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.

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 LEVEL	SRAS £Bn	AD £bn	LRAS £bn
P8	650	150	500
P7	600	200	500
P6	550	250	500
P5	500	300	500
P4	450	350	500
P3	400	400	500
P2	350	450	500
P1	300	500	500
P	250	550	500

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 LEVEL	SRAS £Bn	AD £bn	LRAS £bn
P8	650	450	500
P7	600	500	500
P6	550	550	500
P5	500	600	500
P4	450	650	500
P3	400	700	500
P2	350	750	500
P1	300	800	500
P	250	850	500

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.