Equilibrium Long-Run Aggregate Market

The graph to the right can be used to illustrate equilibrium in the long-run aggregate market. First, to set up the graph, the vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). The negatively-sloped curve, labeled AD, is the aggregate demand curve and the vertical curve, labeled LRAS, is the long-run aggregate supply curve. Long-run equilibrium is the price level and real production obtained at the intersection of the AD and LRAS curves.

Because the LRAS curve is vertical at full-employment real production, long-run equilibrium necessarily occurs at full employment, regardless of shifts in the AD curve or changes in the price level. To demonstrate that long-run equilibrium occurs at the same full-employment level of real production should aggregate demand change, click the [AD Increase] and [AD Decrease] buttons. An increase in aggregate demand leads to a higher price level, but the same level of real production. A decrease in aggregate demand leads to a lower price level, but also the same level of real production.

Long-run aggregate market equilibrium means that there are no economy-wide product market shortages or surpluses. However, this does not necessarily mean that ALL product markets are in equilibrium. A complex economy, like that in the United States, is bound to have shortages in some product markets and surpluses in others, even in long-run equilibrium. As such, prices in some markets rise, while those in other markets fall.

These sorts of imbalances in specific markets reflect the ongoing reallocation of resources at the microeconomic level. What is required for aggregate market equilibrium at the macroeconomic level is that the microeconomic shortages and surpluses cancel out, that rising prices cancel falling prices, that the price level and real production do not change.

By far the most important implication of long-run equilibrium is full employment. Long-run price flexibility ensures that resource markets are in balance, with NO economy-wide shortages or surpluses. In particular, there is no cyclical unemployment or overemployment. Resource market equilibrium is what generates a LRAS curve that is vertical at full-employment real production. And because the LRAS curve is vertical at full-employment real production, long-run equilibrium, the intersection of the AD and LRAS curves, MUST result in full employment. The economy produces NOTHING BUT full-employment real production in the long run.