Model of Economic Equilibrium

Question: Explain why a stable economic equilibrium requires the economy to be operating at an output level at which the aggregate demand curve, the long run aggregate supply curve and the short run aggregate supply curve all intersect. Answer: Introduction Any stable economic equilibrium is a long-run equilibrium. Both the demand and supply are expected to fluctuate in the short-run whereas in the long-run the equilibrium is at the steady state or at a level where the level of fluctuation of both the aggregate demand and aggregate supply is minimum. Hence, to analyze the stable economic equilibrium it is essential to analyze the dynamics that undergirds the movement of both the aggregate demand curve and aggregate supply curve for its initial position. An enquiry into the behavior from a short-run to a long-run will help us in understanding the reasons change has happened. A systematic analysis of the same will help us in understanding the reasons the stable economic equilibrium occurs at the intersection of all the three curves. (Skott, 1996). The existence of the stable economic equilibrium occurs where all the three curves long-run aggregate supply, short-run aggregate supply and short-run aggregate demand intersect. However, it i s essential to understand that this equilibrium is mainly an equilibrium suggested by the new classical economists. Hence, the explanation of this will form a part of the next section where relevant discussion regarding the dynamics of the adjustment has been presented (Goodwin, 2007). Analysis of the Economic Equilibrium The conjecture of the New Classical economists and the Keynesian economists differs mainly regarding the shape (or the slope) that the long-run aggregate supply curve will take. That the economy always has a tendency to come back to its long-run solution is the main reason the intersection takes place of all the three curves. The long-run equilibrium points are all the points on the long-run supply curve which is where the economy always is irrespective of changes in aggregate demand. Changes in price has no effect on the shape of level of productivity in the long-run. This will be the case when the long-run aggregate supply curve will be vertical. Therefore, any movement of the aggregate demand will only lead to a situation of inflationary gap or deflationary gap. In a situation of inflationary gap there is a rise in the level of inflation with a fall in the aggregate level of output in the short-run because the output exceeds the limit the economy is capable of producing. Whereas i n a deflationary gap, there is a fall in the level of output with a rise in the level of output in the short-run. An inflationary gap is a situation when increase in aggregate demand causes the output to go beyond the natural rate. This situation has been illustrated in Figure 1 when the aggregate demand increases and goes beyond the full employment. The economy will not be able to sustain production at that level because the rise in the cost of production, in the long-run, will force the economy to come back its equilibrium level of natural rate output. Therefore, the short-run aggregate supply curve will shift to the left (Tomlinson, n.d.). The same dynamics will repeat when there is a leftward in the short-run aggregate demand curve. The result will be a price fall because then the short-run aggregate supply curve will shift to the right as there is a natural tendency for the economy to move to the long-run equilibrium points if and when the aggregate demand falls. The economy will adjust to the same level of output but will be operating with a price level lower than the one which prevailed before the short-run aggregate curve decreased (McElroy, 2005). Hence, the economy will always have a tendency to come back to the equilibrium position irrespective of the position it occupies in the shot-run and medium-run. However, it is essential to essential to point out that this equilibrium is not the Keynesian outcome. In a Keynesian world the long-run aggregate supply curve is horizontal so change in the aggregate demand induced by greater government activity will have the maximum effect on the output and not on the prices ( Parker, 2010). The Keynesian view is that their always prevails the situation of excess capacity on the market and, therefore, the long-run equilibrium position will keep on shifting with demand getting a boost. However, the new classical always stressed on the ability of the market to correct itself which was mainly driven by the ability of the prices, which they believed, to be flexible. Hence, the flexible prices will always, lead the economy to a situation where the equilibrium will take place along the points given by the long-run aggregate supply curve (Keynes, 1936). As a matter of fact, changes in aggregate supply will induce the necessary changes in aggregate demand so that the economy can always come to settle at a stable equilibrium. Therefore, in all the cases the equilibrium will always occur at the point where the aggregate demand in the economy is equal to long-run aggregate supply. Therefore, the aggregate demand is the most important determinant in the economy (McEl roy, 2005). Therefore, a new classical solution to the stable equilibrium is highly dynamic. The economy always will settle along the points given by the long-run supply curve. However, whether this framework given by the new classical is a realistic explanation of the economy is a matter of serious consideration (Bluedorn, 2005). Conclusion Most of the empirical evidence in the literature that the long-run aggregate supply does have the tendency to change. Hence, under that consideration, the Keynesian economic paradigm of the macroeconomic situation makes more sense. Some of the empirical evidence given in the economic literature seems to suggest that the nature of long-run aggregate supply given by the New Classical economists seems to be a more practical reality for advanced economies where there is hardly any prevalence for excess capacity. However, the Keynesian long-run aggregate supply which is horizontal may be a more realistic assumption for the developed and emerging market economies. These economies have a massive amount of untapped capacity and changes in aggregate demand induced by changes in aggregate demand induced changes in fiscal policy will have the greatest impact on the aggregate output. Hence, fiscal policy under the Keynesian is given the utmost priority. It is due to fiscal policy that nations ca n help revive their economy and bring it to a stable growth path. However, the use of fiscal policy under the assumptions of the New Classical economists has no favorable impact on the economy (Blinder, 2002). However, irrespective of the use of policy the stable equilibrium will always occur at the point where all the three curves namely the short-run aggregate supply, short-run aggregate demand and the long-run aggregate supply curve will cross each other. References Blinder, A. (2002). The Conscience Encyopledia of Economics. Retrieved from https://mysite.avemaria.edu/gmartinez/Courses/ECON201/pdf/Keynes_NewClassical.pdf Bluedorn, J. (2005). Equilibrium of Aggregate Demand and Supply. Nuffield College. Retrieved from https://static1.1.sqspcdn.com/static/f/432578/4647124/1257287182137/ox-int_macro_M8-HT05.pdf?token=u6P6UCgm4UoP30NjgZDd84Ww1gM%3D McElroy, M. (2005). The Classical Model of Macroeconomy. The Macroeconomy Private Choices, Public Actions, and Aggregate Outcomes. Retrieved from https://www4.ncsu.edu/~mcelroy/302/C_Chpt2.pdf Goodwin, A. (2007). Aggregate Supply, Aggregate Demand, and Inflation: Putting It All Together. Retrieved from https://www.ase.tufts.edu/gdae/Pubs/te/PRINCIPLES/Principles_SSG_Ch28.pdf Keynes, J. (1936). The General Theory of Employment, Interest and Money. Retrieved from https://cas2.umkc.edu/economics/people/facultypages/kregel/courses/econ645/winter2011/generaltheory.pdf Parker, J. (2010). Aggregate Supply and Demand: A Simple Framework for Analysis. Retrieved from https://www.reed.edu/economics/parker/s10/314/book/Ch02.pdf Skott, P. (1996). Keynesian Theory and the Aggregate Demand-Aggregate Supply Frameowrk. Retrieved from https://web.holycross.edu/RePEc/eej/Archive/Volume22/V22N3P313_331.pdf Tomlinson, S. (n.d.). New Keynesian and New Classical Approahces to Fiscal Policy. Retrieved from https://www.cengage.com/economics/tomlinson/transcripts/8548.pdf