Macroeconomic Equilibrium
You may already be familiar with the concept of equilibrium from your study of
microeconomics – equilibrium occurs at a market clearing price which balances supply and
demand. Now we look at the concept of equilibrium at a macroeconomic level.
In this chapter, we will be using the neo-Keynesian version of the long run aggregate supply
curve – which is drawn as a non-linear curve. This shape of the curve shows that increases in
aggregate demand may increase real output and employment in the short term though when
SRAS is upward sloping, this may be at the expense of higher inflation.
Equilibrium for the whole economy
Some people question whether it can ever be
the case that an economy can come close to
reaching equilibrium since it would only take
one market to be out of equilibrium for this to
be blocked?
Our interpretation of the idea of equilibrium is
a little different from a microeconomic level.
What matters here is whether the total
demand for goods and services is close to the
actual level of production from domestic and
external sources. We will come back to this
when we look at excess demand and excess
supply and the concept of the output gap.
Macro-economic equilibrium is established when AD intersects with SRAS. This is shown in
the diagram below. At price level P1, AD is equal to SRAS – i.e. at this price level, the value
of output produced within the economy equates with the level of demand for goods and
services. The output and the general price level in the economy will tend to adjust towards this
equilibrium position.
If the general price level is too high, there will be an excess supply of output and producers
will experience an increase in unsold stocks. This is a signal to cut back on production to avoid
an excessive level of inventories. If the price level is below equilibrium, there will be excess
demand in the short run leading to a run down of stocks – a signal for producers to expand
output.
Equilibrium is where the level of income flowing round the system is constant in successive time
periods.
Macroeconomic equilibrium – when AD equates to short run aggregate supply. The
short run equilibrium for an economy may be higher or lower than potential GDP
Inflation
LRAS
Macroeconomic
Equilibrium Point
At price level P2 – there
would be excess supply
P2
At the equilibrium output
in this example, the
economy is still operating
below full capacity
Pe
P1
At price level P1 – there
would be excess demand
SRAS
AD
Ye
Yfc
Real National Income
AD1 – AD2 is an outward shift of AD causing an expansion of short run aggregate
supply, a rise in real national output and an increase in the general price level
AD1 – AD3 is an inward shift of AD causing a contraction of short run aggregate
supply, a fall in real national output and a decrease in the general price level
Inflation
LRAS
P2
P1
P3
AD2
SRAS1
AD1
AD3
Y3
Y1 Y2
Yfc
Real National Income
Changes in short-run aggregate supply (SRAS)
Suppose that lower raw material costs causes the short-run aggregate supply curve to shift
outwards. (Assume that there is no shift in AD). The next diagram shows what is likely to
happen. SRAS1 shifts outwards to SRAS3 and a new equilibrium will be established at Y3.
SRAS1 – SRAS3 is an outward shift of AS causing an expansion of AD, a rise in real
national output and a decrease in the general price level
SRAS1 – SRAS2 is an inward shift of AS causing a contraction of AD, a fall in real
national output and an increase in the general price level
Inflation
LRAS
P2
P1
SRAS2
SRAS1
Aggregate Demand
(AD)
SRAS3
Y2
Y1 Y3
Yfc
Real National Income
Equilibrium using a linear aggregate supply curve
In the next diagram we see the effects of two inward shifts in AD. This might be caused for
example by a decline in business confidence or a fall in exports of goods and services
following a global downturn. It might also be caused by a cut in government spending or a
rise in interest rates.
The result of the inward shift of AD is a contraction along the SRAS curve and a fall in national
output (i.e. a possible recession). This causes downward pressure on the general price level
and takes the equilibrium level of national output further away from full capacity as indicated
by the LRAS curve. We would expect to see a possible rise in unemployment because
businesses may not be able to afford to keep as many workers on when demand, output and
profits are all heading lower. This would lead to a rise in cyclical unemployment.
