Source: Image of AD/AS graph created by Kate Eskra, Image of AD curve created by Kate Eskra, Image of SRAS curve created Kate Eskra, Image of Economy in Long Run equilibrium created by Kate Eskra, Image of economy in recessionary period created by Kate Eskra, Image of Business Cycle created by Kate Eskra, Image of economy in expansionary period created by Kate Eskra
Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on Equilibrium. As always, my key terms are in red, and my examples are in green. In this tutorial, you'll see that the intersection of the short-run aggregate supply curve and aggregate demand curves represents our economy's current equilibrium price level and level of real GDP. You'll see that the long-run aggregate supply shows us the level of real GDP that is possible when our economy is fully employed.
And when we combine all of these curves, what we can see are three things. We can see our economy in the long-run equilibrium, our economy in a recessionary period, or our economy in an expansionary period. OK, so here's the aggregate supply and aggregate demand model. In different tutorials, we've talked about aggregate demand and aggregate supply. I'll review those briefly here.
But let's recall what the axes represent. The x-axis is quantity, generally, in a microeconomics graph. In here it is still quantity, but its overall quantity in the economy, or real GDP. The price level is what the y-axis shows us here. And it's not just the price of one specific item as it is in microeconomics, it's the overall price level. And this is the most common graph that shows us macroeconomic activities. So it's what we use a lot in macroeconomics.
So that x-axis, the real GDP, is defined as your gross domestic product, which we know is the sum as the final value of all goods and services produced in a specific time interval within a country's borders. And we calculate this across time periods using a constant price level. And the fact that we use a constant price level gives us the real part of this real gross domestic product. The y-axis of this model is the price level, which is defined as an aggregate index value that provides an indication of the increase in prices from one period to another. And this helps us to evaluate inflation from one period to the next.
OK, so let's review very briefly what the demand and supply are all about on this model. Aggregate demand is the total amount of goods and services demanded in an economy at a specific point in time and at a prevailing price level. So here is our aggregate demand. And we can see that it's a downward sloping curve, which shows an inverse relationship between the two axes, between the price level and real GDP.
So what does this mean? This means that people, and when we're talking about aggregate demand this is all people in the economy, so it's consumers, it's businesses or firms-- that's the letter I, It's governments-- that's letter G, and then this term here, x minus m, is net foreign purchases of US goods. So all of those things will increase. So people will want to purchase more as the overall price level falls in our economy. And in a different tutorial, we talk specifically about the reasons why. But there it's because of three different effects-- the wealth affect, the interest rate effect, and exchange rate effects.
So then short-run aggregate supply, the other curve on this model, is the short-run aggregate supply, which is assumed to have this positive price and quantity correlation. More can be produced through increased resource utilization, technological improvements, or other factors. And so for those reasons, our short-run aggregate supply curve is, in fact, an upward sloping curve. And you can see that here. So it's the total amount produced at various price levels.
So in the short run, if prices go up and businesses want to take advantage of that, they can. That's in the short run, because they won't have to pay their workers more immediately. Wages don't go up right away. They can draw down some of their inventories, things they already have on hand, to try to crank out more in the short run. And so that's why in the short run, they can produce more as prices go up.
OK, this tutorial is all about equilibrium though. So where aggregate demand and short-run aggregate supply intersect will give us equilibrium. The equilibrium here, the Y star, is going to give us the current level of real GDP. This is how much is currently being produced in the economy. And this is the price level right now, the prevailing price level, P star.
OK, now I need to add the other part of aggregate supply, and that's the idea of the long-run aggregate supply curve. There is not a positive relationship between the overall price level and quantity, or real GDP, in the long run. It's assumed to be constant in the long run, because there are only so many resources that an economy has at a given point in time. So there really is no opportunity to increase past this capacity unless more resources are found. So for that reason, the long-run aggregate supply curve is a vertical line.
It's also known as the solid growth curve. So this represents our economy's full potential. This is the quantity of GDP that we can produce if we are utilizing all of our current resources. So in the short run, remember, you can ramp up your production, but you can only do that so long and so far. Because in the long run, we have a limited amount of materials or a limited amount of workers. Things are scarce.
