Main content

### Course: Macroeconomics > Unit 3

Lesson 5: Equilibrium in the AD-AS Model# Short run and long run equilibrium and the business cycle

Let's look at the concept of equilibrium in macroeconomics, using graphs to illustrate aggregate demand and aggregate supply. See how different price levels and outputs affect the equilibrium point, and how the business cycle—characterized by expansions and recessions—reflects these changes.

## Want to join the conversation?

- Seen as real GDP is plotted on the axis of each graph, surely Y[f] can only exist at one point on the right hand graph? Or is it that the graph on the left is a snapshot of time and the graph on the right is across time(5 votes)
- In reality, the Yf on the left-hand side graph (the AD-AS model) is constantly shifting to the right, which is why there is an upward trend to the graph on the right (the business cycle model).

You can also think about it this way... if there is no economic growth, then there is no upward trend in the business cycle model. That upward sloping straight line is just a horizontal straight line. In this case Yf is a fixed amount of output and actual output just deviates around that, creating the business cycle.(6 votes)

- is it possible to meet the equilibrium point for a long period of time(4 votes)
- Sure, it is theoretically possible. But I would be hard pressed to think of an example of this happening.(4 votes)

- Curious to know whether this is the keynsian method of the AD/AS, in my models SRAS was a not a straight-line but started off horizontal [straight] and curved at the equalibrium point of the LRAS?(2 votes)
- Keynsians don't really differentiate between SR and LR.

There's no reason SRAS would bend at LRAS.(2 votes)

- I have a question. Is equilibrium always at an optimal level of output? If so why?(2 votes)
- No, it's not, particularly in the Keynsian model (which fits the real world). In the Keynesian model, the economy can be at equilibrium at any level of employment(2 votes)

- I think that Yf should be equal to Y1，and Yf is the natural AD, which means natural unemployment rate is considered.

Firstly,if Yf is the maximum of AS, right on the PPC, then the SRAS could not go beyoung the LRAS.Hence it could not be.As a result, Yf must be the natural AD.

Secondly, it is impossible that Yf does not equal to Y1. Because in the long term, the AD and AS must keep that balance right on the equilibrium piont, otherwise it cannot considered as a balance.(1 vote) - Does macroeconomic equilibrium in the short run always occur at full-employment GDP?(0 votes)
- I don't know to be honest, did you figure that out?(1 vote)

- When you graph GDP vs time which mathematical model will use to model this data?(0 votes)

