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Equilibrium


An economy will be in equilibrium, that is it will be in a stable state, when planned withdrawals equal planned injections; hence savings, taxation and import spending (S + T + M) will equal investment, government spending and export revenue (I + G + X). This is also consistent with planned aggregate demand equalling planned aggregate supply.

Showing Equilibrium

Using the SRAS and LRAS, we can analyse the relationship between the current level of AD, and the SRAS and LRAS, and show short run  equilibrium in relation to the long run potential of an economy.

Diverging short run equilibrium and full employment

Short run equilibrium may not coincide with the sustainable full-employment level of real output - the level at which the economy is achieving its economic potential. There are two main cases when this happens.

Insufficient AD

However, short run equilibrium may be less than the level to achieve the full employment level of real GDP, as shown below using hypothetical data. The range of prices levels (P - P8) represent theoretical price levels based on an index of prices, such as the CPI.

PRICE LEVEL SRAS £Bn AD £bn LRAS £bn
P8 650 150 500
P7 600 200 500
P6 550 250 500
P5 500 300 500
P4 450 350 500
P3 400 400 500
P2 350 450 500
P1 300 500 500
P 250 550 500

At the short run equilibrium (P3 and 400bn real output) there is a negative output gap of 100bn, given that the maximum possible output is 500bn. A negative output gap is also called a recessionary gap.

Self-adjustment

In the Classical system, the economy is assumed to self-adjust. This view is shared by those economists who stress the importance of allowing an economy to self-adjust, with minimal government involvement. In terms of a negative output gap the lack of demand will suppress wages and the price level will readjust downwards.

The major problem with this view is the length of time over which the economy will self-adjust and increase real output to reach Yf?

Excess AD

It is possible that short-run equilibrium, where AD equals SRAS, is greater than the economy's potential at its LRAS. In this case, the short run equilibrium is at a higher level of real output than the economy can actually produce, as illustrated below.

PRICE LEVEL SRAS £Bn AD £bn LRAS £bn
P8 650 450 500
P7 600 500 500
P6 550 550 500
P5 500 600 500
P4 450 650 500
P3 400 700 500
P2 350 750 500
P1 300 800 500
P 250 850 500

The short run equilibrium position (P6 and a real poutput of 550bn) is above the full employment, creating a positive output gap.

Self-adjustment

Under the Classical system the excess demand would create a labour shortage and wages would rise. This increases costs and the SRAS curve shifts up the the left, as shown below:

Video

 

Injections and withdrawals

When total injections equal total withdrawals, the level of national income will remain constant, and the economy will be in general equilibrium.

The level of economic activity will change following a change in either injections or withdrawals. An economy will grow if the value of injections is greater than the value of withdrawals, or shrink if the value of withdrawals is greater than injections.

Economists often say that the economy is like a bathtub filling up - the level of the water in the bath will rise when the volume of water coming in increases relative to water going out.

General equilibrium

For an economy to be in general equilibrium it is only necessary that:

Total injections = total withdrawals

Injections and withdrawals

See: Different perspectives on equilibrium