Equilibrium

An economy will be in equilibrium, that is it will be in a stable state, when planned withdrawals equal planned injections; hence savingstaxation and import spending (S + T + M) will equal investmentgovernment spending and export revenue (I + G + X). This is also consistent with planned aggregate demand equalling planned aggregate supply.

Showing Equilibrium

Using the SRAS and LRAS, we can analyse the relationship between the current level of AD, and the SRAS and LRAS, and show short run  equilibrium in relation to the long run potential of an economy.

Diverging short run equilibrium and full employment

Short run equilibrium may not coincide with the sustainable full-employment level of real output – the level at which the economy is achieving its economic potential. There are two main cases when this happens.

Insufficient AD

However, short run equilibrium may be less than the level to achieve the full employment level of real GDP, as shown below using hypothetical data. The range of prices levels (P – P8) represent theoretical price levels based on an index of prices, such as the CPI.

PRICE LEVELSRAS £BnAD £bnLRAS £bn
P8650150500
P7600200500
P6550250500
P5500300500
P4450350500
P3400400500
P2350450500
P1300500500
P250550500

At the short run equilibrium (P3 and 400bn real output) there is a negative output gap of 100bn, given that the maximum possible output is 500bn. A negative output gap is also called a recessionary gap.

Self-adjustment

In the Classical system, the economy is assumed to self-adjust. This view is shared by those economists who stress the importance of allowing an economy to self-adjust, with minimal government involvement. In terms of a negative output gap the lack of demand will suppress wages and the price level will readjust downwards.

The major problem with this view is the length of time over which the economy will self-adjust and increase real output to reach Yf?

Excess AD

It is possible that short-run equilibrium, where AD equals SRAS, is greater than the economy’s potential at its LRAS. In this case, the short run equilibrium is at a higher level of real output than the economy can actually produce, as illustrated below.

PRICE LEVELSRAS £BnAD £bnLRAS £bn
P8650450500
P7600500500
P6550550500
P5500600500
P4450650500
P3400700500
P2350750500
P1300800500
P250850500

The short run equilibrium position (P6 and a real poutput of 550bn) is above the full employment, creating a positive output gap.

Self-adjustment

Under the Classical system the excess demand would create a labour shortage and wages would rise. This increases costs and the SRAS curve shifts up the the left, as shown below:

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

Injections and withdrawals

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