2.4.3 Equilibrium levels of real national output

Question 1

Where does macroeconomic equilibrium occur?

Answer 1

Where the AD and AS curves cross. E.g. at price level P and output Y on the SRAS curve below

Question 2

How do shifts in aggregate demand affect equilibrium levels of real national output in the short run.

Answer 2

• This graph shows a SRAS curve with an AD curve.
• When there’s an increase in aggregate demand and the AD curve shifts from AD to AD1, the new equilibrium point will be at price level P1 and output Y1.
• There’s been an increase in output, which will lead to an increase in derived demand, so more jobs are created and unemployment is reduced.
• But there has also been rises in prices – this is ‘demand-pull’ inflation.
• A decrease in AD will have the opposite effect – output will be reduced and there will be an increase in unemployment, but price levels will fall.

Question 3

How do shifts in aggregate demand affect equilibrium levels of real national output in the long run.

Answer 3

• This graph shows an LRAS curve along with an AD curve.
• Now when the AD curve shifts from AD to AD1, the new equilibrium point will be at price level P1, but the output hasn’t changed (and unemployment cannot fall) – because the economy is already running at full capacity.
• So the only effect is that prices rise – an example of ‘demand-pull’ inflation.

Question 4

How do shifts in aggregate demand affect equilibrium levels of real national output in the short run.

Answer 4

• This graph shows an AD curve with a SRAS curve shifting.
• An increase in AS (shown by a shift to the right from SRAS to SRAS1) will lead to an increase in the capacity of the economy. This will result in an increase in output – so there’s increased economic growth. There will be more jobs, reducing unemployment. The price level will tend to fall and the economy will become more competitive internationally, improving the balance of payments.
• On the other hand, a decrease in AS would worsen the state of all four macroeconomic indicators.

Question 5

How do shifts in aggregate demand affect equilibrium levels of real national output in the long run.

Answer 5

• If LRAS increases (from LRAS to LRAS1), then in the long run output is increased, the price level falls, the balance of payments will potentially improve and the economy remains at full employment.
• So a shift of the LRAS curve will also tend to cause all four macroeconomic policy indicators to improve or worsen at the same time.

Question 6

Effects of an increase in AD on the Keynesian LRAS curve

Answer 6

If AD increases from AD1 to AD2, the effects are the same as those seen in the classical LRAS – there’s an increase in prices but no increase in output. This corresponds to an economy that’s already operating at full capacity.

If AD increases from AD3 to AD4, then there’s an** increase in output but no increase in prices**. This corresponds to an economy deep in depression.

If AD increases from AD5 to AD1, then there are increases in both output and price. This corresponds to an economy operating just under full capacity.