Macroeconomic Equilibrium
Chapter 16
Short run equilibrium
 Equilibrium is established
when aggregate supply equals
aggregate demand
 Make sure you remember to
use Y’s instead of Q’s
Long run equilibrium
 There is disagreement among
economists as to the shape of
the long run AS curve
 According to new classical
economists the economy will
always move towards its long
run equilibrium at the full
employment level of output
(Yf)
Long run equilibrium (neo or
new classical)
 According to this perspective
any change in AD will only
affect the price levels
 An increase in AD1 to AD2
results in an increase in the
average price level (inflation)
from P1 to P2
 The new classical economists
believe the economy will
move automatically to its long
run equilibrium
 Automatically means without
government intervention
 They believe in free markets
Long run equilibrium (neo or
new classical)
 This diagram shows a combination of
short run and long run AS
 Initially the economy is at its long run
equilibrium at Yf
 If there is an increase in AD due to an
increase in any of the components in
the short run there will be an
increase to Y1
 How if the productive potential is Yf?
 Paying existing workers overtime
 This can only happen in the short
term
 There is an inflationary gap from Yf to
Y1 (positive output gap)
 In their efforts to increase output
firms are competing for scare labour
and capital pushing average price
levels up
Long run equilibrium (neo or
new classical)
 In their efforts to increase output
firms are competing for scare labour
and capital pushing average price
levels up from P1 to P2
 The rise in price level means an
increase in costs to all firms (prices
of labour, raw materials and capital)
 Making more (increasing output)
didn’t give any real gain
 Firms decide to supply less and go
back to the original output (shifts
the SRAS from SRAS1 to SRAS2)
 Output returns to its full
employment level but at a higher
price level
Long run equilibrium (neo or
new classical)
 If AD were to drop from the original
equilibrium of Yf
 The economy would be facing a
deflationary gap (negative output
gap)
Long run equilibrium (neo or
new classical)
 As AD falls so does the average price
levels
 This means that costs of production
fall
 Suppliers will supply more shifting
the SRAS
 Output will go back to Yf at a lower
price level
 The important factor in this theory
is that the long run equilibrium level
of output is equal to the full
employment level of output
 The market changes automatically
 No government intervention is
required
 The economy should be left to
market forces rather than trying to
manage levels of AD
Long run equilibrium (Keynesian)
 According to Keynesian economists
equilibrium level of output may occur at
different levels
 Equilibrium can happen at a level of
output below the full employment level
if there is spare capacity
 The level of output depends on the level
of AD
 Aggregate supply can be perfectly elastic
because there is spare capacity (there
are high levels of unemployment)
 There is a deflationary gap (negative
output gap)
 This can also be illustrated with a PPC
diagram
 The economy is not creating to its
productive potential
 The deflationary/output gap is the
distance between the PPC and A
Long run equilibrium (Keynesian)
 It is possible from this perspective to get
an increase in AD and not get a rise in
the price levels
 This depends on how much spare
capacity is available (the size of the
output gap)
 Producers can use unused factors of
production to increase output with no
increase in costs so there is no
inflationary pressure
Long run equilibrium (Keynesian)
 If AD increases further to AD3 the
economy may start to experience
inflationary pressure
 Factors of production are becoming
scarcer
 Price levels increase because firms’ costs
increase but the increases are relatively
small
Long run equilibrium (Keynesian)
 If the economy is operating at full
employment and there is an increase in
AD the outcome will be purely
inflationary
 There is no increase in output
 There is a large increase in price levels
 Aggregate demand cannot be satisfied
with the existing resources
 The important point here is that
government can intervene to close the
gap by increasing aggregate demand
 These are called expansionary policies
 Contractionary policies are used to
reduce the inflationary gap

Changes in Long-Run AS
 Changes in the LRAS are caused by
increases in factors of production or
improvement in quality of FoPs
 This is the equivalent of the PPB shifting
 There is an increase in productive
potential
 This can be illustrated two ways
 Use the one you are most comfortable
with
 The neoclassical version is good to show
how inflationary pressure can be reduced
Time to draw!
Draw the following
1. An economy in recession where AD is
starting to increase
2. An economy in boom where there is high
inflation (large changes in average price
levels
3. An economy that is growing by improving
the quality of factors of production e.g. more
training and development
4. An economy that has shrunk due to an
earthquake
5. An economy that is experiencing short run
negative growth due to sharp rises in the
price of oil
6. An economy that is growing without inflation
Complete Essay Question
P202
1 a) Explain the
components of aggregate
demand (10 marks)
1 b) Evaluate the extent to
which an increase in AD is
beneficial for an economy
(15 marks)
Plan and then complete
under timed conditions (30
mins)
HL Bit!!
