Is it possible for all the products and services an economy produces to be in demand? What if the aggregate supply is higher than the aggregate demand? How do we find out if the aggregate demand is met by an equal aggregate supply? This is where macroeconomic equilibrium comes into the picture.
In this explanation, we will look at macroeconomic equilibrium and its types, its graph, and how to determine macroeconomic equilibrium with the help of equations.
Macroeconomic equilibrium definition
Macroeconomic equilibrium is the point where the aggregate demand curve crosses the aggregate supply curve. Aggregate supply is a measure of the total volume of goods and services produced in the economy over a given period. Aggregate demand is a measure of the total quantity of goods and services demanded in the economy over a given period.
Macroeconomic equilibrium occurs at a point where the aggregate demand meets the aggregate supply.
To learn more about the concepts of aggregate demand and supply check our explanations on Aggregate Demand and Aggregate Supply.
The macroeconomic equilibrium graph
The way we determine the equilibrium in microeconomics is at the point where demand and supply meet. Similarly, in macroeconomics, equilibrium occurs when aggregate demand meets aggregate supply.
However, equilibrium may be different in the short-run and the long-run.
The basic macroeconomic equilibrium graph is shown in Figure 1:
Figure 1. Point of Macroeconomic Equilibrium, StudySmarter Original
There are two types of aggregate supply curves in macroeconomics: short-run and long-run aggregate supply. Depending on the type of curve, the equilibrium may differ.
Short-run macroeconomic equilibrium
Short-run equilibrium is when a short-run aggregate supply curve meets the aggregate demand curve. It looks like the basic macroeconomic equilibrium because, in the short run, the aggregate supply curve is sloping upward.
In the short run, capital is fixed, but the firms may utilise other factors of production to a greater extent. This could shift the short-run aggregate supply curve. Figure 2 shows the short-run macroeconomic equilibrium.
Figure 2. Short-Run Macroeconomic Equilibrium, StudySmarter Original
Long-run macroeconomic equilibrium
Long-run macroeconomic equilibrium occurs when the long-run aggregate supply (LRAS) curve intersects the aggregate demand. When the economy is operating on its long-run aggregate supply curve, it is operating at its full productive capacity.
Additionally, actual output rarely matches the potential output exactly, as short-run aggregate supply and aggregate demand keep on changing. Hence, for the long-run macroeconomic equilibrium to occur all three curves must intersect: AD = SRAS = LRAS.
Figure 3 below shows a long-run macroeconomic equilibrium:
Figure 3. Long-Run Macroeconomic Equilibrium, StudySmarter Original
Shifts in AD and AS and their effect on macroeconomic equilibrium
Macroeconomic equilibrium represents the intersection of aggregate demand (AD) and aggregate supply (AS). Hence, with every shift in AD and AS over the short run and long run, the equilibrium changes.
Some of the factors that shift either the AD or AS curves are:
- Government policy.
- Available resources.
- Inflation or deflation.
- Taxes.
- Wages.
The shift in AD and its effect on short-run macroeconomic equilibrium
The shift in AD can change the position of macroeconomic equilibrium over the short run. These shifts can create a negative or positive demand shock in the economy.
A negative demand shock happens the aggregate demand reduces due to reduced spending or other factors and the AD curve shifts to the left reducing the price and output as shown in Figure 4 below.
Figure 4. Negative Demand Shock, StudySmarter Original
A positive demand shock happens when the aggregate demand increases due to increased spending or other factors and the AD curve shifts to the right increasing the price level and output as shown in Figure 5 below.
Figure 5. Positive Demand Shock, StudySmarter Original
The shift in AS and its effect on short-run macroeconomic equilibrium
The shift in the short-run aggregate supply (SRAS) may also change the position of macroeconomic equilibrium in the short run. Aggregate supply shock can be either positive or negative.
A positive supply shock occurs when the aggregate quantity supplied increases in the short run due to the reduction in production cost or increased labour productivity. This results in the AS curve shifting to the right as shown in Figure 6 below:
Figure 6. Positive Supply Shock, StudySmarter Original
Similarly, a negative supply shock happens when the aggregate supply reduces over a short run, and the SRAS curve shifts to the left leading to an increase in the price level and a decrease in the output in the economy as shown in Figure 7 below.
