Macroeconomic Equilibrium in the Classical Model

Macroeconomics is the branch of economics that deals with the performance, organization, conduct, and decision-making of an economy as a whole. Macroeconomics takes into account local, nation-wide, and global economies. It involves government spending, taxes, and interest rates to stabilize and grow the economy. Equilibrium in economics is equilibrium in money supply, interest rates, inflation rates, aggregate demand and supply, and production. Macroeconomic stability deals with the economic variables (price and quantity) and the financial processes (demand and Supply).

 

What is Macroeconomic Equilibrium?

When the quantity of aggregate demand and aggregate supply become the same, it is called Macroeconomic Equilibrium. In other words, Macroeconomic Equilibrium occurs when Aggregate Demand = Aggregate Supply.

 

This condition plays a significant role in the stability of the economy in a country. Changes in prices, Inflation, and unemployment can be handled when there is a change in aggregate demand or aggregate supply.

 

For example: If a shoe company is manufacturing 5000 pairs of shoes for a month, but 4000 pairs are sold. This means the aggregate demand for shoes is low. If this situation persists for the next few months, the company will have low revenue and profits. The company may also go for downsizing of employees; hence unemployment situations may also arise. Similarly, if aggregate demand is high, it will generate revenue, increase profits, and create employment opportunities.

 

The Concept of Demand and Supply:

 

Demand:

 

Demand refers to a consumer’s desire to purchase a specific item or service from the

market. For example, an electric store receives 250 light bulbs per day as an average, and there are nearly 250 customers who agree to pay the price to purchase it. If all other factors are considered constant, and the electric store will be in-market equilibrium. The total amount demanded by all consumers in a market for a specific item is called “Market Demand.” According to the Macroeconomics point of view, the total demand for all goods and services in an economy is “Aggregate Demand.”

 

Supply:

 

Supply may be defined as the stock of a commodity supplied for consumption. When

producers are willing and capable of producing goods and services for consumers, it is called Supply. Supply is directly related to Price, i.e., when Price is higher, supply increases, generating revenue and profit. For example, a supplier provides 400 mobile phones per month to a mobile phone dealer, and all those are sold out during that month; it is aggregate Supply. Within a particular period, the total economic production of goods and services in an economy is called “Aggregate Supply.” Certain factors affect Aggregate Supply in the long run, including the capital, natural resources, technology, labor, etc. The economy of a country depends on the Aggregate Supply of consumer goods.

 

The Aggregate Demand-Supply Model:

 

The U.S economy faced recessions and expansions throughout the last century. In the 1930’s it met a great economic downfall and took a decade to recover from this downturn. The economy grows at different rates per year, and it also takes a cyclical behavior.

 

Macroeconomics analyzes macro issues by using models. It takes into account the relationship between major economic topics such as Inflation and the unemployment rate. The macroeconomic model of “aggregate demand and aggregate supply” identifies the interaction between these two components. It also takes into account how they affect the Macroeconomic Equilibrium.

The three goals of Macroeconomic Equilibrium are economic growth of the country, minimizing Inflation, and maximizing employment rates. The aggregate demand-supply model determines real GDP taking into account the interaction between total spending and total production (goods and services).

 

Types of Macroeconomic Equilibrium:

 

There are two main types of macroeconomic equilibrium: Short-run Equilibrium and Long-run Equilibrium.

 

  1. 1Short-run Equilibrium:

 

The economy is said to be in short-run equilibrium if the aggregate amount of demanded output is the same as the aggregate supplied work. If the “aggregate supply” exceeds the “aggregate demand” or vice versa, the market is not in full equilibrium. This is called Short-run Equilibrium.

 

  1. Long-run Equilibrium:

 

This is a situation in which the market is in full equilibrium. This means all the prices and, Quantities are synchronized, but it is considered an ideal and theoretical situation.

