8.3 Macroeconomic Equilibrium

Question 1

What is Macroeconomic Equilibrium?

Answer 1

Macroeconomic equilibrium occurs at the intersection of the AD and AS curves and determines the equilibrium values for real GDP and the price level.

Question 2

What does a graph of macroeconomic equilibrium look like?

Answer 2

Question 3

What combination of factors are the demand and supply behavior consistent?

Answer 3

Only at the combination of real GDP and price level given by the intersection of the AS and AD curves are demand behaviour and supply behaviour consistent.

Question 4

What two conditions must be satisified for macroeconomic equilibrium to be present?

Answer 4

• At the prevailing price level, desired aggregate expenditure must be equal to actual GDP. The AD curve is constructed in such a way that this condition holds everywhere along it.
• The second requirement for macroeconomic equilibrium is introduced by consideration of aggregate supply. At the prevailing price level, firms must want to produce the prevailing level of GDP, no more and no less. This condition is fulfilled everywhere along the AS curve. Only where the two curves intersect are both conditions fulfilled simultaneously.

Question 5

What can the aggregate demand and aggregate supply curves now be used to understand?

Answer 5

The aggregate demand and aggregate supply curves can now be used to understand how various shocks to the economy change both real GDP and the price level.

Question 6

What is a shift in the AD curve called?

Answer 6

A shift in the AD curve is called an aggregate demand shock.

A rightward shift in the AD curve is an increase in desired aggregate spending at any given price level; this is a positive shock.

Similarly, a leftward shift in the AD curve is a decrease in desired aggregate spending at any given price level; this is a negative shock.

Question 7

What causes a shift in the AS curve. What is it called?

Answer 7

Also as indicated earlier, a shift in the AS curve caused by an exogenous force is called an aggregate supply shock.

A rightward shift in the AS curve is an increase in aggregate supply; at any given price level, more real GDP will be supplied. This is a positive shock.

A leftward shift in the AS curve is a decrease in aggregate supply; at any given price level, less real GDP will be supplied. This is a negative shock.

Question 8

What are aggregate demand and supply shots labelled according to?

Answer 8

Aggregate demand and supply shocks are labelled according to their effect on real GDP. Positive shocks increase equilibrium GDP; negative shocks reduce equilibrium GDP.

Question 9

What does an increase in aggregate demand mean?

Answer 9

An increase in aggregate demand means that more domestic output is demanded at any given price level.

Question 10

What does an increase/decrease in aggregate demand do to the price level and real GDP?

Answer 10

An increase in aggregate demand causes both the price level and real GDP to rise in the new macroeconomic equilibrium. Conversely, a decrease in demand causes both the price level and real GDP to fall.

Question 11

What does a shift in the AD cruve look like on a graph?

Answer 11

Question 12

What direction does a shift in AD cause price levels and real GDP to move in?

Answer 12

Shifts in aggregate demand cause the price level and real GDP to move in the same direction.

Aggregate demand shocks cause the price level and real GDP to change in the same direction; both rise with an increase in aggregate demand, and both fall with a decrease in aggregate demand.

Question 13

What does the simple multplier determin in terms of a shift in the AD curve?

Answer 13

We saw earlier in this chapter that the simple multiplier determines the size of the horizontal shift in the AD curve in response to a change in autonomous expenditure.

Question 14

If price level remains constant and firms supply all that is demanded at existing price lever, what does the simple multiplier determine?

Answer 14

If the price level remains constant and firms supply all that is demanded at the existing price level (as would be the case with a horizontal AS curve), the simple multiplier determines the increase in equilibrium real GDP.

Question 15

But what happens to the simple multplier in the more usual case in which the AS curve slopes upward?

Answer 15

When the AS curve is positively sloped, the change in real GDP caused by a change in autonomous expenditure is no longer equal to the size of the horizontal shift in the AD curve.

Part of the expansionary impact of an increase in demand is dissipated by a rise in the price level, and only part is transmitted to a rise in real GDP.

Of course, an increase in output does occur; thus, a multiplier may still be calculated, but its value is not the same as that of the simple multiplier.

Question 16

Why is the multiplier smaller when the price level is constant?

Answer 16

An increase in autonomous expenditure causes the AE curve to shift upward, but the rise in the price level causes it to shift part of the way down again. Hence, the multiplier is smaller than when the price level is constant.

Question 17

What will the ultimate change in real GDP look like if an aggregate demand shock leads to a change in price level?