Multiplier
Several key terms will
appear
They will disappear after
30 seconds (do not write
anything in this time)
Your task:
(1)List the terms + (2)
Define them
(8 mins to get as many as
possible)
GDP per capita
Interest Rates
Consumption
Fiscal policy
injection
Balance of Payments
Deficit
Over to you!
Multiplier effect
Where an increase or
decrease in spending leads to
a larger than proportionate
change in the national income
An initial change in AD can
have a much greater change in
national income (GDP)
injections of new demand
for goods and services into the
circular flow of income can
stimulate further rounds of
spending
 in other words ‘one
person’s spending is another's
income’ – and this can lead to
a bigger eventual effect on
output and employment.
Multiplier effect – an increase or
decrease in spending leads to a
larger than proportionate change in
national income
Multiplier effect
Consider a £300 million increase in capital investment
 for example created when an overseas company decides to build a
new production plant in the UK
This may set off a chain reaction of increases in expenditures.
Firms who produce the capital goods
and
construction businesses who win
contracts to build
the new factory will experience an increase
in
their incomes and profits.
If they and their employees in turn,
collectively
spend about 3/5 of that additional income,
then £180m will be added to the incomes of
others.
At this point, total income has grown by
(£300m + (0.6 x £300m) = 480m.
The sum will continue to increase as
the producers of the additional goods and services realize an increase
in their incomes, of which they in turn spend 60% on even more goods
and services.
The increase in total income will then be (£300m + (0.6 x £300m) +
(0.6 x £180m). 588m
Each time, the additional rise in spending and income is a fraction of
the previous addition to the circular flow.
The Multiplier and Keynesian Economic
The concept of the multiplier process
became important in the 1930s when
Keynes suggested it as a tool to help
governments to maintain high levels of
employment.
This “demand-management approach”
was designed to help overcome a shortage of
capital investment
It measured the amount of government
spending needed to reach a level of national
income that would prevent unemployment.
The higher the propensity to consume
domestically produced goods and services,
the greater is the multiplier effect
The government can influence the size of
the multiplier through changes in direct
taxes.
 For example, a cut in the rate of income
tax will increase the amount of extra income
that can be spent on further goods and
services.
Evaluation
If people are given extra money do you
think they are guaranteed to spend it?
No, it depends on their propensity to
consume (or their propensity to save)
In 2010 Obama gave Americans a tax
holiday but it didn’t help growth much
because they just used it to pay debt and
to bolster their savings
In 2011 he extended the tax holiday
arguing that it would prevent the US
economy from going into a recession
He was managing demand; increasing
AD by increasing consumption
The success of this policy will depend
on?
The Americans’ propensity to consume
Factors affecting the size of the
multiplier - evaluation
Another factor affecting the size of the
multiplier effect is the propensity to
purchase imports.
If, out of extra income, people spend
their money on imports, this demand is
not passed on in the form of fresh
spending on domestically produced
output.
It leaks away from the circular flow of
income and spending, reducing the size of
the multiplier.
The UK has a large propensity to
consume imports
The multiplier process also requires that
there is sufficient spare capacity in the
economy for extra output to be produced.
If there is little spare capacity the
multiplier will just cause demand pull
inflation
Factors affecting the
size of the multiplier
- evaluation
The multiplier effect
will be larger when
1.The propensity to
spend extra income
on domestic goods
and services is high
2.The marginal rate of
tax on extra income
is low
3.The propensity to
spend extra income
rather than save is
high
Time lags (evaluation)
It is important to remember that
the multiplier effect will take time
to come into full effect.
 A good example is the fiscal
stimulus introduced into the US
economy by the Obama
government.
 They have set aside many
billions of dollars of extra
spending on infrastructure
spending but these sorts of
capital projects can take months
if not years to be completed.
 Delays in sourcing raw
materials, components and
finding sufficient skilled labour
can limit the initial impact of the
spending projects.
Multiplier effect
The value of the multiplier can be calculated
by using either the marginal propensity to
consume (mpc) or the value of the marginal
propensity to withdraw (mpw)
mpw = mps plus mpm plus mrt
mps is the marginal propensity to save
mpm is the marginal propensity to import
mrt = marginal rate of taxation
The multiplier equals 1/(1-mpc) or
1/mps +mpm + mrt or
1/mpw
Complete the student
workpoint 16.3 P202
Marginal propensity to
consume – the extra
consumption induced
from extra income
Marginal propensity to
withdraw – the extra
withdrawals induced
from extra income
Marginal propensity to
save – the extra saving
induced from extra
income
Marginal propensity to
import – the extra
imports consumed
induced from extra
income
Multiplier effect
How do we draw the multiplier effect?
Just show 3 lots of AD
The first shift is the rise after the initial
injection
The second shift is the final rise
Use arrows to show the direction of the
movement
Complete the
10 mark HL
question on
P202