## Video transcript

- [Instructor] What we're
going to do in this video is talk about the notion of equilibrium in a macroeconomics context. So let's review a little bit
of what we've already studied about aggregate demand
and aggregate supply. So this vertical axis here, that is the price level for the economy that
we are trying to study, and this horizontal axis right over here, this would be the real
GDP for that economy, the real GDP, and now I could draw an
aggregate demand curve. In previous videos we've talked at length why economists like to model
it as a downward-sloping curve, but once again, take all of these things
with a grain of salt. There's a lot of assumptions baked in, and then I could also
draw aggregate supply, aggregate supply. This would be short-run aggregate supply, upward-sloping curve, so I'll just call that
short-run aggregate supply, and I'll call that short-run
aggregate supply one, 'cause we might look at other potential aggregate supply curves, I could also look at other potential aggregate demand curves, but let's just do that for now. So given these curves, what would be the price
level and the level of output for this economy? Pause this video and think about it. Well, some of you all might
just very naturally say, well, it would be the
output and the price level that corresponds to this
point of intersection, and if you said that,
you would be correct. So this would be our
short-run equilibrium output, let me label that. So that right over there is our short-run equilibrium, equilibrium, equilibrium output corresponds to where the
short-run aggregate supply intersects to the aggregate demand curve, and then this right over here would be our equilibrium price level. Let's call that PL1. Now why do we feel good that this would be the
short-run equilibrium output and this would be the price level? Well, let's imagine what would happen if we were at a lower price level, let's say right over here. At that price level, we
see that aggregate demand is outstripping aggregate supply. The output that the aggregate demand wants is much higher than the
output of the aggregate the short-run aggregate supply, and so that would be a shortage situation. There's not enough output
for all of that demand, and what would likely
happen in that situation? Well, the folks producing that
output would probably say, hey, I'm gonna charge a
little bit more for my output, and as they're charging more they'll say, hey, maybe I'll also produce
a little bit more output, and they'll move up the curve towards that equilibrium point, and then on the demand
side, people would say, hey, I'm not getting the output I need. I'm willing to pay more for it, but as the cost of that output
also goes up, the demand, the output demanded would go down, and we'd end up back at
that equilibrium point, and we could do the same
thought exercise if, for some reason we were at
a price level above PL1. In this situation, aggregate supply, short-run aggregate supply is a good bit higher
than aggregate demand, and so you have more output
than what is being demanded, and so what's likely to happen? Well, the suppliers, the people producing the output, will say, well, I'm gonna charge a
little bit less for my output, and produce less, and then similarly,
those demanding will say, hey, there's this glut of output. I'm gonna pay less for that output, but as they're able to pay
less for it, they'll say, hey, I want more and more of it, and we get back to the equilibrium point. Now, what we've talked about
so far is in the short run, but some of you might be saying, well, what about the long run? And in previous videos we have talked about
long-run aggregate supply, and so let's say that this
curve right over here represents the long-run aggregate supply curve, and where it intersects the
horizontal axis, this Yf, you could view this as the output of this economy
at full employment, and it's really the sustainable output of this economy at full employment, and so what's going on in
the graph right over here, our equilibrium output is well, our short-run equilibrium output is below our full employment output, and so we have a gap. So there's a negative to go
from our full employment output to our equilibrium output, and so if we wanted to think about this in the context of the business cycle, where would we be on it? So let's draw the business cycle. So now I'll make the vertical
axis the level of real output. So this would be real GDP right over here, and then on the horizontal axis, this will be the passage of time. That is time, and so what typically So at any given point in
time, there will be a Yf. There will be some
sustainable potential output for that economy, and when I say sustainable it means, you know, people are sleeping
properly, resting properly, you're not unsustainably
depleting resources, and so, for example,
at this point in time, that might be the Yf, and that may be a few years later. Maybe the population has grown, there's more infrastructure,
technology's improved. So now they can sustainably produce more, and then a few years after that, maybe they could produce even more. Population grows, they've thought about better ways to arrange the resources in their economy, technology improves, and so you could imagine a world where that full employment output could just grow in a
very nice way like this, where it could just grow nicely like this, but we know that's not the
way real economies work. They experience the business cycle, and the business cycle
looks more like this. So it will look more like this, where you have your
peaks and these troughs, a boom-and-bust cycle, sometimes
people will talk about it, and the parts of this curve where you have increasing
real GDP, like there, or there, or there, we
would call those expansions. So that is economic expansion, and the parts where GDP is receding. So for example, right over
here, right over here, we would call those recessions, recessions, but let's go back to our aggregate demand and aggregate supply
world right over here. This equilibrium point, Y1, what point could that correspond to on this graph right over
here of the business cycle? And let me label that. This is the business the business cycle. Pause this video. Think about what point
it could correspond to. Well, we're at a point where a short-run equilibrium output is below our full employment output, our potential output, our sustainable full potential output. So this would correspond to some point where our real GDP is sitting
below this blue curve, or this blue line the way I've drawn it, and so Y1 could, for
example, be this point, or it could be that point,
or it could be that point, and so if it was this one right over here, then that right over there would be Y1 and this right over here would be the Yf, would be the Yf for this point in time. Now, as we go forward in time, this Yf, we see this economic growth,
it could move to the right, as population grows, as
we have better technology, et cetera, et cetera, et cetera, but you're probably thinking,
well, what about other points? Are there other possible scenarios? And my answer to you would be absolutely. So you could imagine a world
where the equilibrium output is to the right of our potential output, and I will construct that by making a different short-run
aggregate supply curve, although I could also do that by shifting the aggregate demand curve, and we'll do that in future videos, but imagine a situation like this, imagine. So I'll call this short-run
aggregate supply two, and now this is our equilibrium, equilibrium output, Y2, and it corresponds to price level, price level two right over here, and notice, here there's a
gap, but it's a positive gap. Our actual output is above
our sustainable output, and so for example, this could correspond to maybe this point. If it does correspond to this point, so if this was Y2, then this
would be our current Yf. I didn't actually shift it, but hopefully you're
getting the general idea, and you're saying, well, how can you produce
beyond full employment? How can you produce beyond
your sustainable potential? Well, this is an economy
that is producing output in an unsustainable way. Unemployment is unusually low. You have, maybe, depleting resources. People are working too hard. They're getting stressed out. They're not sleeping properly. However you wanna think about it, it's not considered sustainable, and then you have a third scenario where your short-run equilibrium output actually equals your
full employment output, and so that could be this
scenario right over here. So this would be our short-run
aggregate supply three, and notice over here, our
equilibrium output, Y3, is equal to our full employment output, and when this happens, this is considered a long-run equilibrium. So let me write that down. That is considered a long-run equilibrium, equilibrium, and points that correspond
to long-run equilibria on this business cycle right over here would be this point right over there, and that point, and that
point, and that point. So I'll leave you there. In future videos, we will actually think
about how aggregate demand and short-run aggregate supply will shift, and connect it even further to the cycles in the business cycle.