Stable Long-Term Economic Balance: Maximizing Economic Capacity
Grappling the Long-run Economic Balance:
In the realm of macroeconomics, the long-run equilibrium refers to the point where the aggregate demand curve intersects the long-run aggregate supply curve. This intersection signifies the economy's optimal output, at full capacity, and in harmony with its available resources. However, it's essential to note that the short-run equilibrium often fluctuates from this desired state, leading to the infamous business cycle.
Characteristics of long-run equilibrium:
When the economy maintains long-run equilibrium, the short-run equilibrium aligns with the long-run aggregate supply curve. In simple terms, the economy is functioning at its peak ability, utilizing all productive resources fully and with minimal waste.
Real GDP equals potential GDP, signifying the optimal output level, and the unemployment rate is at its natural rate - a level that accommodates structural and frictional unemployment. Notably, this doesn't imply zero unemployment; rather, it signifies an equilibrium where unemployment exists due to underlying factors, such as skills mismatch or new workers entering the job market.
The economy's dance to long-run equilibrium:
The long-run equilibrium is subject to shifts when aggregate demand changes. For instance, an increase in aggregate demand causes the economy to move away from equilibrium, producing more output at a higher price level. As prices rise, so do real wages, creating pressure for higher nominal wages. This, in turn, increases production costs, forcing businesses to reduce output to maintain profitability. Ultimately, the economy finds a new long-run equilibrium with lower aggregate output but a higher price level.
However, not all economists agree on this process. Keynesian economists argue that an increase in aggregate demand doesn't necessarily lead to a surge in the price level. Instead, the economy might still have untapped capacity, which it can utilize to increase production without experiencing inflation.
The long-run equilibrium also changes when productive capacity evolves due to factors like technological advancements. As the long-run aggregate supply curve shifts to the right, the economy gains a higher potential output, allowing it to meet elevated demand without causing undue pressure on the price level.
A tale of two schools:
- Neoclassical Economics: In this model, the economy eventually self-corrects to full employment in the long run, thanks to flexible prices, wages, and interest rates. An increase in aggregate demand may temporarily boost output and employment, but over time, prices, and wages adjust to reestablish equilibrium at the potential (full-employment) level of output.
- Short-run impact: A surge in aggregate demand can temporarily amplify output and employment.
- Long-run adjustment: Higher demand pushes up prices, leading to higher wages and input costs.eventually, nominal wages and prices adjust completely, restoring output and employment to their natural (potential) levels. The only long-term effect is a higher price level; output and employment remain constant.
- Key assumption: All markets (labor, goods, capital) are perfectly competitive and flexible, with no nominal or real rigidities.
- Keynesian Economics: Keynes challenged the assumption that the economy always returns to full employment in the long run, especially if coordination failures or persistent demand shortfalls arise.
- Short-run and long-run distinction: In the short run, prices and wages are somewhat inflexible, causing changes in aggregate demand to have a direct impact on output and employment.
- Potential for Persistent Disequilibrium: Keynes argued that the economy may remain stuck in a prolonged underemployment equilibrium, even with interest rates at their "natural" level, due to misaligned savings and investment decisions, leading to insufficient aggregate demand.
- Role of Fiscal Policy: Keynesians advocate for active fiscal policy (government spending or taxation changes) to manage aggregate demand and restore full employment, especially when the economy is mired in a low-output equilibrium.
- Key assumption: Markets are imperfect, information is incomplete, and coordination failures can prevent the automatic return to full employment in the long run.
As it stands, the Neoclassical model anticipates that the economy self-adjusts to full employment in the long run following any aggregate demand shock, while the Keynesian model admits the possibility of chronic underemployment if demand remains insufficient and coordination fails.
In the context of economics, finance and business play crucial roles in attaining long-run equilibrium. A thriving economy balancing at its long-run equilibrium can be likened to a well-invested business, utilizing all available resources to achieve optimal output (real GDP equal to potential GDP) and maintaining the unemployment rate at its natural level. Conversely, changes in aggregate demand or evolving productive capacity can disrupt this balance, necessitating strategic financial decisions and investments inorder to find a new long-run equilibrium, much like a business adapting to market fluctuations or technological advancements to sustain profitability.
