1. Macroeconomic Equilibrium
A presentation on the interaction of Aggregate Demand and Aggregate Supply to determine equilibrium national income and prices in both the short term and the long term

2. The economy is in short- run equilibrium where Aggregate Demand equals short- run Aggregate Supply (SRAS)
The output produced by the economy is exactly
equal to the total demand in the economy and so there is no reason
for producers to change their levels of output.

3. What is the relationship between macroeconomic equilibrium and the productive potential of the economy?
Classical economists believed that in the short run the economy could be in equilibrium anywhere- for example the economy could operate in short run equilibrium, at below their potential output.
However in the long-run the economy would always return to its maximum potential output (ie equilibrium would be where AD=LRAS)

4. A fall in aggregate demand from AD1 to AD2 , results in a fall in the level of national output from Yf to Y1 and a decrease in the price level. In this case, the economy would be experiencing what is known as a deflationary gap, where the economy is in equilibrium at a level of output that is less than the full employment level of output.

5. The LR equilibrium in the Classical model.
However, this deflationary gap will not persist. The fall in the price level means that the prices of the factors of production have fallen. For example workers who find themselves unemployed will accept lower wages. This means that firms costs of production fall and this results in a shift in the short run aggregate supply from SRAS1 to SRAS2 . With lower factor costs firms will produce more. As the diagram shows, the economy returns to its long- run equilibrium at the full employment level of output, at a lower price level.

6. Inflationary Gaps in the Classical model
If there is an increase in aggregate demand, AD1, there will be an increase in output from Yf to Y1 . In this case the economy would be experiencing what is known as an inflationary gap, where the economy is in equilibrium at a level of output that is greater than the full employment level of output. But how is this possible?

7. It is possible for output to increase along the short- run aggregate supply curve by existing workers working overtime as a short- term solution. But the excess demand creates inflation (P1-P2) and so wages increase to match this inflation. These increased costs of production leads to firms reducing output (SRAS1-SRAS2) and the economy returning to Yf

8. Implications of the Classical model
The LR equilibrium will always be at “full-employment”, where the economy is at its maximum potential output. Therefore there is no need for Demand management in times of recession. Moreover increasing Demand can only cause inflation In the long run. But then came the great depression of the 1930s. How could that be explained, given that the economy should have moved back into full-employment in the long run?

9. Keynesian Theory
John Maynard keynes wrote his “General Theory” in 1936 as a criticism of the existing model. He criticised the assumption that factor prices such as wages were variable in the long run. He argued in particular that wages may not fall and could be “sticky downwards”. If wages did not change there is no difference between the short run and long run. So Keynes only had one AS curve.

10. The Keynesian AS curve
if the economy has large spare-capacity then any increase in output is likely without an increase in input prices and hence final prices
if the economy is at full employment firms cannot take on extra workers and so any increase in demand will merely raise prices.
If the economy is near full employment the workers will be in a position to bid up wages in response to a rise in demand. Output can increase but inflation may also increase

11. Deflationary Gaps in the Keynesian Model
The key difference between Keynesian and Classical models is that Keynesians believe that Deflationary gaps can occur in both the short run and the long run as wages may not fall and so workers do not price themselves back into the labour market.

12. Because deflationary/recessionary gaps can occur in the LR, there is a key role for AD in Keynesian macroeconomic policies. Governments may need to stimulate AD by Fiscal and Monetary policies.

13. Here expansionary Fiscal and Monetary policies can create economic growth and reduce unemployment, but at the expense of higher inflation

14. Keynesian Inflationary Gap
Keynes didn’t use the AS/AD model, and didn’t place much emphasis on inflation in his work. An inflationary gap therefore is not usually shown using a Keynesian model- Economists tend to opt for the Classical model

15. Implications of the keynesian Model
Expansionary policies are used to increase aggregate demand to increase the equilibrium level of output and to reduce unemployment.
Contractionary policies are used to decrease aggregate demand to reduce the inflationary pressure.

16. Supply-side policies
Keynesians view AD policies as being important in creating “actual economic growth”.
“Potential growth” is achieved more through Supply-side policies. However S-side policies may not create actual growth when there is a recession.

17. Here the productive potential is increased, but no actual growth occurs. For example improving technology may not create economic growth if there is no demand for the products!

18. Classical economists view S-side policies as being very important as not only do they create actual and potential economic growth but also lead to lower inflation

19. Which model is correct?
Both models are theoretically correct, given the assumptions they make
The key question to ask “are wages flexible” as if they are, the Classical model is correct.
In reality the models will apply differently to different circumstances. If an economy has strong trade unions and minimum wage legislation then wages may not fall. However if an economy doesn’t have these and no unemployment benefits then workers may be more willing to accept lower wages.