Equilibrium Levels of Real National Output

These Edexcel A-Level Economics revision notes cover unit 2.4.3, explaining how equilibrium national output is determined by the intersection of AD and AS, how output gaps arise, and what the Keynesian and classical models imply for policy responses.

Specification Coverage: Edexcel unit 2.4.3 - Equilibrium Levels of Real National Output. Students should be able to understand and explain short-run and long-run macroeconomic equilibrium, compare the Classical and Keynesian views of equilibrium, analyse changes in AD and LRAS, identify output gaps, and evaluate the policy implications of different macroeconomic models.

Macroeconomic Equilibrium

Short-run equilibrium: This occurs where aggregate demand equals short-run aggregate supply. It determines the actual price level and real national output.

Long-run equilibrium (Classical view): This occurs where AD = SRAS = LRAS at the full employment level of output, Yfe.

The Two Views of Long-Run Equilibrium

Diagram showing the equilibrium in the AD-LRAS model.
Figure 1: The AD-LRAS model illustrates the different views of long-run equilibrium. The Classical model has a vertical LRAS, while the Keynesian model has an L-shaped LRAS, allowing for equilibrium at various output levels depending on AD.

Classical Equilibrium

In the Classical model, LRAS is vertical at the full employment level of output, Yfe.

Equilibrium occurs where AD intersects SRAS on the LRAS curve.

Belief: The economy always self-corrects to Yfe in the long run. Changes in AD affect only the price level, not long-run output.

Keynesian Equilibrium

In the Keynesian model, LRAS is L-shaped and equilibrium can occur at any point on the curve.

Belief: The economy can become stuck below Yfe, especially in recession. In that case, an increase in AD can raise output without necessarily causing inflation.

Changes in Equilibrium: The Classical View

Diagram showing the effects of an AD shift in both Classical and Keynesian models.
Figure 2: An increase in AD (AD1 to AD2) in the Classical model leads to a higher price level (P1 to P2) but no change in output (Yfe).
Diagram showing the effects of an AD shift in the SRAS-AD model.
Figure 3: An increase in AD (AD1 to AD2) in the SRAS-AD model leads to a higher price level (P1 to P2) and an increase in output (Y1 to Y2) in the short run.

Changes in Equilibrium: The Keynesian View

Diagram showing the effects of an AD shift in the Keynesian model.
Figure 4: An increase in AD (AD1 to AD2) in the Keynesian model can lead to a significant increase in output (Y1 to Y2) without a rise in the price level when the economy is operating in the horizontal section of the LRAS curve.

Key Insight: The effect of an AD shift depends on where the economy is operating on the LRAS curve, especially whether there is spare capacity or full capacity.

Changes in Long-Run Aggregate Supply

Diagram showing the effects of an LRAS shift in the Classical model.
Figure 5: An increase in LRAS (LRAS1 to LRAS2) in the Classical model leads to a higher potential output (Yfe1 to Yfe2) and a lower price level (P1 to P2) in the long run.
Diagram showing the effects of an LRAS shift in the Keynesian model.
Figure 6: An increase in LRAS (LRAS1 to LRAS2) in the Keynesian model can lead to a higher output (Y1 to Y2) and a lower price level (P1 to P2) in the long run, especially if the economy was previously operating in the vertical section of the LRAS curve.

Output Gaps

Negative Output Gap (Recessionary Gap): This occurs when actual output Y is less than potential output Yfe. Resources, especially labour, are underused.

Positive Output Gap (Inflationary Gap): This occurs when actual output Y is greater than Yfe. The economy is overheating and using resources unsustainably, creating inflationary pressure.

Exam Preparation

  • Draw and explain equilibrium using both the Classical and Keynesian LRAS models.
  • Analyse the different effects of an increase in AD depending on the model and the economy's starting point.
  • Show and explain how an increase in LRAS represents long-run economic growth.
  • Identify negative and positive output gaps clearly on diagrams.
  • Evaluate the policy implication that Keynesians support demand-side intervention to close a recessionary gap, while Classical economists believe markets self-correct.

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