Figure 7. Negative Supply Shock, StudySmarter Original
The shift in AD and AS and their effect on long-run macroeconomic equilibrium
Long-run macroeconomic equilibrium happens when all three curves intersect: AD = SRAS = LRAS. In the long run, economists believe that the output is at its optimum and any shift in AD or SRAS may lead to a deviation from the long-run equilibrium, which gets corrected in the long run.
Let’s understand this step by step using diagrams to make it more clear:
Initially, as Figure 8.1 shows, we find a long-run macroeconomic equilibrium using AD1 = SRAS1 = LRAS1:
Figure 8.1 Long-Run Macroeconomic Equilibrium, StudySmarter Original
Let’s assume that, for some reason, demand for the products and services drops to AD2 which will be a short-run demand shock in the economy. This will lead to the demand curve (AD2) shifting to the left as Figure 8.2 shows.
Figure 8.2 Long-Run Equilibrium AD Shock, StudySmarter Original
Now a new short-run equilibrium is formed at point 'a' where AD2 intersects the SRAS1. At the new short-run equilibrium, the price falls to P2 and the output reduces to Q2. However, in the long run, eventually, the shock is reversed and supply starts to increase.
This results in the SRAS curve shifting to the right. It will continue until the SRAS creates a new equilibrium on LRAS intersecting AD2 as Figure 8.3 shows.
Figure 8.3 Long-Run Equilibrium Restored, StudySmarter Original
The economy is now back at long-run equilibrium where AD2 = SRAS2 = LRAS1 at point 'b'. Hence, the economy self corrects in the long run when short-run aggregate demand shocks occur.
The whole concept of macroeconomic equilibrium can be understood with the example of iPhones. Initially, when Apple launches a new series, say iPhone X, the demand is huge and supply is not equal to demand.
This creates a positive demand shock for the iPhone X, so the supply needs to increase to meet the demand to create a short-run macroeconomic equilibrium.
However, as time passes, Apple is able to meet the demand for the iPhone X series over the long run, which eventually creates the long-run macroeconomic equilibrium.
The three types of macroeconomic equilibrium
There are three types of macroeconomic equilibrium which are based on SRAS, LRAS, and AD.
The full-employment equilibrium
When all the available resources are fully utilised, the potential output is equal to the actual output and when there is no excess or deficit in the demand, this is when we say the economy has achieved full employment equilibrium.
Macroeconomic Equilibrium: The recessionary gap
The recessionary gap occurs when the actual output is less than the potential output taking into consideration the aggregate demand and short-run aggregate supply and also long-run aggregate supply.
It is also called the deflationary gap or negative output gap.
However, here AD = SRAS ≠ LRAS, and the LRAS is to the right of the SRAS and AD equilibrium.
Figure 9. Negative Output Gap, StudySmarter Original
Macroeconomic Equilibrium: The inflationary gap
When the actual output is greater than the potential output, we see a positive output gap, which is also known as the inflationary gap. Again, here AD = SRAS ≠ LRAS and the LRAS is to the left of the SRAS and AD equilibrium.
Figure 10. Positive Output Gap, StudySmarter Original
Macroeconomic Equilibrium - Key takeaways
- Macroeconomic equilibrium occurs at the point where the aggregate demand meets the aggregate supply.
- Equilibrium may be different over the short run and the long run.
- The long-run equilibrium occurs where AD = SRAS = LRAS.
- A negative demand shock is when the aggregate demand falls and the AD curve shifts to the left reducing the price and output.
- A positive demand shock is when the aggregate demand increases and the AD curve shifts to the right increasing the price level and output.
- A negative supply shock occurs when the aggregate supply falls and the AS curve shifts to the left. This lead to an increase in price level and a decrease in the output in the economy.
- A positive supply shock occurs when the aggregate supply increases and the AS curve shifts to the right. This leads to a fall in price levels and an increase in the output in the economy.
- The three types of macroeconomic equilibrium are:
- Full employment equilibrium.
- Recessionary gap.
- Inflationary gap.
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