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General Equilibrium

General equilibrium is a concept in macroeconomics that seeks to explain the behaviour of an entire economy with respect to its various interacting markets. The basic theory generally includes the goods market and the money market. Both these markets must be in equilibrium to form a general equilibrium. The goods market is represented by the equilibrium between investment and savings. This determines an equilibrium interest rate. This equilibrium interest rate is affected by changes in GDP negatively. In an open economy, the interest rate is determined by the world and the goods market then determines the exchange rate instead. The money market equilibrium is when money supply equals money demand. This gives an equilibrium interest rate which is positively correlated with GDP. The intersection of the money market (LM Curve) and goods market (IS Curve); when they both use the same equilibrium interest rate (or exchange rate depending on the type of economy) is general equilibrium. From this relationship, we can derive aggregate demand

 

Aggregate demand is the relationship between the price level and the real GDP of an economy at a given time. This general equilibrium can be thought of as a long run macroeconomic equilibrium when the economy is at full employment. A shock to this economy would cause a change in either the IS or LM curve and then result in a change in the aggregate demand function. The economy initially moves to a short run macroeconomic equilibrium defined by the property of an inability for the price level to adjust. Afterwards, long run macroeconomic equilibrium is achieved when price levels adjust which is reflected by a shift of the LM curve causing a return to full employment. 

Macroeconomic equilibrium has two conditions. The first is that the desired aggregate expenditure is equal to actual GDP. This simply means that households are willing to purchase what is being produced (aggregate demand). The second condition is that firms must want to produce the current level of GDP (aggeregate supply). The conditions are fulfilled when both curves intersect.

If price levels are too high, then there is an excess supply of output and there is an increase in unsold stocks for producers. This means that producers need to cut back on production to avoid excess in inventories. When the price level is below equilibrium, there is an excess demand in the short run, which signals to producers to expand output. Shortages of resources will also lead to a general rise in costs and prices.

Changes in macroeconomic equilibrium shows how the economy reacts to shocks to the real GDP and price level. Aggregate demand and supply shocks are described by how they impact real GDP. Positive shocks increase equilibrium GDP and negative shocks reduce equilibrium GDP.

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