Short and Long-Run Macroeconomic Equilibrium - Free Sample Solution

Question: Discuss about the Short and Long-Run Macroeconomic Equilibrium. Answer: Introduction In the determination of an equilibrium level, both the supply and demand curves are put into consideration. In the whole economy, this determination involves the analysis on the aggregate demand and the aggregate supply. The AD is responsive to prices at all levels and hence it slopes downwards; meaning that demand goes down as price rises. This argument is based on the fact that it is obtained by combining all the individual demands in the economy; individual demand curves slope downwards. In an exception scenario, this paper shall also show that price is not a major factor explaining the slope of the AD. However, when we get to the aggregate supply, we shall note that the curve is upward sloping meaning that supply goes up as price rises. This however is only observed in the short run; in the long run, the supply curve tend to be vertical meaning that a further increase in the price level will not stimulate an additional increment in the quantity supplied (Gwartney, Macpherson, Sob el, Stroup, 2006). It is a combination of individual supply curves in an economy whose slope is positive. The vertical AS curve is the optimal level of the output supplied in an economy (Mankiw, 2016). The AD curve, the AS in the short run and the AS in the long run intersects at a certain point. This is the point considered by many economists as the macroeconomic equilibrium. It is an essential condition that the three curves intersect for the economy to be considered stable. The short run AS curve is important as it shows that there is a possibility for the production level to deviate from the optimal level (Hubbard, Garnett, Lewis, O'Brien, 2012). The deviation could take any side. I.e. it can be a reduction in the output supplied or there can be a surplus production beyond the optimum level. The AS in the long run indicates the position of the optimum level. The reason explaining the need for the three curves to intersect is that there is an assumption that any deviation from the optimum level is only temporary as after sometime a recovery back to the optimum level is observed. The slope of each is explained by the following arguments. The first is the slope of the AD where economists argue against price as the major determinant. The argument is that only the money supply can be held constant as it is impossible to hold constant the income earned by households and the prices for other goods that they demand. There are three major factors related to the negative slope of the AD; the origination of the employment of these factors begins with the price change though. The three factors are; wealth effect, interest rate effect and net export effect. As price go up, the wealth held by households lose its purchasing value. Since the households income become insufficient to cater for the initial demand level, the demand falls. This is the point where the interest rate effect comes in; the insufficiency of income creates a need for borrowing from lending institutions. The fact that money supply is assumed not to vary leaves a room only for the interest rate to rise as the money demand rises. The cost of servicing debt goes up and households avoid borrowing and opt to cut their demand instead. The last factor is based on what the component of AD constitutes. The AD is derived by AD = C + I + G + (X-M). Any change in either of these components cause a change in AD. In our case we are considering the net export effect. High domestic prices raises the need for more importing. Since domestic goods are sold at a high price, other economies demand less exports. An increment in imports and a cut in exports reduces the size of the net export component causing the AD to fall. The above diagram is a representation of the point where the equilibrium in the macroeconomics is reached. The equilibrium point is at B where price is 1.14 and real GDP is 12000. The production beyond optimal is represented by shifting of demand curve from point B to point A to the right of the optimal level (McEachern, 2009). The production below optimal is represented by AD shifting from B to point C to the left of the optimal level. According to Tucker (2010) the long run AS curve is vertical since all the resources in the economy are taken to be fully employed. The short run AS curve slope upward because factors such as wages and prices remain sticky in the short run (Boyes Melvin, 2013). For instance the inability for a worker to negotiate price increment in the long run lowers the real wage causing a need to employ more workers. The ratio in which nominal wage is raised in the short run may be different; workers may receive an increment in nominal wage at a ratio that is unequal to the price increment and have a wrong perception that the real wage has been raised. This boosts their morale for supplying more. Production below capacity is represented by AD shift from AD to AD2. Lower demand causes price to fall. Lower price lower production cost and results in a higher supply shifting SRAS1 to SRAS2. This is a shift back to macroeconomic equilibrium but price is lower. As AD rises from AD1 to AD2, the price goes up and production cost increase. This results in supply falling from SRAS1 to SRAS2 back to equilibrium but the price is higher. Conclusion This paper has an important analysis that shows there is a possibility of the quantity supplied in an economy being above the optimum level. Both positive and negative deviations from the optimum are recovered after sometime as the production continue to occur. The common intersection point is therefore to affirm that an economy has a potential to produce beyond the optimal point after full employment of all the production of resources. It is also meant to show that the production beyond optimal is not possible to maintain and the economy moves back to the initial equilibrium (optimal point). The AD is sloping downward since consumers ability to pay is reduced as price rise both in the short and the long run. References Boyes, J. Melvin, M. (2013). Economics. Australia: Cengage Learning South-Western. Gwartney, D., Macpherson, A., Sobel, S., Stroup, L. (2006). Economics: Private and public choice. Mason, Ohio [u.a.: Thomson/South Western. Investopedia (2016). Short and Long-run Macroeconomic Equilibrium - CFA Level 1 | Investopedia. (2016). Investopedia. Retrieved 20 January 2017, from https://www.investopedia.com/exam-guide/cfa-level-1/macroeconomics/short-long-macroeconomic-equilibrium.asp Hubbard, R., Garnett, A., Lewis, P., O'Brien, A. (2012). Essentials of economics (1st Ed.). AU: Pearson Higher Education. Mankiw, G. (2016). Business Economics. Cengage Learning. McEachern, W. A. (2009). Macroeconomics: A contemporary introduction. Mason [Ohio: Thomson/South-Western. Tucker, B. (2010). Macroeconomics for today. Mason, OH: South-Western Cengage Learning. Umn.edu (2017). 22.2 Aggregate Demand and Aggregate Supply: The Long Run and the Short Run | Principles of Economics. (2017). Open.lib.umn.edu. Retrieved 20 January 2017, from https://open.lib.umn.edu/principleseconomics/chapter/22-2-aggregate-demand-and-aggregate-supply-the-long-run-and-the-short-run/.