 

Major Economic Issues Addressed by Macroeconomic Equilibrium:

 

Unemployment

 

It is a term used to define those above a certain age and not engaged in any paid job or self-employment. It is a group of people or workforce who currently do not have a job and seek employment in their appropriate fields or otherwise. When measured as a

percentage concerning the total workforce, the number of unemployed people is called the “Unemployment Rate.”

 

Inflation

 

When there is an increase in the general price level of goods or services over a while in an economy, it is called Inflation. In other words, it is a rise in the cost of living as the price of goods and services increases. The rate of Inflation measures the yearly change of percentage in the general price level. Inflation plays a significant role in the economy and political policies of a country.

 

Inflationary Gap

 

This term is used when equilibrium goes beyond the economy’s potential. An inflationary gap denotes the amount, which is the difference between actual GDP and potential full-employment GDP.

Recessionary Gap

 

On the other side, this situation arises when equilibrium is below the economy’s potential. The recessionary gap occurs when the real GDP becomes less than the full employment rate’s potential GDP.

 

Inflation and Its Types

 

Inflation is sure profitable from the growth in the quantity of money faster than the potential GDP—the three leading types of Inflation.

 

Demand-Pull Inflation:

 

Demand-pull Inflation about when there is an increase in aggregate demand. It is initiated by anything that may increase aggregate demand and is sustained if there is growth in money quantity.

 

Cost-Push Inflation:

 

This type of Inflation happens due to an increase in cost. The two leading causes of the rise in value are an elevation in the money wage rate and a peak in the expenses of raw

materials such as oil or agricultural produce.

 

Stagflation:

 

When recession (lowering real GDP) and Inflation (increasing prices) come together; this condition is called stagflation. The U.S faced stagflation in 1970 due to the oil price shocks.

 

Equilibrium in the Classical Approach

 

The classical theory of equilibrium states that the economy regulates itself and brings about equilibrium. it is believed that the economy attains a level in real GDP, equal to the level of GDP when resources are fully utilized.

At times, the economy may exceed or fall below the real GDP, but it can recover and bring itself back to the real natural GDP. The equilibrium in the classical approach is based on the belief that wages, prices, and interest rates are flexible.

 

Invisible Hand

 

“The invisible hand” signifies the presence of unobservable or unseen forces in the free markets that create equilibrium in the demand and supply of goods and services. It means that without the interruption of governments, the producers and consumers balance the allocation of resources in society.

The “invisible hand” is a significant economic consideration because it sets a predictable pattern of supply and demand. Therefore we can consider it as a regulating force that is free from government policies and interruption.

Competition is the driving force behind this invisible hand that equalizes the market without any conscious efforts. The freedom of production and consumption enables an economy to stabilize itself. This phenomenon is known as the “invisible hand of free marketplace”.

 

Marginal Cost (MC)

 

If the cost of one unit of a good is increased, there is a change in the total cost called Marginal Cost. The cost of any extra inputs required to yield the next unit results in marginal cost at every level of production. All expenses that change with the stages of

production are considered marginal costs. A firm can maximize its profits when it produces a set where marginal cost becomes the same as marginal revenue. If we believe competitive, equilibrate short-run marginal cost is always equal to a product’s price, an extra unit at a price that covers any company can not sell its short-run marginal cost.  

 

Cost-Benefit Analysis

 

Sometimes it’s essential to analyze business or economic decisions. This process is called Cost-Benefit AnalysisBusiness Analysts (and many times economists), also called Economic Consultants, gather benefits of a particular condition and then deducts the costs incurred with that action. Models are also developed by consultants for specific situations yield results of decisions, hence helping those analysts. When marginal revenue becomes lower than the marginal cost, the company performs a cost-benefit analysis and decides to stop production.

Conclusion:

Macroeconomic equilibrium is a condition when aggregate supply and aggregate demand equalize. Researching the market’s economic conditions and the accurate analysis of available financial information enables economists and entrepreneurs to move the economy towards “Equilibrium.” It identifies the real value of goods and services available in the market. It also helps a country’s economy to grow and prosper. Without macroeconomic equilibrium, the country may have to face severe consequences such as unemployment and inflation.

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