Economic Environment

Course book

Short-Run Equilibrium and Long-

Run Equilibrium

Prof Ashok Thomas

IIM Kozhikode
Short run equilibrium

Introduction
Throughout this module, you will visit Econoland, a place created to illustrate macroeconomic
challenge concepts. You will learn from the experiences of the people in Econoland. Enjoy your
visit!

This challenge concept examines how the economy moves to a short-run macroeconomic
equilibrium. In short-run equilibrium, aggregate demand is equal to short-run aggregate supply.
As a result, there is a predicted short-run real gross domestic product (GDP) and price level.
You will see that the short-run equilibrium GDP may be below full employment. In that case,
return to your earlier learning of Classical and Keynesian views of the economy to consider
how best to prompt the economy to a full-employment equilibrium.

In addition to illustrating the adjustments an economy makes in order to reach its short-run
macroeconomic equilibrium, the unit examines how the economy responds to shifts in the
aggregate demand and aggregate supply curves.

Practical Application
This challenge concept examines how the interaction between aggregate demand and aggregate
supply determine a short-run macroeconomic equilibrium. In addition, you will understand
how the economy adjusts in the short run to shifts in either the aggregate demand or aggregate
supply curves

Learning Objectives
You will be able to identify the short-run macroeconomic equilibrium and understand how the
economy adjusts to the short-run macroeconomic equilibrium.

Given a change in aggregate demand, you will be able to illustrate and describe how the
economy will change in response to the shift in the aggregate demand curve.

Similarly, you will be able to describe how the economy responds to shifts in the aggregate
supply curve.

As a foundation for understanding short-run macroeconomic adjustments, this unit examines

the nature of the short-run macroeconomic equilibrium and how the economy adjusts to that
equilibrium.
Question 1) An unintended decrease in inventories indicates:

a) the economy is in a short-run, but not a long-run, macroeconomic equilibrium.

b) the economy is in both a short-run and a long-run macroeconomic equilibrium.
c) the general price level is below the equilibrium general price level.
d) the quantity of aggregate output supplied is greater than the quantity of aggregate
output demanded.
e) the general price level must fall.

Question 2) A decrease in the general price level would cause:

a) a movement down and to the left along the aggregate supply curve.
b) a movement up and to the right along the aggregate supply curve.
c) a movement up and to the left along the aggregate demand curve.
d) a rightward shift in the aggregate supply curve.
e) a rightward shift in the aggregate demand curve.

Question 3) If the economy’s general price level is above the equilibrium price level:

a) Planned investment will increase.

b) The quantity of aggregate output demanded will be greater than the quantity of
aggregate output supplied.
c) The aggregate supply curve will shift left.
d) The aggregate demand curve will shift right.
e) There will be an undesired increase in inventories.

Question 4) The intersection of the short-run aggregate supply and aggregate demand curves:

a) increases real household wealth.

b) occurs only if unemployment equals zero.
c) has a general price index of 100.
d) results in no undesired change in inventories.
e) results in the full employment level of real gross domestic product.

Question 5) If an economy's general price level is below the equilibrium price level:

a) There will be an undesired decrease in inventories.

b) The aggregate supply curve will shift to the right.
c) Real household wealth will increase as the price level adjusts.
d) The aggregate demand curve will shift to the left.
e) Aggregate production will tend to decrease.

Question 6) The short-run macroeconomic equilibrium requires:

 a) full employment.
b) a balanced government budget.
c) the elimination of structural unemployment.
d) zero inventories.
e) no undesired investment into inventories.

Activity 1

Response OF economy’s short-run response to a shift in the aggregate demand curve.

During the period 1917 to 1919, Econoland experienced a severe demand shock due to a war.
In order to fight the war, Econoland's government spent a lot of money to purchase goods and
services. How did this increase in government expenditures affect Econoland's economy?

Draw the graph and answer the questions below:

What has happened to the price level in Econoland?

a) increased
b) decreased
c) remained the same

What has happened to the quantity of aggregate demanded at every price level?

a) increased
b) decreased
c) remained the same

What has happened to the quantity of aggregate supply?

a) increased
b) decreased
c) remained the same

Now what is the relationship between the quantity of aggregate supplied (QAS) and the
quantity of aggregate demanded (QAD)?

a) QAS > QAD

b) QAD > QAS
c) QAS = QAD

What has happened to the level of inventories in Econoland?

 a) increased
b) decreased
c) remained the same

Activity 2

During the period 1929 to 1933, Econoland's real gross domestic product fell from $103.1
billion to $71.6 billion. At the same time, unemployment rose from 3.2% to 24.9%. Finally,
from 1929 to 1933, Econoland's general price level fell from 100 to 78. What event would
explain these changes in Econoland's economy from 1929 to 1933?

