Lecture 13 - Short Run Macroeconomic Equilibrium

Short run macroeconomic equilibrium occurs when the quantity of aggregate supply (SRAS) equals the quantity of aggregate demand (AD). At this point, the economy is producing an output level where there is no tendency for the price level or output to change in the short run. This equilibrium may or may not coincide with the economy's potential output or full employment output (Y_P).

Components of Equilibrium

  • Aggregate Demand (AD): Represents the total demand for all goods and services in an economy at different price levels. It is the sum of consumption (C), investment (I), government spending (G), and net exports (X-M). (AD = C + I + G + (X-M))

  • Short Run Aggregate Supply (SRAS): Represents the total output that firms are willing and able to produce at different price levels in the short run, assuming some factor prices (like wages) are sticky or fixed.

Achieving Equilibrium

Equilibrium is graphically represented by the intersection of the AD and SRAS curves on a graph with the price level (P) on the vertical axis and real GDP (Y) on the horizontal axis.

  • When AD > SRAS: If aggregate demand exceeds short-run aggregate supply at a given price level, there will be upward pressure on the price level and firms will increase production until equilibrium is restored.

  • When SRAS > AD: If short-run aggregate supply exceeds aggregate demand, there will be downward pressure on the price level and firms will reduce production until equilibrium is restored.

Types of Short Run Equilibrium

Short run equilibrium can occur at different levels relative to potential output, leading to different macroeconomic conditions:

  1. Full Employment Equilibrium:

    • Occurs when the equilibrium real GDPis equal to the potential output(YP). This indicates that the economy is operating at its natural rate of unemployment, with resources fully utilized without inflationary pressures.

    • Graphically, the AD, SRAS, and Long Run Aggregate Supply (LRAS) curves all intersect at the same point.

  1. Recessionary Gap (Output Gap):

  • Occurs when the equilibrium real GDPis less than the potential output (YP). This indicates that the economy is operating below its full capacity, resulting in high unemployment and underutilized resources.

  • The gap between (YP)and(Y) is known as a recessionary gap or output gap.

  • This situation typically calls for expansionary fiscal or monetary policies to shift AD to the right and close the gap.

  1. Inflationary Gap (Overheating Economy):

  • Occurs when the equilibrium real GDP is greater than the potential output(YP). This indicates that the economy is operating beyond its sustainable capacity, leading to rising price levels (inflation) due to excessive demand for goods, services, and productive resources.

  • The gap between (Y)and(YP) is known as an inflationary gap.

  • This situation typically calls for contractionary fiscal or monetary policies to shift AD to the left and alleviate inflationary pressures.