The Reasons for Disequilibria in AS/AD Systems - Coursework Example

4 The Reasons for Disequilibria in AS/AD Systems Supply and demand is a familiar concept that is commonly discussed in introductory microeconomics texts. It suggests that the prices of any single item reach higher levels when larger numbers of individuals consume the item and lower levels when fewer numbers of individuals consume the item. This results in the establishment of equilibrium between price and quantity. When discussing entire economies, incorporating the production of not just one but many consumables, the microeconomic concept of supply and demand is expanded into the concept of Aggregate Supply and Aggregate Demand, commonly referred to as the AS/AD model (Evans, 1999, p.1). The AS/AD model is somewhat more difficult to predict and manipulate than a simple supply and demand model, and disequilibria may exist between aggregate supply and aggregate demand causing a chain reaction of price increases or decreases. This is caused by the fundamental difference between an isolated commodity and a total population of commodities produced within an economic system. Outside influences, such as public policy and industry specific goals that affect real economies must also be considered, as may be clearly observed through simple discussion of the mathematics associated with disequilibria of the AS/AD model. Microeconomics sets the standard for supply and demand by observing the price of only a single commodity. The field of microeconomics generally concerns itself with only the relative price, as opposed to real or nominal value (Colander, 2007, p.5). Because the relative price is the price in comparison to other prices assumed to be from the same scale, it is not useful for comparing products across different scales, such as different time periods, and makes no account for economic phenomena such as inflation. In macroeconomics it is necessary to observe not the relative price, but instead the price level, whose dynamics are fundamentally different than those of relative prices (Colander, 2007, p.5). This is a fundamental difference that accounts for much of the disequilibria associated with the AS/AD model when compared to microeconomic applications of supply and demand. The first macroeconomics texts of the twentieth century did not included aggregate supply and aggregate demand as topics. Instead, as increasing numbers of economics experts were converted away from classical economics to Keynesian economics during this period, an Aggregate Expenditure and Production Curve was commonly used to depict the multiplier process seen in economic systems that was discussed by Keynes in The General Theory. The widespread adoption of many Keynesian economic ideas resulted from the Great Depression (Yates, 2003, p.135). The graph of this model was generally called the Keynesian cross (also the AE/AP model), which was used to determine aggregate equilibrium when price level was assumed fixed (Colander, 2007, p.2). The AE/AP model was widely used until mid century, when the necessity to account for modern trends of inflation in general macroeconomics led to the widespread adoption of the AS/AD model (Colander, 2007, p.3). These models more accurately reflected changes in an economy over time. The AS/AD model has two variables, aggregate supply and aggregate demand which may be in a state of disequilibria. Aggregate demand refers to the entire demand, which combines the purchase of products and services as well as other investments within an economy over a fixed period of time (“Aggregate Demand”, 2010). Similarly, aggregate supply measures the total volume of products and services, as well as other investments that an economy is producing at a given overall price level (“Aggregate Supply”, 2010). In terms of the macroeconomic AS/AD model, it can be stated that depression is caused when sufficient aggregate demand for newly developed output does not exist (Yates, 2003, p.135). Using the AS/AD model economies can only exist in four states: Keynesian unemployment, classical unemployment, repressed inflation, or under-consumption (Lambert, 1988, p.6). As such, an economy can be characterized by either limited demand or limited supply. Understanding the mathematical treatment for AS/AD can make clear the factors that cause disequilibria in the model. The AS/AD model is generally expressed as two curves plotted where the real national output is located on the x-axis (often the GDP) and the price level (often the inflation rate) is located on the y-axis (Evans, 1999, p.1). The aggregate supply is normally a curve that is influenced by changes in the size and quality of labour, capital investment, and producer taxes and subsidies as well as technological progress, unit wage costs, and societal expectations of inflation (“Aggregate Supply”, 2010). The aggregate demand line normally has a negative slope that is influenced by real rates of returns on investments, consumption, business confidence, political priorities, international competitiveness, and growth of national income (“Aggregate Demand”, 2010). Normally, the two curves intersect to form an equilibrium point, which neoclassic economist would argue always exists. Keynes, however, had the idea that some markets will not be in equilibrium (McCain 2010). Many reasons exist why an economy might not be in equilibrium, commonly referred to as a state of disequilibrium. Disequilibria can results from a sudden decrease in aggregate demand, such as that which results when a major export product is no longer needed by a foreign country due to war, embargo, or other causative global factors (McCain, 2007). Neoclassic economics would predict that that new equilibrium point, where the new aggregate demand line meets the aggregate supply line, would be reached. In practice, many individual companies may not reduce their price level—or may be cautious is doing so, results in price drops that are not immediately implemented—according to