The concept of macroeconomic equilibrium

Macroeconomic equilibrium is the point where the total demand for goods and services in an economy matches the total supply. This balance determines key economic outcomes like price levels and output.

Where aggregate demand meets aggregate supply

Macroeconomic equilibrium happens at the intersection of the aggregate demand (AD) curve and the aggregate supply (AS) curve. The AD curve slopes downwards, showing that higher prices reduce demand, while the AS curve can vary depending on whether it is short-run or long-run.

Key characteristics of equilibrium:

• At equilibrium, the price level is P and real national output is Y.
• Any shift in either the AD or AS curve changes this point, affecting the economy differently.
• These shifts impact the government's four main macroeconomic indicators: economic growth (output), unemployment, inflation, and the balance of payments.

Effects of shifts in aggregate demand on equilibrium

Shifts in aggregate demand (AD) alter the equilibrium, but the outcomes depend on whether the economy is in the short run or long run, due to the shape of the aggregate supply (AS) curve.

Short-run effects of increasing aggregate demand

In the short run, the AS curve (SRAS) slopes upwards. An increase in AD shifts the curve rightwards from AD to AD₁.

New equilibrium outcomes:

• Higher price level (P₁) and higher output (Y₁).
• Positive impacts: Increased output boosts derived demand for labour, creating jobs and reducing unemployment.
• Negative impacts: Rising prices cause demand-pull inflation.
• A decrease in AD has the opposite effects: lower output, higher unemployment, but falling prices.

In both cases, rising prices may worsen the balance of payments.

Long-run effects of increasing aggregate demand

In the long run, the AS curve (LRAS) is vertical, as the economy operates at full capacity. An increase in AD shifts the curve rightwards from AD to AD₁.

New equilibrium outcomes:

• Higher price level (P_A) but unchanged output (still at Yf).
• No increase in output or reduction in unemployment, as resources are fully used.
• Only demand-pull inflation occurs.
• Rising prices may again harm the balance of payments.

To improve all four macroeconomic indicators simultaneously, an increase in LRAS is generally needed.

The influence of spare capacity on the multiplier effect

The multiplier effect shows how an initial increase in spending can lead to a larger rise in national income. However, its size depends on the economy's spare capacity, which affects how elastic aggregate supply (AS) is.

Elastic aggregate supply and high spare capacity

When AS is elastic (relatively flat curve), there is significant spare capacity.

An increase in AD from AD to AD₁ leads to:

• A large rise in output (from Y to Y₁).
• A small increase in prices (from P to P₁).
• The multiplier effect is strong, as the economy can handle more demand without major constraints.

Inelastic aggregate supply and low spare capacity

When AS is inelastic (steep curve), spare capacity is limited.

The same AD increase results in:

• A small rise in output (from Y to Y₁).
• A large increase in prices (from P to P₁), causing inflation.
• The multiplier effect is weak, as supply struggles to meet extra demand.

Effects of shifts in aggregate supply on equilibrium

Shifts in aggregate supply (AS) can improve or worsen all four macroeconomic indicators at once, unlike AD shifts which have mixed effects.

Short-run effects of increasing aggregate supply

An increase in short-run aggregate supply shifts the curve rightwards from SRAS to SRAS₁.

New equilibrium outcomes:

• Lower price level (P₁) and higher output (Y₁).
• Higher output drives economic growth and creates jobs, reducing unemployment.
• Falling prices reduce inflation and improve international competitiveness, potentially bettering the balance of payments.
• A decrease in SRAS worsens all indicators: lower growth, higher unemployment, inflation, and a poorer balance of payments.

Long-run effects of increasing aggregate supply

An increase in long-run aggregate supply shifts the vertical curve rightwards from LRAS to LRAS₁.

New equilibrium outcomes:

• Lower price level (P₁) and higher output (Yf₁).
• Similar to short-run effects – increased growth, maintained full employment, lower inflation, and possible balance of payments improvements.

The Keynesian perspective on aggregate supply shifts

Keynesian economists view long-run aggregate supply (LRAS) as an L-shaped curve: horizontal at low output (spare capacity), upward-sloping near full capacity, and vertical at maximum output. This affects how AD and AS shifts play out.

Effects of increasing aggregate demand on Keynesian LRAS

Different outcomes depending on the economy's position:

• If AD increases from AD to AD₁, there's an increase in price but no increase in output, corresponding to an economy at full capacity.
• If AD increases from AD₂ to AD₃, there's an increase in output but no increase in prices, corresponding to an economy deep in depression.
• If AD increases from AD₃ to AD₄, there are increases in both output and prices, corresponding to an economy operating just under full capacity.

Effects of increasing aggregate supply on Keynesian LRAS

An increase from LRAS to LRAS₁ changes equilibrium depending on AD position.

Impact varies by demand level:

• If AS increases from LRAS to LRAS₁, there is a change in the macroeconomic equilibrium if AD is at either AD₀ or AD₁.
• However, if AD is at AD₂, then there is no change in the equilibrium.

Keynesians argue that boosting AS during a depression is ineffective, as it won't increase output or employment without higher demand.