices) will bring about a new short-run macroeconomic equlibrium, with higher prices and lower real GDP than prior to the shift. As Parkin notes, this combination of higher prices and reduced output -- stagflation -- was encountered following the increases in oil prices in the 1970s.
Note that in the real world, there are continual changes in various factors that influence either aggregate supply or aggregate demand. Hence, there are corresponding fluctuations in macroeconomic equilibrium -- the equilibrium price level and level of real GDP.

Aggregate supply, aggregate demand, and the behavior of the U.S. economy


Parkin provides a clear and concise discussion of the performance of the U.S. economy since 1960, using the aggregate supply-aggregate demand model to look at inflation and cycles (around the long-term growth trend). Note his explanation for the persistence of inflation over the period: growth of aggregate demand that is more rapid than the growth in potential GDP (long-run aggregate supply). Further, note that he identifies growth in the quantity of money as the most important source of the continuing increases in aggregate demand and hence sustained inflation. This is something we will get back to later, in considering the money supply and the behavior of the Fed.