Macroeconomics - Short and Long-run Macroeconomic Equilibrium

In the short-run, an unanticipated decrease in aggregate demand will lead to an excess supply of resources, which will lead to a decline in resource prices. Unemployment will increase, prices will go down and output will be reduced. Over a longer period of time, lower resource costs will cause a shift to the right in aggregate supply. The economy will move to producing a level of output consistent with full employment (as was the case before the decrease in aggregate demand), but at a lower price level.

An unanticipated increase in aggregate demand will, in the short-run, lead to an output level that is greater than what is consistent with full employment. This occurs because price levels are different that what was anticipated by resource providers. There will be less unemployment than the "natural rate" of unemployment. There will be upward pressure on resource prices and interest rates, which will, over the long-run, result in a decrease in aggregate demand. Resource providers will make adjustments to the new price levels and output will decline to what is consistent with full employment. A new market equilibrium will occur at a higher price level. So in the long-run, inflation (higher prices) will be the major effect of the increase in aggregate demand.

In the short-run, an unanticipated decrease in SAS will lower the availability of resources. This will lead to an increase in resource prices, which will in turn cause the aggregate supply curve of goods and services to shift up and to the left. A reduced level of output will be produced at higher prices. If the cause of the unanticipated decrease in SAS is temporary, then there should be no changes in prices or output over the long-run. If the cause is more important, then the long-run supply curve will shift to the left. The economy would produce a lower level output at higher prices.

An unanticipated increase in aggregate supply will, in the short-run, lead to a shift to the right in SAS. Output and income will expand beyond what is consistent with full employment at a lower price level. If what produced the increase in aggregate supply is only temporary, the SAS curve will return to normal levels and prices and output will be as before. If what produced the change is permanent, then both SAS and LAS will shift to the right. There will be a greater amount of output, at lower prices.

Self-Correcting Mechanisms
Three aspects of a market economy that help to stabilize the economy and lessen the impact of economic shocks include:

1.Changes in Resource Prices - If the economy is operating at less than full employment, there will be downward pressure on prices for labor and other resources. That effect will stimulate short-run aggregate supply. If the economy is operating above full employment, prices for labor and other resources will get bid up, and short-run aggregate supply will be reduced.

2. Change in Real Interest Rates - During recessions, business demand for capital funding declines, causing a lowering of real interest rates. The lower interest rates in turn stimulate consumers to buy large items and cost of business investment projects are reduced, which stimulates business investment spending. Economic booms lead to higher interest rates, thereby lowering demand for consumer durable goods and funding for business investment projects. Therefore, interest rate movements work to stabilize aggregate demand.

3.Relative Stability of Consumption - The permanent income hypotheses states that household consumption is mainly a function of expected long-range (permanent) income. Since long-run income has more of an impact on spending than temporary changes in current income, consumption spending stays relatively the same across business cycles. During economic boom times, consumers will increase their savings; during a recession, temporary declines in income will induce households to draw on their savings so as to maintain a level of consumption in line with their expected long-run incomes.

Economic Theories


Related Articles
  1. Entrepreneurship

    Cost-Push Inflation Versus Demand-Pull Inflation

    Gain a deeper understanding of aggregate supply and demand, forces which raise the price of goods and services.
  2. Economics

    What's Aggregate Demand?

    Aggregate demand is a macroeconomic term describing the total demand in an economy for all goods and services at any given price level in a given time period.
  3. Economics

    Cost-Push Inflation Versus Demand-Pull Inflation

    Do you remember how much less you paid for things ten years ago? That’s inflation at work.
  4. Economics

    Economics Basics: Supply and Demand

    Investopedia explains: The Law of Demand, The Law of Supply, Supply and Demand Relationship, Equilibrium, Disequilibrium, and Shifts vs. Movement
  5. Term

    What Is Equilibrium?

    Equilibrium is a state of balanced supply and demand.
  6. Economics

    What Is Supply?

    Supply is the amount of goods a producer is willing to produce at a given price, and is one of the most basic concepts in economics.
  7. Financial Advisor Technology

    Top Problems with Financial Data Aggregation

    A new front in personal finance technology—data aggregation—seeks to make our financial lives easier. But here's why it may be stalling.
  8. Economics

    Do Deflationary Shocks Help Or Hurt The Economy?

    Find out how deflationary shocks can both benefit and hurt consumers and businesses.
  9. Active Trading

    Why You Can't Influence Gas Prices

    Don't believe the water-cooler talk. Big oil companies aren't to blame for high prices.
  10. Economics

    Explaining The World With Macroeconomic Analysis

    Macroeconomists try to forecast economic conditions to help consumers, firms and governments make better decisions.
RELATED TERMS
  1. Aggregate Supply

    The total supply of goods and services produced within an economy ...
  2. Aggregate Demand

    The total amount of goods and services demanded in the economy ...
  3. Output Gap

    An economic measure of the difference between the actual output ...
  4. Change In Supply

    A term used in economics to describe when the suppliers of a ...
  5. Demand

    An economic principle that describes a consumer's desire and ...
  6. Supply Shock

    An unexpected event that changes the supply of a product or commodity, ...
RELATED FAQS
  1. What factors cause shifts in aggregate demand?

    Find out how aggregate demand is calculated in macroeconomic models. See what kinds of factors can cause the aggregate demand ... Read Answer >>
  2. What's the difference between regular supply and demand and aggregate supply and ...

    Understand how businesses use supply and demand and aggregate supply and demand to forecast economic activity. Learn about ... Read Answer >>
  3. How are aggregate demand and GDP related?

    See why aggregate demand and gross domestic product (GDP) are necessarily the same thing according to Keynesian macroeconomic ... Read Answer >>
  4. How do changes in aggregate demand affect output?

    Find out why aggregate demand and total output are linked in macroeconomic models, and why economists disagree about the ... Read Answer >>
  5. How does aggregate demand affect price level?

    Read about the relationship between aggregate demand and the general price level, and learn why it is difficult to determine ... Read Answer >>
  6. How do fiscal and monetary policies affect aggregate demand?

    Learn about the impact fiscal and monetary policy have on aggregate demand, and discover how the government influences economic ... Read Answer >>
Hot Definitions
  1. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  2. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  3. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  4. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  5. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  6. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
Trading Center