⚖️ Short-Run Macroeconomic Equilibrium
Equilibrium: Macroeconomic equilibrium occurs where AD intersects SRAS. This determines the equilibrium price level and real GDP in the short run.
If this equilibrium is at full-employment output (where SRAS also meets LRAS), the economy is in long-run equilibrium. But often, the short-run equilibrium is above or below potential GDP — creating an output gap.
- Equilibrium to the left of LRAS → recessionary/deflationary gap → unemployment above natural rate.
- Equilibrium to the right of LRAS → inflationary gap → economy overheating, upward pressure on prices.
- Equilibrium at LRAS → no output gap → economy at full employment.
💥 Demand-Pull and Cost-Push Changes
Demand-pull inflation
AD shifts right → price level rises AND real GDP increases (in the short run). Caused by rising consumer confidence, expansionary fiscal/monetary policy, or booming exports.
Demand-pull: "too much money chasing too few goods". Both output and prices rise in the short run — but if the economy is already at full employment, mostly just prices rise.
Cost-push inflation
SRAS shifts left → price level rises BUT real GDP falls. Caused by rising oil prices, wage increases, supply chain disruptions, or higher indirect taxes.
Cost-push creates stagflation.
In diagrams: demand-pull = shift AD right (both P↑ and Y↑). Cost-push = shift SRAS left (P↑ but Y↓). Label the new equilibrium clearly.
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🔄 Long-Run Adjustment (New Classical View)
In the new classical model, the economy self-corrects in the long run:
After an AD increase (inflationary gap)
- AD shifts right → short-run equilibrium beyond LRAS (inflationary gap).
- Higher prices → workers demand higher wages → costs rise → SRAS shifts left.
- New long-run equilibrium at a higher price level but back at potential GDP.
- Conclusion: in the long run, an increase in AD only raises prices, not output.
After an AD decrease (deflationary gap)
- AD shifts left → output below LRAS (deflationary gap, unemployment rises).
- Lower demand for labour → wages eventually fall → costs fall → SRAS shifts right.
- Economy returns to potential GDP at a lower price level.
- But this process can be very slow — Keynesian economists argue government should intervene rather than wait.
The Keynesian critique: wages are sticky downward (workers resist pay cuts, minimum wages prevent falls). So the economy can get stuck in a deflationary gap for years — justifying fiscal/monetary intervention.