Macroeconomic equilibrium for an economy in the short run is established when aggregate demand intersects with short-run aggregate supply. This is shown in the diagram below
At the price level Pe, the aggregate demand for goods and services is equal to the aggregate supply of output. The output and the general price level in the economy will tend to adjust towards this equilibrium position.
If the price level is too high, there will be an excess supply of output. If the price level is below equilibrium, there will be excess demand in the short run. In both situations there should be a process taking the economy towards the equilibrium level of output.
Consider for example a situation where aggregate supply is greater than current demand. This will lead to a build up in stocks (inventories) and this sends a signal to producers either to cut prices (to stimulate an increase in demand) or to reduce output so as to reduce the build up of excess stocks. Either way - there is a tendency for output to move closer to the current level of demand.
There may be occasions when in the short run, the economy cannot meet an increase in demand. This is more likely to occur when an economy reaches full-employment of factor resources. In this situation, the aggregate supply curve in the short run becomes increasingly inelastic.
The diagram below tracks the effect of this. We see aggregate demand rising but the economy finds it difficult to raise (expand) production. There is a small increase in real national output, but the main effect is to put upward pressure on the general price level. Shortages of resources will lead to a general rise in costs and prices
Impact of a change in aggregate supply
Suppose that increased efficiency and productivity together with lower input costs (e.g. of essential raw materials) causes the short run aggregate supply curve to shift outwards. (I.e. an increase in supply - assume no shift in aggregate demand).
The diagram below shows what is likely to happen. AS shifts outwards and a new macroeconomic equilibrium will be established. The price level has fallen and real national output (in equilibrium) has increased to Y2.
Aggregate supply would shift inwards if there is a rise in the unit costs of production in the economy. For example there might be a rise in unit wage costs perhaps caused by higher wages not compensated for by higher labour productivity.
External economic shocks might also cause the aggregate supply curve to shift inwards. For example a sharp rise in global commodity prices. If AS shifts to the left, assuming no change in the aggregate demand curve, we expect to see a higher price level (this is known as cost-push inflation) and a lower level of real national output.
Impact of a shift in aggregate demand
In the diagram below we see the effects on an inward shift in aggregate demand in the economy. This might be caused for example by a decline in business confidence (reducing planned investment demand) or a fall in United Kingdom exports following a global downturn. It might also be caused by a cut in government spending or a rise in interest rates which leads to cutbacks in consumer spending.
The result of the inward shift of AD is a contraction along the short run aggregate supply curve and a fall in the real level of national output. This causes downward pressure on the general price level.
If aggregate demand shifts outwards (perhaps due to increased business confidence, an economic upturn in another country, or higher levels of government spending), we expect to see both a rise in the price level and higher national output.
National Income Equilibrium when Aggregate Supply is Perfectly Elastic
When short run aggregate supply is perfectly elastic, any change in aggregate demand will feed straight through to a change in the equilibrium level of real national output. For example, when AD shifts out from AD1 to AD2 (shown in the diagram below) the economy is able to meet this increased demand by expanding output. The new equilibrium level of national income is Y2. Conversely when there is a fall in total demand for goods and services (AD1 shifts inwards to AD3) we see a fall in real output.
Long Run Economic Growth
We have considered short-term changes in both aggregate demand and aggregate supply. For an economy to experience sustained economic growth over the longer run it must shift out the long run aggregate supply curve by either increasing the supply of factors of production available (e.g. an increase in the labour supply, more land and more capital inputs); increasing the productivity of those factors or the economy might increase LRAS by achieving an improvement in the state of technology.
An outward shift in the LRAS is similar to an outward shift in the production possibility frontier.
The effects are shown in the diagram below. If LRAS shifts out the economy can operate at a higher level of aggregate demand and can achieve an increase in real national output without running into problems with inflation.
One of the main long-term economic objectives of the current Labour government is to raise the economy's productive potential and therefore provide a platform for faster economic growth in future years. For this to happen the economy needs to achieve a higher level of investment in new capital and new technology. And the quantity and productivity of the labour force also needs to increase over time.
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