demand as predicted due to fear of permanent price reduction or loss of position in the global market (McCain, 2007). Disequilibria can result from sudden decreases in aggregate demand, largely influenced by the economy’s interactions with other global economies. Policy may also play a role in establishment of disequilibria in AS/AD models. In the former example, when aggregate demand suddenly drops, a government entity may step in to buy excess product in order to keep prices stable until such a time as demand returns to normal (McCain, 2007). An example of this can be seen in agricultural industries that produce large export crops. If the country to which the crop is exported no longer needs the crop, beginning to produce the crop themselves, or finds another supplier of the crop, government bodies often step in to help maintain the price, particularly if the low demand situation is expected to be temporary. A government body might also intercede in order to prevent aggregate supply and aggregate demand from reaching their mathematical equilibrium to prevent the decline in needed labour that would lead to loss of employment. Sudden price reductions could mean significant layoffs for workers resulting from the decline in the demand for labour, resulting in and additional decline in income. The overall decline in income affects not just one industry, even if the original reduction in demand was industry specific, such as in the agricultural example. Instead, this decline in income then could produce a secondary reduction in demand across many other industries resulting in an uncontrolled downward spiral in production and demand (McCain, 2007). Because of the economic significance of this effect, many governments across the globe now utilize small disequilibrium macro models to elaborate and determine economic trends that have a strong influence over policy (Lambert, 1988, p.6).This would result in a state of depression if not external entity, such as a government body, intervened. This is the concept that Keynes explored, resulting in deviation from the idea of traditional supply and demand equilibrium and the creation of the term “general disequilibria”. In this model, if aggregate demand is set above aggregate supply and this situation is maintained, such as when the average rate of interest falls below the normal rate and is maintained there, no matter how small the gap, a trend of rising prices will begin that will continue infinitely. If, conversely, aggregate demand is set below aggregate supply, the prices will drop infinitely (McCain, 2007). New Classical critics of the idea of general disequilibria would argue that if external factors, such as companies not wanting to sell below some fixed price, would actually result in a modification to the supply line, making it horizontal at that point, accounting for a “new” equilibrium point (McCain, 2007). Despite some critics, this theory of disequilibria in aggregate supply and aggregate demand has a large influence over contemporary national economic policies in a number of countries across the globe. Keynes built upon the ideas of other economists in establishing a theory for disequilibria. Most notably, Keynes was both a critic and contributor to Pigou’s work, including the idea of the Pigou curve that represents the relationship between the rate of inflation and the growth of GDP (McCain, 2007). The Keynesian approach is one of aggregate demand, showing that the GDP is independent of price level, and thus the Pigou curve appears vertical. It is logical to think about the curve for aggregate supply as being a vertical line over a long period because the aggregate supply takes into account the production potential of an economy—such as available labour, factories, and equipment—which cannot drastically increase over a short time, and can only drastically decrease in extremely rare cases of large scale disaster, such as either of the World Wars (“Aggregate Supply”, 2010). This means that over long periods, aggregate supply is independent of the price level but will shift as productive capacity increases or decreases. Though this may not always be true, it was particularly applicable to the period in the 1930s when Keynes was writing (McCain, 2007). Aggregate supply and aggregate demand systems experience disequilibria in terms of the simple supply and demand system; however, Keynesian economics argues that it is normal for an aggregate systems to proceed towards the “general disequilibria” point. Disequilibria may be brought about by sudden or dramatic changes in the aggregate supply or aggregate demand, which respectively affect the productive capacity and the overall ability to consume producible goods. If not controlled by policy or intervention by outside forces, such as a government entity, disequilibria may propagate itself leading to an economic depression. For this reason, models for disequilibria in AS/AD systems play an important part in global economic policy. References “Aggregate Supply”. (2010) Tutur2u Resources. Retrieved from http://tutor2u.net/economics/content/topics/ad_as/ad-as_notes.htm “Aggregate Demand”. (2010) Tutur2u Resources. Retrieved from http://tutor2u.net/economics/content/topics/ad_as/ad-as_notes.htm Colander, David. (2007) The Textbook Aggregate Demand Curve. Middlebury College. Retrieved from http://community.middlebury.edu/~colander/articles/The%20Textbook %20Aggregate%20Demand%20Curve.pdf Evans, Gary R. (1999) HMC Course Material: Chapter two. Retrieved from http://www2.hmc.edu/~evans/chap2.pdf Lambert, Jean-Paul. (1988) Disequilibrium Macroeconomic Models: Theory and estimation of rationing models using business survey data. New York: Cambridge University Press Archive. McCain, Roger. (2007) Essential Principles of Economics: A Hypermedia Text. Retrieved from http://faculty.lebow.drexel.edu/McCainR//top/prin/txt/EcoToC.html Yates, M. D. (2003). Naming the system: Inequality and work in the global economy. New York: Monthly Review Press. Read More