Determination Of Stable Economic Essay

Question:

Discuss about the Determination of Stable Economic Equilibrium.

Answer:

Introduction

Equilibrium in macroeconomics is a situation where demand of all individual in the economy equates the aggregate supply. The aggregate demand in an economy is obtained by summing up all individual demand curves. The aggregate supply is obtained by summing up all the individual supplies. In the determination of individual demand curve, price and income are necessary factors put under consideration. Any change in the price level causes individual demand to fall. At every price level, the demand level is different. However, when we analyze the aggregate supply, we shall note that there is a difference between the responsiveness of supply to price changes in both the short and long run. There are factors behind each of these behaviors. This paper will also consider those factors. The main aim of this paper is to explain the reason as to why economists determined the stable economic equilibrium to be at the point where the aggregate demand intersects with aggregate supply in both the short and in the long run.

The behavior of each of these curves have an important explanation in the determination of the equilibrium level. The AD curve is sloping negatively because demand have a negative relationship with the price level. At high prices, consumers cut their spending causing demand to fall. Similarly, when prices are low, consumers demand more goods and services. The aggregate supply curve in the short run slopes upward because supply has a positive relationship with the price level (Arnold, 2010). The willingness of suppliers to supply increase with price increment and falls when price is low. This however is only possible in the short run owing to the stickiness of wages and price (Gwartney, 2009). An explanation for this is that, newly employees are not legible for negotiating wage increments in the short run; others are employed under contracts which are fixed. When price increases therefore, the real wages for these employees is lower to the employing firms. Lower wages boosts supply as firms are able to hire more labour.


In the long run, the responsiveness of supply to price is insignificant; the supply curve is vertically sloped. This represents the optimal economic output level (saylordotorg.github.io, 2017). This means that the resources in the economy have been fully employed.


Fig: Macroeconomic equilibrium in the long run

Source: analystnotes.com

The curves determine the equilibrium point when analyzed together as shown above since the economy has to be operating at an optimal output level. This however does not limit the economy’s potential to produce output which is above the optimal level. Various factors may cause the aggregate demand to either fall below the equilibrium level or above it. If an economy is producing more than the potential output, it is noted that after sometime it will lose the ability to produce that much and will fall back to the potential level. This assumption argues for the need to include the SAS in determination for equilibrium. This is because production above potential means that aggregate demand is higher causing price to rise. According to Walstad, McConnell, & Brue, 2008), since it’s the price of all goods that has gone up, the cost of inputs becomes higher discouraging production causing supply to fall and price to rise even further. A fall in supply shifting it to the left causes the disequilibrium to be resolved. This is as shown in the diagram below.


Fig: Recovery from an excess aggregate demand

Source: Personal.psu.edu

Initially the economy is at equilibrium where the LRAS, SRAs1 and AD1 intersect. When the economy is producing below potential, the aggregate demand shifts to the left of the LRAS. Deficiency in demand makes the price charged for goods and services to fall from price level A to B as shown in the diagram below. This includes even the price of inputs. When inputs are cheaper, suppliers are induced to produce more and supply curve shifts from SRAS1 to SRAS2 as shown by the arrow. The new supply is at price level C. the price is low than the initial equilibrium level.


Fig: Recovery from production below potential output

Source: Personal.psu.edu

Conclusion

Each of the three curves is essential in determining the stable equilibrium since both the aggregate demand curve and the short run aggregate supply variations are guided by the long run aggregate supply. It has been noted that all the variations in AD and AS occurs only in the short run. In the long run the equilibrium point holds.

References

Analystnotes.com. (2017). Equilibrium GDP and Prices. analystnotes.com. Retrieved 22 January 2017, from

Arnold, R. A. (2010). Macroeconomics. Mason, OH: Cengage Learning, South Western.

Gwartney, J. D. (2009). Economics: Private and public choice. Australia: South-Western Cengage Learning.

Latzko, D. (2016). Lecture 22: Macroeconomic Equilibrium. Personal.psu.edu. Retrieved 22 January 2017, from

Saylordotorg.github.io. (2017). Aggregate Demand and Aggregate Supply. Saylordotorg.github.io. Retrieved 22 January 2017, from

Walstad, B., McConnell, R., & Brue, L. (2008). Study guide for use with McConnell and Brue Macroeconomics. Boston: McGraw-Hill/Irwin.

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