Long-Run Equilibrium

Question 1

What is the long-run equilibrium according to neo-classical economists?

Answer 1

Neo-classical economists believe that in the long-run the market will self-correct itself to full employment level of output

Question 2

How is the long-run equilibrium represented? (according to neoclassical economists)

Answer 2

The economy is in long-run equilibrium when the AD curve and the SRAS curve intersect at any point on the LRAS curve

Question 3

What happens to long-run equilibrium if AD falls? (according to neoclassical economists)

Answer 3

fall in AD => economy moves in to short-run recessionary gap

after time has passed (i.e. long run):
fall in AD (and PL) => reduced output and employment => fall in wages due to labour surplus => increase in supply => economy is producing at LRAS curve again

Question 4

What happens to long-run equilibrium if AD increases (according to neoclassical economists)?

Answer 4

rise in AD => economy moves in to short-run inflationary gap

after time has passed (i.e. long run):
rise in AD (and PL) => increased output and employment => increase in wages due to labour shortage => decrease in supply => economy is producing at LRAS curve again

Question 5

What is the impact of changes to AD in the long run (according to neo-classical economists)?

Answer 5

Since in the long-run the economy will revert back to producing at potential GDP, the only impact of a change in aggregate demand is to change the economy’s price level

Question 6

What is the long-run equilibrium according to Keynesian economists?

Answer 6

Since Keynesian economists believe in sticky prices and wages in the long run, they propose that the economy can be “stuck” in a recessionary gap or inflationary gap in the long-run as well

Question 7

How is the long-run equilibrium represented? (according to Keynesian economists)

Answer 7

Macroeconomic equilibrium in the Keynesian model is determined by the point where the AD curve intersects the Keynesian AS curve

Question 8

What are the 3 possible long-run equilibrium points according to Keynes?

Answer 8

1. Inflationary Gap
   - unemployment lower than natural rate
   - strong aggregate demand
   - producing at higher level of output than potential output
2. Recessionary Gap
   - unemployment higher than natural rate
   - weak aggregate demand
   - producing at lower level of output than potential output
3. Full employment
   - unemployment = natural rate
   - stable aggregate demand
   - real GDP = potential output