Macroeconomic Equilibrium

Idea

The economy’s equilibrium real national income and general price level are set where aggregate demand equals aggregate supply — the intersection of the AD and AS curves. The AD–AS diagram is the central tool of macroeconomic analysis: shifts in either curve trace out growth, inflation and unemployment.

Diagram

Macroeconomic equilibrium at the intersection of AD and SRAS, setting the equilibrium general price level P0 and equilibrium real national output Y0.

Mechanism

At the intersection, the output firms are willing to supply equals the output all agents wish to demand, so there is no tendency for the general price level or real national output to change. A change in any determinant shifts a curve and moves the equilibrium:

A rightward shift of AD — from stronger consumption, investment, government spending or net exports — raises real national output and, except in the Keynesian range, the general price level. This is demand-pull: output is pulled up by demand, and where the economy nears capacity, demand-pull inflation follows.
A shift of AS — leftward from higher costs (cost-push pressure on the price level), or rightward from greater capacity — changes the price level and output in the corresponding direction.

The range of AS in which the economy sits governs how a given AD shift splits between output and prices, which is why reading the AS ranges is essential to the analysis.

Considerations

The diagram connects back to Theme 1. Actual growth — moving from a point inside the PPC towards it — appears here as a rise in real national output towards full-employment output along an unchanged AS. Potential growth — an outward shift of the PPC — appears as a rightward shift of LRAS. A full evaluation weighs which curve a policy actually moves, and over what horizon.