How aggregate demand and aggregate supply determine equilibrium

Overview

Difference between short-run and long-run macroeconomic equilibrium and macroeconomic equilibrium occur alongside substantial unemployment.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define macroeconomic equilibrium and describe how it is shown on a diagram.

   Model answer

   Macroeconomic equilibrium occurs where aggregate demand equals aggregate supply, so that total planned spending on domestic output exactly matches the output firms are willing to produce. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, it is the point where the downward-sloping aggregate demand curve crosses the aggregate supply curve. That intersection determines both the equilibrium general price level and the equilibrium level of real national output.

2. 2

   Explain what the intersection of the aggregate demand and aggregate supply curves determines, and what it does not.

   Model answer

   It determines the general price level and the level of real national output at which the economy settles. It does not determine that this output is desirable: the equilibrium may lie well below the economy's productive potential, leaving heavy unemployment, or above the level that can be sustained without accelerating inflation. Equilibrium means only that plans to spend and plans to produce are consistent.

3. 3

   Explain the process that pushes the economy towards equilibrium when the general price level is above the equilibrium level.

   Model answer

   At a price level above equilibrium, the quantity of real output supplied exceeds the quantity demanded, because higher prices widen firms' margins while discouraging spending through the real balance, interest rate and international trade effects. Firms find goods unsold and stocks accumulating beyond what they planned. They respond by cutting prices to clear stock and reducing output, so on a diagram with the general price level on the vertical axis and real national output on the horizontal axis the economy slides down the aggregate supply curve until the two curves intersect.

4. 4

   Explain the process that pushes the economy towards equilibrium when the general price level is below the equilibrium level.

   Model answer

   Below the equilibrium price level, the quantity of real output demanded exceeds the quantity supplied, because spending is high while narrow margins discourage production. Firms find stocks running down faster than expected and order books lengthening. They raise prices and expand output, so the economy moves up along the aggregate supply curve, with the general price level on the vertical axis and real national output on the horizontal axis, until planned spending and planned output are equal.

5. 5

   At a general price level of 110, an economy's firms would supply real output of 2,060 billion pounds while buyers would demand 1,950 billion pounds. Calculate the excess and state what happens next.

   Model answer

   Excess supply = 2,060 - 1,950 = 110 billion pounds of output produced but not bought. Stocks build up beyond what firms intended, so they cut prices to shift them and reduce production. The general price level and real output both fall until the two curves intersect and the excess is eliminated.

6. 6

   At a general price level of 100, real output demanded is 2,080 billion pounds while real output supplied is 1,940 billion pounds. Calculate the excess and describe the adjustment.

   Model answer

   Excess demand = 2,080 - 1,940 = 140 billion pounds. Firms cannot meet orders from current production, so stocks are run down and waiting lists lengthen. Prices are bid up, which widens margins and encourages firms to expand output, so the economy moves up along the aggregate supply curve to equilibrium at a higher price level and a higher real output.

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