School of Management and Business Ysgol Rheolaeth a Busnes

EC10320 - Economic Principles and Skills IISemester 2

Word Count : 1758

Describe how equilibrium occurs using the AS/AD framework. Use this framework to explain why real GDP fluctuates around potential GDP.

The aggregate supply (AS) and aggregate demand (AD) model is one of the basic macroeconomic models. It helps us to understand some features of Macroeconomics the growth of potential GDP (Gross Domestic Product), Economic Inflation, fluctuations of real GDP around potential GDP and Business Cycle fluctuations. Aggregate supply and demand framework is expressed with curves for the long-term and the short-term. The aggregate supply curve shows us the quantity of products and services that firms would produce at a given price level or the total quantity of products and services produced in the country. The aggregate demand curve shows us the quantity of goods and services that consumers (households, firms, the government) would purchase at a given price level, or the total demand of goods and services purchased in the country. The aggregate supply / aggregate demand framework uses the AS / AD concept to conclude the real GDP and the price level (GDP deflator).In order to understand how the Macroeconomic equilibrium occurs in the aggregate supply / aggregate demand framework for the short-run and the long-run and how this framework is used to explain why real GDP fluctuates around potential GDP a further look will be taken on this model.In the Aggregate Supply concept the quantity of real GDP supplied (Y) depends on three factors, which are as follows: the quantity of capital (K), the quantity of labour (L) and the state of the technology (T). Its dependence is described with the aggregate supply production function Y = F (K, L, T), which would suggest that quantity of real GDP supplied is a function of the quantity of capital, labour and state of technology. Given that the higher those quantities and the better the state of technology is, the larger is the amount of real GDP supplied. The quantity of capital and the state of technology are constant unlike the quantity of labour supplied, which is the only variable. It varies according to the decisions of the companies and people on the supply of and the demand for labour those decisions affect the labour market directly and it has three general stages below full employment, at full employment and above full employment. At full employment on the labour market the demand for labour matches the supply of labour, but even so there is percentage of unemployment, which is the natural rate of unemployment. It happens because there are always firms which look for people to hire and there are always people which look for job. Companies hire new workers if it brings them profit and the lower the wage rate is the more profit they gain, so the bigger is the quantity of labour demanded. People seek for jobs to make the most value of their time and the higher the wage rate is the more is the quantity of labour supplied. So the equilibrium of the quantity of labour supplied and the quantity of labour demanded is the equilibirium wage rate at which there is full employment. In connection to this, the real GDP supplied at full employment state of the labour market is the potential GDP, which as well depends on the quantity of labour, capital, and the condition of technology.With the peaks and the troughs of the Business cycle real GDP fluctuates around the potential GDP, as the employment factor is not steady. The real GDP is above the potential in an expansion and goes below in a recession.To differentiate the aggregate supply in the different stages of the labour market there is a long-run aggregate supply and a short-run aggregate supply.Fluctuations of the real GDP around the potential GDP and instability of the unemployment rate cause unstable economy and a tendency grows for the real GDP to be pushed back to the level of the potential GDP. The macroeconomic long-run is a suitably long economic time-frame in which the equalization of the real GDP with the potential GDP should be completed and the labour market is borught back at full employment. The long-run aggregate supply is expressed via long-run aggregate supply (LAS) curve which shows the relation between price level (GDP deflator) and the real GDP in the state of real GDP equal to potential GDP, in other words the relation between price level and the potential GDP.

The long-run supply curve is always vertical and points at the potential GDP, which equals real GDP. Along the curve the price level changes, but it remains at the potential GDP because potential GDP does not depend on the the price level, which comes from the fact that a movement along the LAS curve is followed by changes in the price level (prices of goods and services) and the price of the production factors. Any change by a given percent of the price of goods and services correspondes to a change by the same percentage in the money wage rate and other production facotrs, which results in a double change for both the factors and they actually remain unchanged. After price level changes but the other factors remain constant, real GDP remains constant as well.The macroeconomic short-run is a time-frame in which real GDP has fallen below or risen above the potential GDP with which the unemployment rate has fallen or risen the natural rate of unemployment as well. The short-run aggregate supply is described with the short-run aggregate supply (SAS) curve, whis expresses the relation between the quantity of real GDP supplied and the price level in the short-run period, with given potential GDP, wage rate and production factors being constant.