Now it is your turn to practice. Show what would happen in Econoland if there was a decrease
in consumer confidence. Use the slider to illustrate this change. Based on how you
manipulated the graph above, answer the questions below:

What has happened initially to the price level in Econoland (just following the change in
aggregate demand)?

a) increased
b) decreased
c) remained the same

What has happened to the quantity of aggregate demanded at every price level?

a) increased
b) decreased
c) remained the same

What has happened to the quantity of aggregate supply at each price level?

a) increased
b) decreased
c) remained the same

Inititally, what is the relationship between the quantity of aggregate supplied (QAS) and the
quantity of aggregate demanded (QAD)?

a) QAS > QAD

b) QAD > QAS
c) QAS = QAD

What has happened to the level of inventories in Econoland?

 a) increased
b) decreased
c) remained the same

Although the short-run macroeconomic equilibrium changes when there is a shift in aggregate demand,
it is crucial to remember that the economy will quickly begin adjusting to the new short-run
macroeconomic equilibrium that exists where the new aggregate demand curve intersects aggregate
supply. For instance, following an increase in aggregate demand, initially there will be a shortage, price
levels will increase, and real output will increase. At the new short-run equilibrium there will be a higher
equilibrium price level and higher real GDP.

Multiple-Choice Questions

Question1) An increase in the general price level will:

a) cause a movement down and to the right along the aggregate demand curve.
b) cause a movement up and to the left on the aggregate demand curve.
c) shift the aggregate demand curve to the left.
d) shift the aggregate demand curve to the right.
e) affect only the aggregate supply curve.

Question 2) A rightward shift in the aggregate demand curve could be caused by:

a) growing business optimism leading to an increase in planned investment.

b) undesired investment into inventories.
c) an increase in taxes.
d) a decrease in household consumption expenditures.
e) an increase in imports.

Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If the

government reduces its purchases of goods and services:

a) the equilibrium general price level will fall and equilibrium real gross domestic
product will fall.
b) the equilibrium general price level will rise and equilibrium real gross domestic
product will fall.
c) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
d) the equilibrium general price level will rise and equilibrium real gross domestic
product will rise.
e) there will be no change in the short-run macroeconomic equilibrium.

Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. If businesses

become more optimistic about the future and increase their level of planned investment:

a) the equilibrium general price level will rise and equilibrium real gross domestic
product will fall.
 b) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
c) the equilibrium general price level will fall and equilibrium real gross domestic
product will fall.
d) the equilibrium general price level will rise and equilibrium real gross domestic
product will rise.
e) there will be no change in the short-run macroeconomic equilibrium.

Question 5) An economy is experiencing falling unemployment and rising prices. This could
be explained by:

a) an increase in aggregate supply.

b) a decrease in aggregate supply.
c) an increase in aggregate demand.
d) a decrease in aggregate demand.
e) both aggregate demand and aggregate supply decrease.

Question 6) An economy is experiencing rising unemployment and deflation. This could be

explained by:

a) a leftward shift in the aggregate supply curve.

b) a leftward shift in the aggregate demand curve.
c) a rightward shift in the aggregate demand curve.
d) a rightward shift in the aggregate supply curve.
e) a rightward shift in both the aggregate demand and aggregate supply curves.

Short run equilibrium and aggregate supply shifts

The economy’s short-run response to a shift in the aggregate supply curve is examined in this
unit.

In the mid and late 1920s, Econoland experienced substantial increases in worker productivity. Assume
that the economy was producing below the full employment equilibrium. How did these productivity
improvements affect Econoland's economy in the short run? On the interactive graph below, use the
slider on the bottom to show the effect.

Activity 3

Based on your work on the graph above, consider the following questions:

i) Will the increase in worker productivity increase aggregate supply or aggregate demand?

ii) What caused the undesired buildup of inventories?

iii) Describe the effect of the increase in inventories on price level

iv) Describe the effect of the change in price level on QAD and QAS as the economy returns
to a short-run equilibrium.

Activity 4

During the period 1973 to 1975, Econoland's real gross domestic product fell from $1,255
billion to $1,234 billion. At the same time, unemployment rose from 4.8% to 8.3%, and the
general price level rose from 106 to 126. What event would explain these changes in
Econoland's economy from 1973 to 1975?

On the interactive graph below, use the slider on the bottom to show the effect of this event.

Based on your work on the graph above, consider the following questions:

i) If output has decreased and price level has increased, has there been a change in aggregate
supply or aggregate demand?

ii) What caused the undesired decrease of inventories?

iii) Describe the effect of the decrease in inventories on price level

iv) Describe the effect of the change in price level on QAD and QAS as the economy returns
to a short-run equilibrium.

