IB ECONOMICS

Macroeconomic Equilibrium
Short Run Macroeconomic Equilibrium
Average Price

Short run equilibrium:

Aggregate Demand equals SRAS
Level

Short Run Aggregate

Supply. Short Run Aggregate
Supply curve

e Output produced is equal to total demand,

Pe there are no reasons for producers to
change their levels of output.

As AD equals SRAS, there is no

pressure on the price level, and Aggregate Demand
the economy remains in curve
equilibrium. AD
Y Real Output (Y)
Colegio San Jorge Chacras
Economics 2017 5 Year
Pablo J. Torrecilla
Long Run Macroeconomic Equilibrium: New Classical Perspective

Long Run Aggregate Supply:

LRAS
Average Price

Full employment level of

Level

output

The long run equilibrium is where the

Aggregate Demand curve meets the vertical
e Aggregate Supply, at the full employment
Pe level of output.

Aggregate
Demand curve

AD
Real Output (Y)
Colegio San Jorge Chacras
Economics 2017 5 Year
Pablo J. Torrecilla
New Classical Perspective: Adjustment Path

LRAS An increase in AD results only

Average Price

in an increase in the price

Level

level, from Pe1 to Pe2, without

e2 any change in the level of real
Pe2 output

Pe1
e1 Increase in AD,
from AD1 to AD2.
Initial long run
equilibrium, at the full
employment level of
AD2
output () and average
price level Pe1.
AD1
Real Output (Y)
Colegio San Jorge Chacras
Economics 2017 5 Year
Pablo J. Torrecilla
New Classical Perspective: Short to Long Run Adjustment

LRAS
Average Price

SRAS1
Level

The economy is in
equilibrium at a level of
P1
eSR output (Y1) greater than
the full employment level
Pe1 e1 of output ()

AD2

AD1
Y1 Real Output (Y)
Colegio San Jorge Chacras
Economics 2017 5 Year Inflationary Gap
Pablo J. Torrecilla
New Classical Perspective: Short to Long Run Adjustment

SRAS2
LRAS
Average Price

SRAS1
Level

As there are no
e2 unemployed resources,
Pe2 the increased production
level faces higher costs,
P1
eSR raising the price level.
Higher prices mean
Pe1 e1 increased costs, which
cause a shift to the left in
The economy finally reaches a new the SRAS, to SRAS2
Long Run equilibrium at the full
employment level of output (),at a
higher price level (Pe2), and closing AD2
the inflationary gap AD1
Y1 Real Output (Y)
Colegio San Jorge Chacras
Economics 2017 5 Year Inflationary Gap
Pablo J. Torrecilla
New Classical Perspective: Short to Long Run Adjustment

Analyze what would happen in the short and

long run, under the new classical perspective,
after a fall in Aggregate Demand.
Consider the adjustment path steps:
1. AD Shift
2. Short run production level below full employment,
price level decrease, and deflationary gap
3. SRAS Shift
4. New long run equilibrium Colegio San Jorge Chacras
Economics 2017 5 Year
Pablo J. Torrecilla
Long Run Macroeconomic Equilibrium: Keynesian Perspective

Long-Run AS
Price Level
Average

When employment reaches full

capacity, output can not
At low levels of economic
increase any further, and LR AS
activity, the LRAS is
becomes perfectly inelastic.
perfectly elastic: producers
can increase output
without incurring in higher
average costs (Spare As output rises and factors
capacity) become increasingly scarce,
increasing output require the
producers to face increasing
(average) costs.

Real Output
(Y)
Colegio San Jorge Chacras
Economics 2017 5 Year
Pablo J. Torrecilla
The Keynesian Perspective: Output Gap

Production Possibilities Frontier Model

Output Gap, illustrating the difference

Consumer Goods
between an economys actual output (A)
and its full employment potential
output (B, or any other point on the PPF)

B
=

=
A

Colegio San Jorge Chacras Capital Goods

Economics 2017 5 Year
Pablo J. Torrecilla
Long Run Macroeconomic Equilibrium: Keynesian Perspective

LRAS
Price Level
Average

Increase in AD,
from AD1 to AD2. An increase in
AD results in an
increase in
output level
e1 e2 from Y1 to Y2,
Pe1 without impact
Initial long run equilibrium, at the level on the price
of output Y1 below full employment AD1 AD2 level
(), and average price level Pe1.

Y1 Y2 Real Output
(Y)
Colegio San Jorge Chacras
Economics 2017 5 Year
Pablo J. Torrecilla
Long Run Macroeconomic Equilibrium: Keynesian Perspective V.2

Price Level LRAS

Average

Increase in AD, Approaching the full

from AD2 to AD3.
employment level of
output, as factors
become scarcer, the
economy starts to
experience
e3 inflationary
pressures, and the
Pe2
e2 price level starts to
Pe1 rise following and
Initial long run equilibrium, at the level of increase in AD
output Y2, below but closer to full employment
(), and average price level Pe1. AD2 AD3
Y2 Y3 Real Output
(Y)
Colegio San Jorge Chacras
Economics 2015 5 Year
Pablo J. Torrecilla
Changes in the Long Run Aggregate Supply

A countrys long run AS is based on the quantity and quality of its factors of production. As
economic growth occurs, the LRAS curve shifts to thee right, representing the increase in the
potential (full employment, ) output of the economy

APL LRAS1 LRAS2 APL LRAS1 LRAS2

$ From a new classical standpoint, an $
increase in the LRAS will have an
entirely favourable impact: Increase
in the full employment level of
Pe1
income from 1 to 2, and a fall in
the price level from P1 to P2
Pe2
Pe1
Under a Keynesian viewpoint, the
impact of an increase in the LRAS
will depend in the initial equilibrium
position of the economy: if an
economy is operating below its full
employment level of output (Y1),
and expansion of the LRAS will have
no effect on the equilibrium output.
AD

AD
Colegio San Jorge Chacras Y1 1 2 Real Output 1 2 Real Output
Economics 2017 5 Year (Y) (Y)
Pablo J. Torrecilla
New Classical vs Keynesian Perspective: Long Run Adjustment

Analyze what would happen in the long run, under

both the new classical and Keynesian perspectives,
after an increase in Long-
Long-Run Aggregate Supply.
Consider the adjustment path steps:
1. LRAS Shift (New classical vs. Keynesian)
2. Post--shift disequilibrium/gap
Post
3. AD movement along the curve
4. New long run equilibrium
Note: Remember that, depending on the perspective considered, not all
curves/variables change in every case! Colegio San Jorge Chacras
Economics 2017 5 Year
Pablo J. Torrecilla