Economy Balance: Brief Period vs. Extended Period

Economy Balance: Brief Period vs. Extended Period

Macroeconomic equilibrium: A tale of balanced production and desire

In the vast arena of the economy, a delicate balance must be maintained: the total production of goods and services needs to be equal to the total demand for these wares. This delicate balance is known as macroeconomic equilibrium, and understanding it is crucial for grasping the forces that drive economic stability. Let's dive in!

Why does it matter?

Changes in either production or demand can have significant repercussions on key economic indicators, such as inflation, the level of real GDP, and the unemployment rate. When economists and policymakers comprehend the intricacies of this equilibrium, they can make educated decisions on how to steer the economy towards a path of growth and stability.

Types of Macroeconomic equilibrium: Short-run and long-run equilibria

In the world of macroeconomics, a distinction is made between short-run and long-run concepts for aggregate supply.

Short-run aggregate supply represents the quantity of goods and services that firms produce when some costs are variable but wages and other input prices remain constant. When the price level goes up, it increases the profits of the firms and encourages them to increase production, causing the short-run aggregate supply curve to slope upwards.

Long-run aggregate supply, on the other hand, denotes the quantity supplied when wages and other input prices are also variable. In this scenario, a price increase does not boost profits, as input prices rise proportionally. Consequently, the long-run aggregate supply curve is vertical.

The Aggregate Demand Curve: Why Does it Slope Downward?

The aggregate demand curve slopes downward in macroeconomics because of the inverse relationship between the overall price level and the quantity of goods and services demanded in an economy. This inverse relationship is driven by several key factors:

1. Wealth Effect (Real Balances Effect) When the price level decreases, the value of money holdings increases, making consumers feel wealthier. They are more likely to spend, causing the demand for goods and services to rise. The opposite happens when the price level rises.
2. Interest Rate Effect Lower price levels reduce the demand for money, leading to lower interest rates and increased borrowing and investment. Higher price levels have the opposite effect.
3. Foreign Trade Effect When the domestic price level falls, domestic goods become cheaper compared to foreign goods, boosting exports and reducing imports. The opposite happens when the domestic price level rises.

Short-run equilibrium and long-run equilibrium

1. Short-run equilibrium Short-run equilibrium happens when aggregate demand equals short-run aggregate supply, causing actual real GDP to fluctuate around potential GDP.
2. Long-run equilibrium Long-run equilibrium occurs when aggregate demand equals short-run aggregate supply at a point on the long-run aggregate supply curve. At this point, actual real GDP equals potential GDP, and the unemployment rate equals its natural rate. Another term for long-run equilibrium is full employment equilibrium.

Short-run equilibrium, a rollercoaster ride

Short-run aggregate supply assumes constant nominal wages. The intersection of short-run aggregate demand and supply sets the economy's price level and actual real GDP. If the price level is above equilibrium, aggregate supply exceeds aggregate demand, creating excess supply and driving down the price level. If the price level is below the equilibrium price, there is a shortage in the economy, leading to rising prices and decreased aggregate demand.

Long-run equilibrium: The magic number

Long-run aggregate supply represents the maximum capacity an economy can produce. Achieving long-run equilibrium means the economy is operating at full employment. In this scenario, actual real GDP matches potential GDP, and all resources are fully utilized.

The deviation of actual real GDP from potential GDP, known as the output gap, forms the business cycle phase. Positive output gaps indicate that actual real GDP exceeds potential GDP, while negative output gaps indicate that actual real GDP is lower than potential GDP.

A positive output gap, a party in the economy

Positive output gaps, also known as expansionary gaps, usually occur during the last phase of expansion. During this phase, actual real GDP exceeds potential GDP, suggesting that aggregate demand is greater than the economy's maximum capacity. This situation generates upward pressure on the price level and tends to cause a trade balance deficit due to the high demand for imports.

A negative output gap, a market downturn

Negative output gaps, also known as deflationary gaps, occur during a contraction or recession. During this phase, the inflation rate slows down or may lead to deflation, the unemployment rate increases, and actual real GDP is lower than potential GDP. These conditions can generate downward pressure on the price level.

Shifts in aggregate demand and aggregate supply

Aggregate demand and short-run aggregate supply can shift due to various factors. By understanding these factors, we can comprehend how they can disrupt or restore equilibrium, impacting inflation, real GDP, and unemployment.