Conclusion

Shifts in the aggregate supply curve lead to a new short-run macroeconomic equilibrium. As
the economy moves to the new equilibrium, it experiences changes in the general price level
and real gross domestic product. For instance, with an increase in aggregate supply (or shift to
the right), there will initially be excess supply of some goods and prices will fall. The new
short-run equilibrium will have a lower price level and an increased real GDP. When aggregate
supply shifts to the left there will be an increase in the price level and a decrease in output
accompanied by an increase in unemployment. This can be called stagflation or cost push
inflation.

Question 1) A decrease in the general price level will:

a) shift the aggregate supply curve to the left.

b) shift the aggregate supply curve to the right.
c) affect only the aggregate demand curve.
d) cause a movement up and to the right along the aggregate supply curve.
e) cause a movement down and to the left on the aggregate supply curve.

Question 2) A leftward shift in the aggregate supply curve could be caused by:

a) an increase in worker productivity.

b) an increase in taxes.
 c) a decrease in the price of oil.
d) rising nominal wages.
e) an increase in government purchases of goods and services.

Question 3) Initially, an economy is in a short-run macroeconomic equilibrium. If there is a

general increase in nominal wages:

a) the equilibrium general price level will rise and equilibrium real gross domestic
product will fall.
b) the equilibrium general price level will rise and equilibrium real gross domestic
product will rise.
c) the equilibrium general price level will fall and equilibrium real gross domestic
product will fall.
d) the equilibrium general price level will fall and equilibrium real gross domestic
product will rise.
e) there will be no change in the short-run macroeconomic equilibrium

Question 4) Initially, an economy is in a short-run macroeconomic equilibrium. A general

increase in labor productivity causes:

a) the equilibrium general price level to rise and equilibrium real gross domestic product
to rise.
b) the equilibrium general price level to rise and equilibrium real gross domestic product
to fall.
c) the equilibrium general price level to fall and equilibrium real gross domestic product
to rise.
d) the equilibrium general price level to fall and equilibrium real gross domestic product
to fall.
e) no change in the short-run macroeconomic equilibrium.

Question 5) An economy is experiencing falling unemployment and deflation. This could be

explained by:

a) a decrease in aggregate supply.

b) an increase in aggregate supply.
c) an increase in aggregate demand.
d) a decrease in aggregate demand.
e) both aggregate demand and aggregate supply decrease.

Question 6) An economy is experiencing rising unemployment and inflation. This could be

explained by:
a) a leftward shift in the aggregate demand curve.
b) a leftward shift in the aggregate supply curve.
c) a rightward shift in the aggregate supply curve.
d) a rightward shift in the aggregate demand curve.
e) a rightward shift in both the aggregate demand and aggregate supply curves.
Long-run equilibrium

Introduction

Throughout this module, you will visit Econoland, a place created to illustrate macroeconomic
challenge concepts. You will learn from the experiences of the people in Econoland. Enjoy
your visit!

You will see that, at any current time, the short-run equilibrium of the overall economy may
differ from the long-run equilibrium, or the capacity of the economy. Moreover, you will learn
how to apply both the Classical and Keynesian policy perspectives for the economy to move
towards a full-employment equilibrium.

The Classical view, as you recall, anticipates that if the economy is in short-run equilibrium
below full employment, then wages and prices will fall, employment will increase (with
unemployment decreasing), and the economy will move towards full-employment real GDP.

In contrast, with the Keynesian approach that assumes some downward rigidity in wages and
prices, discretionary fiscal and monetary policy to stimulate aggregate demand would move
the economy towards full-employment real GDP.

Practical Application

You will see how economists define the long-run equilibrium for an economy, in which there
is no cyclical unemployment. There will always be some frictional unemployment; that is,
individuals who are between jobs. Yet, when the economy is in this long-run equilibrium,
there is no need for a policy to either stimulate or contract the economy.

Prior to the Great Recession of 2007, most economists would agree that the United
States economy had been in a long-run equilibrium with little cyclical unemployment and
modest inflation for the preceding three years.

Learning Objectives

As a result of this unit, you will be able to compare and contrast the differing schools of
thought of how the economy moves back towards its long-run equilibrium.
Specifically, you will be able to utilize your knowledge of the Classical and Keynesian views
and to demonstrate both of these theories with the aggregate demand and aggregate supply
model.

Moving fromm a short run to short run equilibrium

Question 1) Which of the following would most likely cause the United States economy to
fall into a recession?
 a) an increase in welfare payments
b) an increase in exports
c) a decrease in savings by consumers
d) a decrease in the required reserve ratio
e) a decrease in consumer spending

Question 2) Which of the following will most likely result from a decrease in government
spending?

a) an increase in output
b) an increase in the price level
c) an increase in employment
d) a decrease in aggregate demand
e) a decrease in aggregate supply

Question 3) An unanticipated decrease in aggregate demand when the economy is in

equilibrium will result in:
a) a decrease in real gross domestic product.
b) a decrease in voluntary unemployment.
c) a decrease in aggregate supply.
d) a decrease in the natural rate of unemployment.
e) a decrease in unplanned inventories.

