Equilibrium
An economy will be in equilibrium, that is it will be in a stable state, when planned withdrawals equal planned injections; hence savings, taxation and import spending (S + T + M) will equal investment, government spending and export revenue (I + G + X). This is also consistent with planned aggregate demand equalling planned aggregate supply.
Example
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Equilibrium Equilibrium occurs at the price level where AD equals AS. In this hypothetical case, equilibrium output (Y) is at £600b, with a price level (in an index form) of 100. |
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Equilibrium can be shown using the AD-AS diagram, and will occur at the price level where AS and AD equate.
In our hypothetical example, equilibrium will be where the average price
level is £100 and the value of output is £600b.
Proving
equilibrium
It is essential to explain why is equilibrium is achieved when AS = AD. In the example, at a price level higher than 100, such as 140, SRAS is greater than AD. Firms are producing more goods than the economy wants and needs.
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Disequilibrium At at price level of 140, supply is much greater than demand. |
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AD is effectively too low because at this high price level there are negative
trade, liquidity and wealth effects, causing planned AD to contract to
£380b.
Stocks rapidly build up, with planned output increasing to £680b. In an
attempt to reduce these stock levels firms across the economy cut prices
- until the price level falls back to 100!
At a price lower than 100, such as 80, there is much less incentive to
produce, and AS contracts to £100b.
However,
AD extends to £710b because lower prices stimulate positive trade,
liquidity, and wealth effects.
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Disequilibrium At at price level of 80, demand is much greater than supply. |
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Stocks quickly run down, and firms will raise their prices. The price level will eventually rise back up to reach a stable state at 100.
The response of
AS to changes in AD
A movement along the AS curve will occur if the AD curve shifts to the left or right. For example, if the AD curve shifts to the right, AS will expand up along the curve, in response.
Movement along the AS curve
As aggregate demand increases, firms will run down stocks which triggers an increase in production. Graphically, there is an expansion along the aggregate supply curve.
Showing an output gap
Output gaps may be negative, which occurs when actual output is less than potential
output, or positive, when actual output is greater than potential output.
If an economy has a negative output gap, then it means it is capable of
producing more output, without having to create or employ new factors of
production.
Such an output gap means there is likely to be unemployment, and possibly a recession.
Video
Injections and withdrawals
When total injections equal total withdrawals, the level of national income will remain constant, and the economy will be in general equilibrium.
The level of economic activity will change following
a change in either injections or withdrawals. An economy will grow if the value of injections is greater
than the value of withdrawals, or shrink if the value of withdrawals is
greater than injections.
Economists
often say that the economy is like a bathtub filling up - the level of
the water in the bath will rise when the volume of water coming in
increases relative to water going out.
General equilibrium
For an
economy to be in general equilibrium it is only necessary that:
Total injections = total withdrawals
See: Different perspectives on equilibrium