Concept of Equilibrium in Economic Traditions

Question: Discuss about the Concept of Equilibrium in Economic Traditions. Answer: Introduction Economic equilibrium is a state where the economic forces of demand and supply are equal or balanced. This occurs at the point of intersection between the supply and the demand curve (Tieben, 2012). This is the point that is referred to as the point of equilibrium. In a free market, the unit price of a particular good keeps on changing and stabilizes at the point where demand equals supply. For a countries` economy to be at equilibrium, it means that the aggregate demand must be equal to the aggregate supply in the short run and aggregate supply in the long run. This concept of macro-economics is explained through the Keynesian theory and the theory of knowledge. However, there are instances when government intervention is needed in order to achieve equilibrium in production of goods and services as well as distribution of income through various policies in order to influence economic stability. In economics, the national income is the same as the level of output that a country produces within a period of time. This level of output is therefore very important to the health of any economy. The actual output of a particular country and its corresponding price are determined at the point which the aggregate demand curve and the aggregate supply curve intersect. Since economists distinguish between short run and long run aggregate supply, there are both short run and long run macroeconomic equilibrium. However for the economy to be in stable equilibrium, both of this needs to intersect at a point. Short-run equilibrium output An economy is in short-run equilibrium at the point where there is equal short-run aggregate supply and aggregate demand. In macro-economic analysis, short-run means the period in which prices are not affected by prevailing economic conditions. The output Y and price P are determined at the point where the aggregate demand curve and short-run aggregate supply curve intersect. This output Y is the equilibrium output and price p is the equilibrium price. This means that the output from the economy is equivalent to the level of demand in that economy and so producers should maintain their level of output. In the short-run, there is no inflationary or deflationary gap. Equilibrium output in the long-run This occurs at the point where aggregate demand equals the long-run aggregate supply. Long-run is a period long enough to allow prices of outputs to correspond to prevailing economic conditions. The equilibrium output and price in the long-run will be determined at the point where long-run aggregate supply curve and long run aggregate demand curve intersect. There are two theories that explain the equilibrium of an economy. These theories are; new classical economic theory and the Keynesian economists. New classical model According to this model, the economy will be at equilibrium in the long run at the point where maximum level of output is employed. Therefore, long-run equilibrium is achieved at the point of intersection between the vertical long-run aggregate supply curve and the aggregate demand curve as illustrated in the figure below. If aggregate demand changes, it will only affect price level. The illustration Below shows change in aggregate demand from AD1 to AD2 which in turn increases the price from P1 to P2 with the level of real output remaining the same. The figure above shows an illustration of combination of the long run supply curve and the short run supply curve. A shift in demand curve from AD1 to AD2 due to changes in any component of aggregate demand, the economy will experience an inflationary gap. This is where the economy is at equilibrium only at the point where output is greater than the full employment output level. This will occur only for a short period of time. Therefore, the level of equilibrium output in the long-run is equal full employment output level. The free market forces will cause the economy to move to equilibrium without the government intervening. According to this theory, increase in aggregate demand brings about inflationary gap in the long run and therefore government wont need to intervene. Keynesian model The point where aggregate demand and long-run aggregate supply are equal determines the equilibrium output .Keynesian economists have however argued that the equilibrium level of output occurs at different levels. During full employment , and where the output is lower than the output level, the state of the economy can be economy can be said to be at equilibrium . This happens especially in the event where the output of the economy operating below its optimum output capacity. In such scenarios, the aggregate demand determines the equilibrium output. An increase in demand from AD1 to AD 2 will increase output Y1 to Y2 without changing the price levels. The reason for this is the spare capacity in the economy which means that producers can use the existing capacity to increase levels of production without increasing production costs. inflationary pressure will therefore be experienced in the economy. Further increase of demand to AD3 will result to inflationary pressure due to scarcity of factors of production hence increase in prices from P1 to P2. In situations where the economy is at full employment and an increase in the aggregate demand is experienced, there will be no increase in the output levels but price levels will increase. This is because the production capacity of the economy is full and therefore output cannot be increased further (Urai, 2010). The inflationary gap may cause the government to intervene in order to prevent the prices from increasing any further. The government will intervene to reduce the aggregate demand through fiscal and monetary policies. The government will cut its spending and increase taxation or reduce the supply of money in the economy. It can also increase interest rates through the central bank. In a situation where the aggregate supply in the long term and the prices keep on reducing, the government will employ policies that will reduce economic recession. The government can implement expansionary fiscal policies. This involves decreasing taxes and increasing spending by the government. This will in turn increase aggregate demand. The central bank can also reduce interest rates in order to increase money supply hence increasing demand. Conclusion From the analysis carried out above, the stable economic equilibrium is achieved only when the aggregate short run supply, aggregate long-run supply and demand are equal. At this point, the equilibrium output level and equilibrium price level is determined. Equilibrium is achieved through interaction of market forces of demand and supply. However, according to Keynesian economist government intervention is necessary in order to bring about market equilibrium as discussed in the previous paragraphs. References: Tieben, B. (2012). The concept of equilibrium in different economic traditions: An historical investigation. Cheltenham: Edward Elgar Pub. Urai, K. (2010). Fixed points and economic equilibria. Singapore: World Scientific.