Price level Real GDP(GDP deflator) (billions of 2005 pounds)A 95 1200B 100 1250C 105 1,300D 1101,350E 115 1,400

The SAS curve is always upward-sloping. This derrives from the fact that if increase in the companys output occurs, the marginal cost for producing a product would increase as well, so there is a need for higher price to adjust with the prices of productive resources. The effect of this would be an increase in the quantity produced. The short-run aggregate supply curve is tightly bound with the short-run aggregate supply schedule and the dots on it correspond on the rows of the schedule. On the SAS curve in the equilibrium point real GDP equals potential GDP, if it is above equilibrium it is more than potential GDP, if it is below equilibirium real GDP is less than potential GDP.The quantity of real GDP demanded in the economy of a given country is the total sum of final goods and services produced in that country, that government, firms, consumers, visitors are willing to buy. This quantity of real GDP is presented with the equation Y = C + I + G + X M , in which C stands for real consumption expenditure, I stands for investments, G is government expenditure, X is exports and M stands for imports. The buying plans of the buyers vary according to four things mainly: the price level, future expectations, fiscal policy and monetary policy, the world economy. When keeping all other factors on the buying plans constant, the higher the price level is, the smaller is the amount of the total real GDP demanded. This relation between the quantity of real GDP demanded and the price level is the aggregate demand (AD). It is described with an aggregate demand (AD) curve and an aggregate demand (AD) schedule.

The AD curve always slopes down. It is generally for three reasons: The Wealth effect, The Interest Rate effect and The Exchange Rate effect. The Wealth effect suggests that if the price level is decreased, the consumers feel more wealthy and can afford to buy more products and services, which in turn increases the quantity of real GDP demanded. The Interest Rate effect suggests that if the interest rate is reduced by a lower price level, there is an immediate increase in investment spending on investment goods, which again increases the quantity of goods and services demanded. The third effect The Exchange Rate effect suggests that if the countrys price level falls, interest rates fall, too and the exchange rate depreciates. That stimulates net exports, which in turn increases the quantity of goods and services demanded. Changes in aggregate demand might occur if any of the buying factors, different from the price level expectations, fiscal policy and monetary policy, the world economy changes.One of the main reasons for the AS / AD framework to exist is to describe changes in real GDP and the price level. This is why a Macroeconomic equilibrium is established for both the short-run and the long-run periods. For the Macroeconomic equilibrium to be found out aggregate supply and aggregate demand are combined. The economy aims for the long-run equilibrium, as the short-run equilibrium is its normal condition.In the short-run macroeconomic equilibrium the aggregate demand curve represents the quantity of real GDP demanded at any price level and the short-run aggregate supply curve shows us the quantity of real GDP supplied at any price level. The equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the intersection point between the AD curve and the SAS curve. If the price level and real GDP were above equilibrium, then the companies would not be able to sell all their output and would have to cut prices. If the price level and the real GDP were below equilibrium, consumers would not be able to buy all the goods and services demanded and companies would have to increase their production and prices.

When real GDP equals potential GDP the economy is in its Long-run Macroeconomic Equilibrium state.

Long-run Equilibrium occurs in the intersection point of the long-run aggregate supply (LAS) curve with the aggregate demand (AD) curve. In this case AD determines the GDP deflator and real GDP is not affected by it. Moreover, the wage rate takes part here adjusting in the long-run so the short-run aggregate supply (SAS) curve crosses LAS curve in the point of equilibrium price level.The economic cycles (business cycles) often take place in the real-world economy because aggregate supply and aggregate demand rise and fall, but the money wage rate does not correct quickly to keep real GDP at potential GDP, it is not flexible enoughThe aggregate supply and the aggregate demand framework is one of the most useful Macroeconomic models. It helps us a lot to understand the Macroeconomic basic features and broadens the horizon for further studies.

Bibliography: Parkin, M., Powell, M. and Matthews, K. (2005): Economics (6th edition), London: Pearson. EC 10320 - Economic Principles and Skills II lectures 5 / 6