The concept of macroeconomic equilibrium

Macroeconomic equilibrium refers to the point where the total amount of goods and services demanded in an economy equals the total amount supplied.

How macroeconomic equilibrium is determined

Macroeconomic equilibrium occurs at the intersection of the aggregate demand (AD) curve and the aggregate supply (AS) curve.

At this point:

• The economy achieves a specific price level and level of output on the short-run aggregate supply (SRAS) curve.
• Any shift in either the AD or AS curve alters this equilibrium, leading to a new balance at a different price level or output.
• These shifts influence key economic indicators, but the exact effects depend on whether AD or AS is changing.

Short-run effects of changes in aggregate demand

In the short run, changes in aggregate demand (AD) primarily affect output and prices, with varying impacts based on the economy's capacity and the shape of the aggregate supply (AS) curve.

Effects of an increase in aggregate demand

When AD increases, shifting the curve to the right, the new equilibrium results in a higher price level and greater output. Higher output creates more jobs, reducing unemployment. Prices rise, leading to demand-pull inflation.

The extent of these changes depends on the elasticity of AS:

• Elastic AS - Indicates significant spare capacity in the economy, allowing a large increase in output through the multiplier effect, with a smaller rise in prices.
• Inelastic AS - Suggests limited spare capacity, resulting in a smaller output increase but a larger price rise (higher inflation). If the economy is already near full capacity, the multiplier effect is minimal.

Effects of a decrease in aggregate demand

A leftward shift in AD has the reverse impacts:

• Output falls.
• Unemployment rises.
• Price levels decrease.

Effects of shifts in aggregate supply

Shifts in aggregate supply (AS) have widespread effects on the economy, simultaneously influencing all major macroeconomic indicators.

Impacts of an increase in aggregate supply

A rightward shift in AS:

• Boosts the economy's overall capacity.
• Increases output, promoting economic growth.
• Generates more employment opportunities, lowering unemployment.
• Tends to reduce price levels, helping to control inflation.
• Enhances international competitiveness, which can improve the balance of payments.

Impacts of a decrease in aggregate supply

A leftward shift in AS worsens economic conditions:

• Reduces output and capacity.
• Increases unemployment.
• Raises price levels.
• Weakens the balance of payments.

Long-run effects of aggregate supply changes

In the long run, aggregate supply is represented by the long-run aggregate supply (LRAS) curve, which is vertical and reflects the economy's full productive capacity. Changes here focus on sustainable growth without relying on short-term demand fluctuations.

Effects of an increase in long-run aggregate supply

A rightward shift in LRAS:

• Increases output while maintaining full employment.
• Lowers the price level.
• Improves the balance of payments through greater competitiveness.

Effects of shifts in AD along the LRAS curve:

• An increase in AD raises prices but leaves output unchanged.
• A decrease in AD lowers prices but similarly does not affect output.

To enhance all four key macroeconomic indicators (growth, employment, stable prices, and balance of payments) at once, an increase in LRAS is essential.

Keynesian perspectives on aggregate supply and demand

The Keynesian view of aggregate supply differs from the classical vertical LRAS curve, presenting it as L-shaped to reflect varying economic conditions. This perspective emphasises how demand and supply interact differently depending on the economy's state.

Effects of increases in aggregate demand under Keynesian theory

The impact varies by economic phase:

• At full capacity - Prices rise, but output stays the same.
• In depression (low output) - Output increases without affecting prices.
• Just below full capacity - Both output and prices rise.

Effects of increases in aggregate supply under Keynesian theory

Shifting AS rightward has different outcomes based on AD levels:

• If AD is at or near full capacity, the equilibrium shifts to higher output and lower prices.
• If AD is at depression levels, there is no change in equilibrium.
• Increasing AS during a depression offers little benefit, as it fails to boost output or employment without corresponding demand increases.