Factors affecting aggregate demand to shift

1. Money supply Increased money supply boosts aggregate demand, while decreased money supply weakens it.
2. Tax Lower taxes increase aggregate demand, while higher taxes decrease it.
3. Government spending Increased government spending stimulates aggregate demand, while decreased government spending reduces it.
4. Consumer and business confidence High confidence encourages more spending and investment, while low confidence discourages it.
5. Exchange rate Depreciation of a country's currency favors domestically produced goods, increasing aggregate demand. Conversely, appreciation decreases demand for these goods.
6. Global economic growth Robust global economic growth increases demand for a country's exports, boosting aggregate demand.

Factors affecting aggregate supply to shift

• Nominal wages In the short run, wages may be fixed by contracts. If prices rise but wages stay the same, businesses become more willing to produce, shifting the short-run aggregate supply curve to the right. Conversely, if wages rise faster than prices, production costs increase, causing the short-run aggregate supply curve to shift left.
• Raw material costs Higher raw material costs increase production costs, causing the short-run aggregate supply curve to shift left. Lower raw material costs allow businesses to produce more at the same price level, shifting the short-run aggregate supply curve to the right.
• Exchange rate Similar to aggregate demand, depreciation of the currency can stimulate production and shift the short-run aggregate supply curve to the right. An appreciation can reduce production and shift the curve to the left.
• Business tax Increased business taxes reduce profits and discourage production, causing the short-run aggregate supply curve to shift left. Lower business taxes can encourage production and shift the curve to the right.
• Subsidy Government subsidies to businesses can lower production costs and encourage them to produce more, shifting the short-run aggregate supply curve to the right. Reduced subsidies have the opposite effect.
• Expectations of future prices and profits Businesses with optimistic expectations of future prices or profits are more willing to produce now, increasing the short-run aggregate supply curve. Conversely, pessimistic expectations can decrease production and cause the curve to shift to the left.
• Changes in the quantity and quality of production factors Increasing the quantity or quality of labor, capital, or natural resources can boost production efficiency, allowing businesses to produce more at a given price level. A decrease in these factors can have the opposite effect.

Note: Long-run aggregate supply occurs only because of changes in production factors' quantity and quality. Long-term aggregate supply increases when the amount of labor, natural resources, and capital increases. Additionally, the quality of human capital and technology contributes to increasing long-term aggregate supply by improving economic productivity.

Economic Shocks and Macroeconomic Equilibrium

Economic shocks can affect either the aggregate supply (AS) or aggregate demand (AD) curve, pushing them out of equilibrium.

• Positive shock: a natural disaster, technological breakthrough, or fiscal policy that increases production or demand
• Negative shock: a recession, unemployment, or political instability that reduces production or demand

When macroeconomic equilibrium is disrupted, the economy may take time to return to its previous state. The duration and severity of the disequilibrium depend on several factors, such as the type of shock, the flexibility of the economy, and the effectiveness of government policies.

Restoring equilibrium: Self-correction vs. Policy intervention

The economy can return to equilibrium through self-correcting mechanisms or by implementing expansionary policies, such as fiscal policy or monetary policy. Under certain conditions, the equilibrium can be restored by allowing wages, prices, and resources to adjust naturally. When these adjustments are insufficient, policymakers may intervene to stimulate aggregate demand and nudge the economy back towards its potential.

Learn More

• Aggregate supply: Understanding Production Capacity in the Economy + Determinants
• Business Cycle: Understanding the Economy's Ups & Downs [Phases and Characteristics]
• Very Short-Run Aggregate Supply: Definition and Reason Its Horizontal Curve
• Long-Run Aggregate Supply (LRAS): Potential Output and Its Drivers
• Short-Run Macroeconomic Equilibrium: Understanding Economic Fluctuations
• Long-Run Macroeconomic Equilibrium: Achieving Full Potential

[1] Principles of Macroeconomics, N. Gordon, Worth Publishers, 5th Ed.[2] Macroeconomics, O. Blanchard, McGraw Hill Education, 7th Ed.[3] Macroeconomics, R. Barro, MIT Press, 2nd Ed.[4] Macroeconomics, J. Greenwood, Pearson Education, 6th Ed.

1. In the realm of business, understanding the intricacies of macroeconomic equilibrium, particularly the short-run and long-run equilibria, is crucial for finance professionals to make informed decisions about investment strategies.
2. optimized business operations rely on maintaining a balance between the total production of goods and services (finance) and the total demand for these wares, ensuring economic stability and maximizing profitability.

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