Long-run equilibrium

Definition

Long-run equilibrium refers to a state in which all economic forces are balanced, leading to stable prices and quantities in the market. In this state, supply equals demand, and there are no incentives for firms or consumers to change their behavior. This concept is particularly important when considering how variables interact over time, especially in the context of cointegration and error correction models.

5 Must Know Facts For Your Next Test

1. In long-run equilibrium, markets are efficient, and resources are allocated optimally, ensuring that all economic agents are satisfied with their decisions.
2. The concept of long-run equilibrium is essential for understanding how economies adjust to changes over time, particularly when analyzing trends and relationships between variables.
3. Long-run equilibrium often assumes that all adjustments have occurred, leading to no further economic pressures that could disturb the balance.
4. In error correction models, deviations from long-run equilibrium are corrected over time through adjustments in supply and demand.
5. The presence of cointegrated variables indicates that even if individual time series may drift apart in the short run, they will converge to a long-run equilibrium relationship.

Review Questions

• How does long-run equilibrium relate to the concepts of cointegration and error correction models?
  • Long-run equilibrium is closely linked to cointegration as it represents a stable relationship between non-stationary time series that move together over time. When two or more variables are cointegrated, it implies they share a long-run equilibrium relationship. Error correction models utilize this relationship by correcting short-term deviations back to the long-run equilibrium, illustrating how economic systems adjust to maintain stability.
• Discuss the implications of long-run equilibrium for market efficiency and resource allocation.
  • Long-run equilibrium implies that markets are efficient, meaning that supply meets demand without excess shortages or surpluses. In this state, resources are allocated optimally, as economic agents make decisions based on available information without any further incentives for change. This balance ensures stability within the economy and helps maintain consistent growth patterns over time.
• Evaluate the role of long-run equilibrium in understanding economic adjustments following shocks or changes in external conditions.
  • Long-run equilibrium plays a crucial role in evaluating how economies respond to shocks or changes in external conditions by providing a baseline for recovery. When disturbances occur, such as policy changes or economic crises, markets may deviate from this equilibrium. Understanding how quickly and effectively the economy adjusts back to long-run equilibrium helps economists predict future trends and assess the resilience of different sectors within the economy.

Related terms

Cointegration: A statistical property indicating that two or more time series move together over time, maintaining a stable relationship despite being non-stationary.

Error Correction Model (ECM): A type of econometric model that adjusts short-term fluctuations in time series data back to long-term equilibrium values.

Stationarity:

A characteristic of a time series where its statistical properties, such as mean and variance, remain constant over time.