Equilibrium Levels of Real National Output

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

Two panels contrasting Classical equilibrium fixed at full employment with Keynesian equilibrium possible below it
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 Yfe, and equilibrium can only occur at that point. Any deviation from Yfe is temporary, as the economy will self-correct through changes in wages and prices.

Keynesian Equilibrium

In the Keynesian model, LRAS is L-shaped, allowing for equilibrium at various output levels below Yfe. This means that the economy can be in equilibrium with unemployment and unused capacity, and may not self-correct without government intervention.

Aggregate Demand shifts: The Classical View

Classical diagram showing aggregate demand shifting right and raising only the price level, with output fixed at full employment
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).
AD/AS diagram showing aggregate demand shifting right along SRAS, raising both real GDP and the price level
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.

Aggregate Demand shifts: The Keynesian View

Keynesian diagram showing aggregate demand shifting right and raising output with little price change while capacity is spare
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.

Shifts in Long-Run Aggregate Supply

Classical diagram showing the vertical LRAS shifting right, raising real output and lowering the price level
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.
Keynesian diagram showing LRAS shifting right, raising real output and lowering the price level
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.

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Seven original multiple-choice questions on short-run and long-run macroeconomic equilibrium, the Classical and Keynesian models, and shifts in AD and LRAS.

Practice Questions: 2.4.3 Equilibrium Levels of National Output