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Macroeconomic Equilibrium.

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Macroeconomic Equilibrium Introduction Macroeconomic equilibrium for an economy in the short run is established when aggregate demand intersects with short-run aggregate supply. This is shown in the diagram below At the price level Pe, the aggregate demand for goods and services is equal to the aggregate supply of output. The output and the general price level in the economy will tend to adjust towards this equilibrium position. If the price level is too high, there will be an excess supply of output. If the price level is below equilibrium, there will be excess demand in the short run. In both situations there should be a process taking the economy towards the equilibrium level of output. Consider for example a situation where aggregate supply is greater than current demand. This will lead to a build up in stocks (inventories) and this sends a signal to producers either to cut prices (to stimulate an increase in demand) or to reduce output so as to reduce the build up of excess stocks. Either way - there is a tendency for output to move closer to the current level of demand. There may be occasions when in the short run, the economy cannot meet an increase in demand. This is more likely to occur when an economy reaches full-employment of factor resources. In this situation, the aggregate supply curve in the short run becomes increasingly inelastic. ...read more.


An outward shift in the LRAS is similar to an outward shift in the production possibility frontier. The effects are shown in the diagram below. If LRAS shifts out the economy can operate at a higher level of aggregate demand and can achieve an increase in real national output without running into problems with inflation. One of the main long-term economic objectives of the current Labour government is to raise the economy's productive potential and therefore provide a platform for faster economic growth in future years. For this to happen the economy needs to achieve a higher level of investment in new capital and new technology. And the quantity and productivity of the labour force also needs to increase over time. Aggregate Demand (AD) Aggregate demand (AD) is the total demand for goods and services produced in the economy over a period of time. * AGGREGATE DEMAND * SHIFTS IN AGGREGATE DEMAND * THE AD CURVE Defining Aggregate Demand Aggregate planned expenditure for goods and services in the economy = C + I + G + (X-M) C Consumers' expenditure on goods and services: This includes demand for durables & non-durable goods. I Gross Domestic Fixed Capital Formation - i.e. investment spending by companies on capital goods. Investment also includes spending on working capital such as stocks of finished goods and work in progress. G General Government Final Consumption. ...read more.


AS to shift inwards In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labour force. An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labour force. LONG RUN AGGREGATE SUPPLY Long run aggregate supply is determined by the productive resources available to meet demand and by the productivity of factor inputs (labour, land and capital). In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run. In the long run we assume that supply is independent of the price level (money is neutral) - the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labour force etc). As a result we draw the long run aggregate supply curve as vertical. Improvements in productivity and efficiency cause the long-run aggregate supply curve to shift out over the years. This is shown in the diagram below ...read more.

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