Question

Describe the relationship of the \(A D,\) SRAS, and LRAS curves when the economy is in long-run macroeconomic equilibrium.

Short answer

In long-run macroeconomic equilibrium, the Aggregate Demand (AD), Short Run Aggregate Supply (SRAS), and Long Run Aggregate Supply (LRAS) curves all intersect at a single point. This intersection point represents an economic state where the quantity of goods and services demanded equals the quantity of goods and services supplied, and the economy is producing at its full-employment level of output.

Step-by-step solution

Understand the AD, SRAS, and LRAS curves

Firstly, each of these curves needs to be understood in isolation. The Aggregate Demand (AD) curve represents the total demand for goods and services within an economy. The Short-Run Aggregate Supply (SRAS) curve represents the total quantity of goods and services supplied by businesses in the short run. The Long-Run Aggregate Supply (LRAS) curve depicts the overall supply of goods and services when unemployment is at a natural rate.

Recognize the state of the economy in long-run equilibrium

When the economy reaches its long-run macroeconomic equilibrium, all three curves intersect at a single point. This point defines the real Gross Domestic Product (GDP) and the price level at equilibrium where the total demand equals the total supply in the economy.

Relate the AD, SRAS, and LRAS curves

In a scenario of long-run macroeconomic equilibrium, the AD, SRAS, and LRAS curves intersect at the same point. This means that the total quantity of goods and services that households, firms, and the government intend to buy (aggregate demand) equals the total quantity that its firms would like to produce (aggregate supply), and this quantity is at a level that’s consistent with its full-employment level of output (which the LRAS curve depicts).

Key concepts

Aggregate Demand

Aggregate demand ( AD ) is an essential concept in understanding the equilibrium in a country's economy. Think of aggregate demand as the total quantity of goods and services that all economic players in the economy want to purchase at a specific price level. These players include households, businesses, and the government. The aggregate demand curve is downward sloping, which means that as prices drop, consumers demand a larger quantity of goods and services.
Several factors can shift the aggregate demand curve, causing changes in the economy's output. Here are some noteworthy factors that influence aggregate demand:

• **Consumer Income**: Higher incomes increase purchasing power, boosting demand.
• **Interest Rates**: Lower interest rates reduce borrowing costs, increasing spending on investments.
• **Government Spending**: Increased government spending injects more money into the economy, shifting the demand curve to the right.
• **Foreign Exchange Rates**: A weaker currency can make exports cheaper, boosting foreign demand.

Understanding how aggregate demand functions helps in comprehending how external factors and government policies can influence the economic equilibrium.

Short-Run Aggregate Supply

Short-run aggregate supply ( SRAS ) reflects the period in which wages and some other prices are sticky or inflexible. In this short run, firms respond to price changes with variations in production level. The SRAS curve typically slopes upwards because, in the short run, higher price levels often lead to increased production as firms see higher profitability.
Short-run supply changes are driven by different elements compared to AD shifts:

• **Input Prices**: Sudden changes can shift the curve; for example, an increase in oil prices can reduce supply.
• **Wages**: Labor costs rising faster than productivity can reduce the amount a firm can supply.
• **Technology and Expectations**: Technological advancements and positive business expectations can shift supply outward as firms become more productive.

In an equilibrium scenario, SRAS meets AD at a price level where resources are efficiently employed, but some external forces can alter this balance, prompting a fresh negotiation of output and prices.

Long-Run Aggregate Supply

Long-run aggregate supply ( LRAS ) represents a more stable view of the economy's potential output. Unlike the short run, the long run implies that all input prices, including wages, have fully adjusted to changes in the economy. The LRAS curve is vertical at the natural level of output, which means that this level does not change with the price level.
Typically, the primary factors affecting LRAS shifts are the following:

• **Resource Availability**: More resources, like labor and capital, can increase potential output.
• **Technological Advancement**: Better technology allows for more efficient production, increasing output.
• **Institutional Factors**: Policies that enhance business efficiency and workforce productivity can shift LRAS to the right.

In the long-term equilibrium, the economy meets its full employment potential, where the intersection of LRAS with AD and SRAS occurs. This mix represents optimal production demand-and-supply at stable price levels.