Macroeconomic Equilibrium Determination

Question: Discuss about the Macroeconomic Equilibrium Determination. Answer: Introduction The main objective of this paper is to determine the position of the macroeconomic equilibrium. This is derived from the analysis of the aggregate demand (AD) and both the short and the long run aggregate supply. The analysis will commence by describing the three curves and explaining the reason for the direction in which they slope. This paper will try to confirm the reason as to why a stable equilibrium has to be at the position where the operating output level is at the point where the AD curve and both the short run and the long run AS curve intersect. The AD curve shows a macroeconomic relationship that exist between the price level and the output level of all demand for goods and services that the households demand at every price level (McEachern, 2011). Since its derivation is from the combination of individual demands in an economy that are downward sloping, the AD curve also slopes downwards. I.e. it contracts with an increment in prices. The short run AS curve shows the relationship that exists between price and all the supply for goods and services intended to be sold by the firm at any given time given the price levels (Sexton, 2013). Since it is derived from the combinations of all upward sloping individual curves, the AS curve is also upward sloping. I.e. it expands with a price increment. The maximum production capacity is represented by the potential real GDP or rather the long run AS curve. The analysis In the derivation of individual demand curves, price for other goods and the income of households are held constant. However, this is not possible in the derivation of the AD curve. The only factor that economist decided to hold constant therefore is the money supply. From this, there are other reasons that hence explain the downward sloping AD curve that are not price related. One of them is the wealth effect where the wealth of households is considered to be reduced by a loss in purchasing power resulting from a price rise. The wealth that households hold become insufficient to cater for the demands for goods and services and they end up cutting their demand. The second factor is the interest rate effect where interest rate goes up as the price rises. The explanation is that since we have seen in the first factor that money held become insufficient to facilitate business transactions, households and businesses demand more money and borrow this from banks and other lending instituti ons. Since money is held constant, an increase in money demand follows the law of demand. I.e. it causes an increment in the cost of obtaining money; this cost is the interest rate. Households cut their spending to avoid obtaining money at the high interest rate. Finally we have the net export effect where the demand for exports fall and the demand for imports rise. Higher domestic prices makes exports expensive and imports cheaper. The difference between a small export quantity and a big import quantity is a reduced net export. Since net export is a component of aggregate demand, its decline results in a fall in AD. The short run AS curve slopes upward because supply expands as price rises owing to stickiness of wages and price in the short run (Mankiw, 2012). The real wage falls as prices rise since nominal wage remain fixed causing labour to be cheaper; firms employ more workers and output expands. The other explanation is workers nominal wage is increased and they think their real wage has increased also and they are motivated to supply more labour causing an output expansion. The long run AS curve is vertical since there is an assumption of optimal utilization of all resources apart from capital, labour and technology (Tucker, 2010). The firms supply is independent, and the expected profit determines the supply level. Where the three curves intersect, that the stable equilibrium that can be maintained in an economy. However, the optimal Real GDP level does not indicate the production limit. There is also a potential for production beyond the optimal real GDP since some components of AD may change causing it to expand. On the other hand, the full utilization of resources in an economy may not be applicable and the firms production level may fall below the optimal level of real GDP. This is because some changes in the AD components may lead to its contraction. However, the deviation from the optimal level of real GDP is in the short run as it cannot be sustained in the long run (Hubbard, Garnett, Lewis, O'Brien, 2012). The economy is assumed after sometime to get back to the optimal level of real GDP. These deviations from the stable equilibrium explains the need to incorporate the short run AS curve in the determination of the equilibrium point (Tucker, 2010). Initially, the price level and the output level is at the point where the three curves intersect. A fall in the AD will cause the AD curve to shift left from AD to AD1 (Burton and Lombra, 2000). This is at a lower price than the optimal price. The lower price will deduce that the production cost will fall of which will make firms and workers to raise the supply of output resulting in the supply curve shifting from SRAS to SRAS1. This is moves the equilibrium back to the potential but at a lower level. On the other hand, a rise in AD will cause the AD curve to shift right from AD to AD2 (Boyes Melvin, 2013). This is at a higher price than the optimal price. The higher price raises the cost of production which makes firms and workers to cut the supply of output resulting in the supply curve shifting from SRAS to SRAS2 Conclusion It is rare to find an economy operating at the optimal level where resources are utilized optimally. Far rare is the situation where resources are over utilized and the economys output exceed the optimal level. The most common situation is where resources are underutilized and production of output is below optimal. The three curves have to intersect to determine equilibrium as deviation from optimal are only short run and cannot be sustained in the long run. References Boyes, W. Melvin, M. (2013). Fundamentals of economics (1st Ed.). Mason, OH: South-Western Cengage Learning. Bromley, R. (2016). Aggregate Goods and Services Equilibrium and Changes. Raybromley.com. Retrieved 29 December 2016, from https://www.raybromley.com/notes/ADASequiMove1.html. Burton, M. Lombra, R. (2000). 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