Macroeconomic Equilibrium: Definition, Short Run & Long Run

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

This lesson will take a look at what happens to an economy at equilibrium in the short run and the long run. We'll take a look at some graphs of recessionary and inflationary gaps, and discuss what producers do in reaction to economic changes.

Equilibrium Defined

When Paul opened Valley Pizza, he needed ovens to bake the pies along with tables and chairs for the customers to sit on. So his demand for ovens and tables became part of aggregate demand.

You've heard of supply and demand, but what does that word 'aggregate' mean? Well, macroeconomics concerns itself with the whole economy, not just pieces of it. So aggregate demand is what the whole economy demands. That includes the big total of what all of us consumers demand, but also what business and government demand as well.

Valley Pizza

Business demand is often called 'investment' since that is what Paul did when he opened his shop.

Governments demand goods to meet the needs of their constituents. They want to be safe and protected from invasions, so government buys military weaponry. At a more local level, constituents want good roads and schools, so governments need to buy many things to build and maintain them.

Aggregate demand, then, is the total demanded by consumers, plus business investment, plus government purchases.

Aggregate supply is just the total amount of goods and services provided to the economy to meet all of the components of demand.

Equilibrium in macroeconomics occurs when aggregate demand = aggregate supply.

If equilibrium exceeds the economy's potential, it called an 'inflationary gap'. On the other hand, if it dips below the economy's potential, it's called a 'recessionary gap'.

Equilibrium occurs where aggregate demand equals aggregate supply. Here it is at an output level of 35 when the potential is at 50, so it is a recessionary gap.
graph 1

Short Run Equilibrium

Markets often adjust quickly. The stock market, for example, will reprice a stock the instant that good (or bad) news hits the street. So you may assume that when aggregate demand increases, aggregate supply will quickly follow suit.

But the goods and services markets aren't like the stock market - prices and wages are sticky in the short run. Sticky wages and prices mean they can't react to market forces and change quickly.

Paul at Valley Pizza knows that his customers have a good idea what his amazing pizza will cost them when they phone in an order. He wouldn't think of changing his prices everyday to keep up with market forces!

Likewise, his employees have bills and obligations, and expect Paul to pay them the rate they agreed to when they were hired. Can he change their pay every time market forces change? Not if he wants them to keep making pizzas!

He will indeed change his pay rates and prices, but it will take a good bit of time before he does. First he needs to find out what changes are permanent, and not just a temporary occurrence. Only then will he consider changing his prices or pay. That will take a good deal of time.

Wages and prices are sticky in the short run, but in the long run wages, prices and everything else can change. When a recessionary gap occurs, the economy has slack. That means that not all of it's resources are being used. People who want to work will not have jobs and factories will run below capacity.

In that case, Paul will be able to hire new employees at a lower wage rate since so many are out of work. That will lower his costs, and allow him to have more specials and maybe even lower the prices on his products.

Long Run Equilibrium

In long run equilibrium, the aggregate supply curve is a vertical line at the potential output level of 50.
graph 2

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