Question 4) If businesses are experiencing an unplanned increase in inventories, which of the

following is most likely to be true?
a) The economy is growing and will continue to grow until a new equilibrium level of
spending is reached.
b) Aggregate demand is less than output, and the level of spending will decrease.
c) Aggregate demand is greater than output, and the level of spending will increase.
d) Planned investment is greater than planned saving, and the level of spending will
decrease.
e) Planned investment is less than planned saving, and the level of spending will
increase.

Question 5) Which of the following statements best describes the impact of a decrease in
Japanese income on aggregate demand in the United States?

a) Aggregate demand will decrease because demand for U.S. exports decreases.
b) Aggregate demand will decrease because the value of the U.S. dollar decreases
relative to the Japanese yen.
c) There will be no change in aggregate demand because U.S. aggregate demand
depends only on the income of U.S. consumers.
d) Aggregate demand will increase because a decrease in income in Japan causes an
increase in income in the U.S.
e) Aggregate demand will increase because interest rates in the U.S. decrease.
Adjustments in the long run

Activity 1

Based on the graph

A) Based on the graph above, the economy is in:

a) a recessionary gap.
b) an inflationary gap.

B) Which of the following policy responses would a Keynesian favor? Check all that apply:

a) increase taxes
b) increase government spending
c) increase interest rates
 d) increase exchange rates
e) increase money supply
f) decrease taxes
g) decrease government spending
h) nominal wages falling

C) Based on the Keynesian response identified above, show the change on the graph.

D) Which change(s) would occur that a Classical economist would say are most effective for
bringing the economy back to its long run equilibrium?
a) increase taxes
b) increase government spending
c) increase interest rates
d) increase exchange rates
e) increase money supply
f) decrease taxes
g) decrease government spending
h) nominal wages falling

E) Based on the Classical response identified above, show the change on the graph.

Multiple- Choice Questions

Question 1) If an economy’s short-run aggregate supply curve is upward sloping, a Keynesian

would argue that an increase in government spending will most likely result in a decrease in
the:
a) real level of output.
b) price level.
c) unemployment rate.
d) interest rate.
e) government’s budget deficit.

Question 2) The classical economists argued that involuntary unemployment would be

eliminated by:
a) increasing government spending to increase aggregate demand.
b) increasing the money supply to stimulate investment spending.
c) maintaining the growth of the money supply at a constant rate.
d) self-correcting market forces stemming from flexible prices and wages.
e) decreasing corporate income taxes to encourage investment.

Question 3) Which of the following policies would a Keynesian recommend during a period
of high unemployment and low inflation?

a) decreasing taxes to stimulate aggregate demand

b) decreasing the money supply to reduce aggregate demand
c) decreasing government spending to stimulate aggregate supply
 d) balancing the budget to stimulate aggregate supply
e) imposing wage and price controls to stimulate aggregate supply

Question 4) Suppose the economy of a country is currently in a recessionary gap. A classical

economist would argue that which of the following will occur?
a) Rising wages will shift the aggregate demand curve to the right, producing full
employment.
b) The economy will remain in its current equilibrium level of output because of sticky
wages.
c) Rising wages will shift the short-run aggregate supply curve to the right, producing
full employment.
d) Falling wages will shift the short-run aggregate supply curve to the right, producing
full employment.
e) Falling wages will shift the aggregate demand curve to the right, producing full
employment.

Question 5) An important assumption in Keynesian theory is that:

a) Price rigidity will cause downturns in the economy to self-correct.

b) Prices are sticky and decreases in aggregate demand will lead to an increase in
unemployment.
c) When aggregate demand is inadequate, prices will fall.
d) When interest rates are high, many businesses borrow money.
e) Changes in the money supply are the major cause of changes in real output and price
level.

Conclusion
A decrease in aggregate demand (for example, from a decrease in real wealth) will lead to a
lower level of real GDP and lower price level. The economy will be operating below full
employment, in a recession, with cyclical unemployment. As you know, there are two
responses to this concern: Classical and Keynesian.

With the Classical view, flexible wages and prices should result in lower wages and an increase
(outward or rightward shift) in the short-run aggregate supply curve, bringing the equilibrium
back towards full employment. Market forces, not government intervention, will bring the
economy back to full employment.

With the Keynesian view, wage rigidity or stickiness can result in continued and persistent
cyclical unemployment. Intervention in the form of expansionary fiscal or monetary policy is
needed to increase (a rightward shift) aggregate demand and increase real GDP, reducing
cyclical unemployment. In this case, the economy will return to its full employment GDP.