Short run and long run equilibrium and the business cycle | AP Macroeconomics | Khan Academy

What we're going to do in this video is talk about the notion of equilibrium in a macroeconomics context.

So let's review a little bit of what we've already studied about aggregate demand and aggregate supply.

So this vertical axis here, that is the price level for the economy that we are trying to study, and this horizontal axis right over here, this would be the real GDP for that economy, the real GDP.

And now I could draw an aggregate demand curve. In previous videos, we've talked at length about why economists like to model it as a downward sloping curve, but once again, take all of these things with a grain of salt. There's a lot of assumptions baked in. And then I could also draw aggregate supply. Aggregate supply this would be short run aggregate supply, upward sloping curve.

So I'll just call that short run aggregate supply, and I'll call that short run aggregate supply 1 because we might look at other potential aggregate supply curves. I could also look at other potential aggregate demand curves, but let's just do that for now.

So given these curves, what would be the price level and the level of output for this economy? Pause this video and think about it.

Well, some of y'all might just very naturally say, well, it would be the output and the price level that corresponds to this point of intersection. And if you said that, you would be correct.

So this would be our short run equilibrium output. Let me label that. So that right over there is our short run equilibrium. Equilibrium output corresponds to where the short run aggregate supply intersects to the aggregate demand curve, and then this right over here would be our equilibrium price level. Let's call that PL1.

Now, why do we feel good that this would be the short run equilibrium output and this would be the price level? Well, let's imagine what would happen if we were at a lower price level.

Let's say right over here, at that price level, we see that aggregate demand is outstripping aggregate supply. The output that the aggregate demand wants is much higher than the output of the short run aggregate supply, and so that would be a shortage situation. There's not enough output for all of that demand.

And what would likely happen in that situation? Well, the folks producing that output would probably say, "Hey, I'm going to charge a little bit more for my output," and as they're charging more, they'll say, "Maybe I'll also produce a little bit more output," and they'll move up the curve towards that equilibrium point.

And then on the demand side, people would say, "Hey, I'm not getting the output I need. I'm willing to pay more for it," but as the cost of that output also goes up, the output demanded would go down, and we'd end up back at that equilibrium point.

And we could do the same thought exercise if for some reason we were at a price level above PL1. In this situation, short run aggregate supply is a good bit higher than aggregate demand, and so you have more output than what is being demanded.

And so what's likely to happen? Well, the suppliers, the people producing the output will say, "Well, I'm going to charge a little bit less for my output and produce less," and then similarly those demanding will say, "Hey, there's this glut of output, I'm going to pay less for that output," but as they're able to pay less for it, they'll say, "Hey, I want more and more of it," and we get back to the equilibrium point.

Now what we've talked about so far is in the short run, but some of you might be saying, "Well, what about the long run?" In previous videos, we have talked about long run aggregate supply.

And so let's say that this curve right over here represents the long run aggregate supply curve, and where it intersects the horizontal axis, this Y sub F, you could view this as the output of this economy at full employment.

And it's really the sustainable output of this economy at full employment. And so what's going on in the graph right over here? Our equilibrium output is, well, our short run equilibrium output is below our full employment output, and so we have a gap.

So there's a negative to go from our full employment output to our equilibrium output. And so if we wanted to think about this in the context of the business cycle, where would we be on it?

So let's draw the business cycle. So now I'll make the vertical axis the level of real output, so this would be real GDP right over here. And then on the horizontal axis, this will be the passage of time, that is time.

And so what typically, so at any given point in time, there will be a Y sub F. There will be some sustainable potential output for that economy. And when I say sustainable, it means, you know, people are sleeping properly, resting properly, you're not unsustainably depleting resources.

And so for example, at this point in time, that might be the Y sub F, and that maybe a few years later, maybe the population has grown, there's more infrastructure, technology has improved, so now they can sustainably produce more.

And then a few years after that, maybe they could produce even more. Population grows, they've thought about better ways to arrange the resources in the economy, technology improves, and so you could imagine a world where that full employment output could just grow in a very nice way like this, or it could just grow nicely like this.

But we know that's not the way real economies work; they experience the business cycle. And the business cycle looks more like this.

So it will look more like this where you have your peaks and these troughs, boom and bust cycles. Sometimes people will talk about it, and the parts of this curve where you have increasing real GDP, like there or there or there, we would call those expansions.

So that is economic expansion, and the parts where GDP is receding, so for example right over here, right over here, we would call those recessions.

But let's go back to our aggregate demand and aggregate supply world right over here. This equilibrium point Y sub 1, what point could that correspond to on this graph right over here of the business cycle?

Let me label that. This is the business cycle. What? Pause this video, think about what point it could correspond to.

Well, we're at a point where our short run equilibrium output is below our full employment output, our potential output, our sustainable full potential output. So this would correspond to some point where our real GDP is sitting below this blue curve or this blue line the way I've drawn it.

And so Y sub 1 could, for example, be this point, or it could be that point, or it could be that point. And so if it was this one right over here, then that right over there would be Y sub 1, and this right over here would be the Y sub F for this point in time.

Now, as we go forward in time, this Y sub F, we see this economic growth, it could move to the right as population grows, as we have better technology, etc., etc., etc.

But you're probably thinking, "Well, what about other points? Are there other possible scenarios?" And my answer to you would be absolutely.

So you could imagine a world where the equilibrium output is to the right of our potential output, and I will construct that by making a different short run aggregate supply curve.

Although I could also do that by shifting the aggregate demand curve, and we'll do that in future videos. But imagine a situation like this. Imagine, so I'll call this short run aggregate supply 2, and now this is our equilibrium output Y sub 2, and it corresponds to price level, price level 2 right over here.

And notice here there's a gap, but it's a positive gap. Our actual output is above our sustainable output.

And so for example, this could correspond to maybe at this point, if it does correspond to this point, so if this was Y sub 2, then this would be our current Y sub F. I didn't actually shift it, but hopefully you're getting the general idea.

And you're saying, "Well, how can you produce beyond full employment? How can you produce beyond your sustainable potential?" Well, this is an economy that is producing output in an unsustainable way.

Unemployment is unusually low, you have maybe depleting resources, people are working too hard, they're getting stressed out, they're not sleeping properly, however you want to think about it. It's not considered sustainable.

And then you have a third scenario where your short run equilibrium output actually equals your full employment output. And so that could be this scenario right over here. So this would be our short run aggregate supply 3, and notice over here our equilibrium output Y sub 3 is equal to our full employment output.

And when this happens, this is considered a long run equilibrium. So let me write that down. That is considered a long run equilibrium.

And points that correspond to long run equilibria on this business cycle right over here would be this point right over there, that point, that point, and that point.

So I'll leave you there. In future videos, we will actually think about how aggregate demand and short-run aggregate supply will shift and connect it even further to the cycles in the business cycle.