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The core idea is that the market will be eventually be cleared of all surpluses and shortages (excess supply and demand). The first version assumes that this process occurs instantaneously.
If, for example, a community is subject to a terrorist attack, its members might become more anxious and insecure, leading to an increased demand for means of protection (such as weapons). The market will be temporarily out of equilibrium, suffering from an excess demand (shortage). But if markets are free to operate (i.e., if prices are free to change), and given enough time, prices will increase causing (1) manufacturers to produce more weapons in the short run and (2) new companies to enter the market in the longer run. This increase in production brings supply into balance with the new demand. The adjustment mechanism has cleared the shortage from the market and established a new equlibrium. A similar mechanism is believed to operate when there is a market surplus (glut), where prices fall to end the excess supply.
For 150 years (from approximately 1785 to 1935), the vast majority of economists -- the classical or neoclassical school -- took the smooth operation of this market-clearing mechanism as inevitable and inviolate, based largely on faith in Say's law. But the Great Depression of the 1930s caused many economists, including John Maynard Keynes, to doubt their classical faith. If markets were supposed to clear, how could ruinously high rates of unemployment persist for so many painful years? Was the market mechanism not supposed to eliminate such surpluses? In one interpretation, Keynes identified imperfections in the adjustment mechanism that, if present, could introduce rigidities and make prices sticky. In another interpretation, price adjustment could make matters worse, causing what Irving Fisher called " debt deflation". Not all economists accept these theories. They attribute what appears to be imperfect clearing to factors like labor unions or government policy, thereby exonerating the clearing mechanism.
Most economists see the assumption of continuous market clearing as not very realistic. However many see the assumption of flexible prices as useful in long-run analysis, since prices are not stuck forever: market-clearing models describe the equilibrium towards which the economy gravitates. Therefore, many macroeconomists feel that price flexibility is a good assumption for studying long-run issues, such as growth in realIn economics, the distinction between nominal and real numbers is often made. It corresponds to the distinction between money and inflation-corrected numbers. Nominal numbers such as nominal wages, interest rates and gross domestic product (GDP) refer to GDPIn economics, the gross domestic product GDP is a measure of the amount of the economic production of a particular territory in financial capital terms during a specific time period. Definition GDP is defined as the total value of all goods and services p. Other economists argue that price adjustment may take some much time that the process of equilibration may change the underlying conditions that determine long-run equilibrium. That is, there may be path dependenceIn economics, path dependence refers to the view that any economic process does not progress steadily toward some pre-determined and unique equilibrium. Rather, initial conditions determine the path followed and the final result. Path dependence is someti, as when a long depression changes the nature of the " full employmentIn economics, full employment has more than one meaning. To many laypeople, it means zero unemployment or underemployment. To economists, it means the lowest level of unemployment that can be sustained given the structure of the economy. In standard macro" period that follows.
In the short run (and possibly in the long run), markets may find a temporary equilibrium at a price and quantity that does not correspond with the long term market clearing equilibrium. For example, in the theory of " efficiency wagesIn labor economics, the efficiency wage hypothesis argues that wages are determined by more than simply supply and demand. Specifically, it points to the incentive for managers to pay their employees more than the market-clearing wage in order to increase," a labor market can be in equilibrium above the market-clearing wage, since each employer has the incentive to pay wages above market-clearing to motivate their employees on the job. In this case, equilibrium wages (where there is no endogenousIn an economic model, an endogenous change is one that comes from inside the model and is explained by the model itself. For example, in the simple supply and demand model, suppose that there is a change in consumer tastes or preferences (an exogenous cha tendency for wages to change) would not be the same as market-clearing wages (where there is no classical unemployment).