The Output Gap
How much spare capacity does an economy have to meet a rise in demand? How close is an
economy to operating at its productive potential? Will the current recession have a permanent
effect on our ability to supply goods and services? These sorts of questions all link to an
important concept – the output gap.
The output gap is the difference between the actual level of national output and its potential
level and is usually expressed as a percentage of the level of potential output.
Negative output gap – downward pressure on inflation
The actual level of real GDP is given by the intersection of AD & SRAS – the short run
equilibrium. If actual GDP is less than potential GDP there is a negative output gap. Some
factor resources such as labour and capital machinery are under-utilized and the main
problem is likely to be higher than average unemployment.
A rising number of people out of work indicate an excess supply of labour in the factor
market, which means there is downward pressure on real wage rates. In the next time period,
a fall in real wage rates shifts SRAS downwards until actual and potential GDP are identical
– assuming labour markets are flexible.
Positive output gap – upward pressure on inflation
If actual GDP is greater than potential GDP then there is a positive output gap. Some
resources including labour are likely to be working beyond their normal capacity e.g. making
extra use of shift work and overtime. The main problem is likely to be an acceleration of
demand-pull and cost-push inflation. Shortages of labour put upward pressure on wage rates,
and in the next time period, a rise in wage rates shifts SRAS upwards until actual and
potential GDP are identical – assuming labour markets are flexible.
Recession and the output gap
The latest forecasts from the OECD suggest that the UK will operate with a large negative
output gap for some time to come. The gap between actual and potential GDP is estimated
to widen to its greatest level since the recession of the early 1980s. Much depends on how
long and how deep is the recession. There are some economists who argue that the fall out
from the slump will have long-term damage to our productive capacity and that the UK
economy may experience a permanent loss of output equivalent to between 4 and 5 per cent
of GDP. This might arise from a sharp rise in the number of business failures together with a
long-term loss of people from the labour market if they suffer extended periods out of work.
Spare Capacity
When a business is operating at less than 100% capacity, it is said to have “spare capacity”.
Demand factors:
 Lower demand due to a decline in consumption
 Loss of market share due to poor marketing or competitors having better
products
 Seasonal variations in demand - i.e. temporary spare capacity during off-peak
times
Supply factors:
 Increase in capacity not yet matched by increased demand
 Because new technology has been introduced in anticipation of higher demand
 Improvements in productivity mean capacity increases for a given level of
demand
Spare capacity can be useful in that it allows businesses to respond to short-term or an
unexpected increase in demand, when there is some productive slack, supply is price elastic. It
also provides time for maintenance, repairs and employee training.
The next chart shows how the recession is creating a large amount of spare capacity in the
economy – the output gap has become negative and is likely to be around 6% of potential
GDP in 2010.
United Kingdom, Output gap of the total economy
Percentage of potential GDP
Actual GDP - Potential GDP, measured as a percentage of potential GDP source: OECD
5
5
4
4
3
3
2
2
1
1
0
0
-1
-1
-2
-2
-3
-3
-4
-4
-5
-5
-6
-6
-7
-7
82
80
84
86
88
90
92
94
96
98
00
02
04
06
08
10
Source: OECD World Economic Outlook
The Output Gap and Unemployment in the UK
Output Gap, Unemployment - claimant count measure
10.0
10.0
Unemployment
7.5
7.5
5.0
5.0
Per cent
Output gap
2.5
2.5
0.0
0.0
-2.5
-2.5
-5.0
-5.0
-7.5
88
-7.5
90
92
94
96
98
00
02
04
06
08
10
Source: Reuters EcoWin
As the recession takes hold unemployment rises and the economy is operating well within its
production possibility frontier (PPF). In the last recession unemployment reached nearly 10 per
cent of the labour force. The output gap in the current downturn is forecast to be larger than in
the last recession – what might this mean for the rate of unemployment in the UK in 2010 and
2011?
Key terms
Full capacity output
A level of national output where all factor inputs are fully employed
Labour shortages
When businesses find it difficult to recruit the workers they need
Output gap
The difference between actual and potential national output