So you can think of this curve right here as our economy producing as much as possible given what we have. So given all of our current resources, this represents our full potential where we can produce. So now if we combine all three of these things, we can see how our economy is doing at any given point in time. This graph, the way that I have drawn it, shows that our economy is in fact producing. See Y star is right here. We are producing where our long-run aggregate supply curve intersects.
Well, what would that mean? That's good. That means our economy is fully employed, we're utilizing all of our land, labor, and capital, and we're producing the maximum amount possible given all of our current resources. Generally speaking, this is not the case. We're generally not producing the exact quantity of real GDP, in the short run, as represented by this long-run aggregate supply curve.
So what would it look like if we're not? Well, here's one way that it could look. Here, you can see that we are producing. Here's where we are producing. Our real GDP is less than our full potential. So this would be during a recession. This means that we are not using all of our resources. We're not fully employed. So it's producing less than its full potential.
That means that resources are unemployed. An unemployment is defined as-- it's measured as a percentage rate of the number of individuals that would like to work and are an active part of the labor force, and we compare that to the number of individuals that comprise the active labor force. And unemployment-- again, in a different tutorial, we talk about these different components of unemployment. There can be people frictionally unemployed, structurally unemployed, and cyclically unemployed.
What's important to remember here is that frictional and structural unemployment will always exist. They're very normal. They are normal parts of unemployment that will always be around. It's cyclical unemployment that is the abnormal kind that we want to look out for. Cyclical is what exists during a recession.
OK, so if we're in a recession, we could be nearing a trough. And the trough is the business cycle period that coincides with the lowest GDP for a given point in time. So remember, here's what a business cycle looks like, and according to the NBER, a recession is a significant decline in economic activity spread across the economy that lasts more than a few months. And you see real GDP, real income, employment, industrial production, and wholesale retail sales typically falling throughout this period. So that would be in this period here where our GDP is less than our full potential. And if we're at a trough, we're at the bottom of the recession.
OK, so that's what this graph looks like again. Since the economy is operating at less than full employment then, there would be some cyclical unemployment existing. If that lasts a long time, expansionary fiscal and monetary policies can both be put in place to try to raise us out of this recession. So the opposite situation could also occur in the short run. This shows us that here's where we're producing, and here's our full potential.
How can that happen? How do we produce be producing beyond? Well, that can happen during a period of expansion. And so during a period of expansion, GDP is growing at a rate faster than the overall time trend. And that's possible only when producers are using resources a lot faster than they're being replaced. And there's some very, very low unemployment rate going on here-- less than 5%. So we would be above full employment or have negative cyclical unemployment here.
This is not sustainable in the long run, hence it will go back to the long-run equilibrium, because you cannot sustain this type of production into the long run. But you can in the short run. And so a peak is defined as the business cycle period that coincides with the maximum attainable GDP for a given point in time.
So here's what we went over in this tutorial. We looked at all these different situations, and we got to see the equilibrium on our aggregate supply/ aggregate demand model. Thanks so much for listening. Have a great day.
The total amount of goods and services demanded in an economy at a specific point in time and at a prevailing price level.
Short-run aggregate supply is assumed to maintain the positive price and quantity correlation; more can be produced through increased resource utilization, technological improvements or other factors. SRAS is an upward sloping curve.
Long-run aggregate supply is assumed to be constant in the long-run as in the long-run resources are assumed to be used optimally, leaving no potential for increasing capacity. LRAS is a vertical curve.
An aggregate index value that provides an indication of the increase in prices from one period to another; used to evaluate inflation across periods.
Real Gross Domestic Product: Gross Domestic Product (the sum of the final value of goods and services produced over a specific time interval and within a country’s national borders.) Calculated across time periods using a constant price level.
Measured as a percentage rate of the number of individuals that would like to work and are an active part of the labor force to the number of individuals that comprise the active labor force. Unemployment may be categorized as frictional, structural and cyclical components.
The business cycle period that coincides with the lowest GDP for a given point in time.
The business cycle period that coincides with the maximum obtainable GDP for a given point in time.