Answer 17

If an aggregate demand shock leads to a change in the price level, the ultimate change in real GDP will be less than what is predicted by the simple multiplier. In other words, a variable price level reduces the value of the multiplier.

Question 18

What is the effect of increases in aggregate demand divided between?

Answer 18

The effect of increases in aggregate demand is divided between increases in real GDP and increases in the price level, depending on the slope of the AS curve.

Question 19

Over the flat range, what does any aggregate demand shock lead to? Why?

Answer 19

Over the flat range, which is also called the Keynesian range of the AS curve, any aggregate demand shock leads to a change in equilibrium GDP but no change in the price level.

The price level does not change because firms with excess capacity can adjust their output without generating any change in their unit costs.

As seen earlier, the change in output in this case is determined by the size of the simple multiplier.

Question 20

Over the intermediate range, what does a shift in the AD curve do to GDP and price level?

Answer 20

Over the intermediate range, along which the AS curve is positively sloped, a shift in the AD curve gives rise to appreciable changes in both real GDP and the price level. Because of the increase in the price level, the multiplier in this case is positive, but smaller than the simple multiplier.

Question 21

Over the steep range, what does a change in AD lead to?

Answer 21

Over the steep range, very little more can be produced, no matter how large the increase in demand.

This range deals with an economy near its physical capacity constraints. Any change in aggregate demand leads to a sharp change in the price level and to little or no change in real GDP.

The multiplier in this case is nearly zero.

Question 22

In general, what will any shift int he demand curve lead to. How does the steepness of the AS curve effect this?

Answer 22

The effect of any given shift in aggregate demand will be divided between a change in real GDP and a change in the price level, depending on the conditions of aggregate supply. The steeper the AS curve, the greater the price effect and the smaller the GDP effect.

Question 23

What is one of the central points in this chapter concerning aggregate demand shocks?

Answer 23

One of the central points of this chapter is that aggregate demand shocks typically lead to changes in both the price level and real GDP.

Question 24

In the case of avertical AS curve, what do aggregate demand shocks do to real GDP and price level?

Answer 24

In the case of a vertical AS curve, aggregate demand shocks will result in no change in real GDP, but only a change in the price level.

Question 25

How do we reconcile this possibility (demand shocks typically lead to changes in both the price level and real GDP.) with the analysis of Chapters 6 and 7, where shifts in AE always change real GDP?

Answer 25

The answer is that each AE curve is drawn on the assumption that there is a constant price level. An upward shift in the AE curve shifts the AD curve to the right. However, a positively sloped AS curve means that the price level rises, and this rise shifts the AE curve back down, offsetting some of its initial rise.

Question 26

It is instructive to consider an extreme version of Figure 8-8, one with a vertical AS curve.

Answer 26

If you draw this diagram for yourself, you will note that an increase in autonomous expenditure shifts the AE curve upward, indicating an increase in desired expenditure. However, a vertical AS curve means that output cannot be expanded to satisfy the increased demand. Instead, the extra demand merely forces prices up, and as prices rise, the AE curve shifts down again. The rise in prices continues until the AE curve is back to where it started. Thus, the rise in prices offsets the expansionary effect of the original shift and consequently leaves both real aggregate expenditure and equilibrium real GDP unchanged.

Question 27

What does a negative aggregate supply shock lead to?

Answer 27

A negative aggregate supply shock—such as an increase in factor prices or a deterioration in technology—leads to an increase in firms’ costs. This increase in costs leads to an upward (or leftward) shift in the AS curve, meaning that firms will supply less real output at any given price level.

Question 28

Whaht does a positive aggregate supply shock lead to?

Answer 28

A positive aggregate supply shock, shown by a downward (or rightward) shift in the AS curve, means that more real output will be supplied at any given price level.

Question 29

What is a potential reason for a negative supply shock?

Answer 29

This could have occurred because of, say, an increase in the world price of important inputs, such as oil, copper, or iron ore.

Question 30

What direction do aggregate supply shocks cause the price level and real GDP to move in?

Answer 30

Aggregate supply shocks cause the price level and real GDP to change in opposite directions. With an increase in supply, the price level falls and GDP rises; with a decrease in supply, the price level rises and GDP falls.

Question 31

What do world evens, such as changes in world prices in raw materials, cause?

Answer 31

Many economic events—especially changes in the world prices of raw materials—cause both aggregate demand and aggregate supply shocks in the same economy. The overall effect on real GDP in that economy depends on the relative importance of the two separate effects.

Question 32

What is stagflation?

Answer 32

We can see that the equilibrium level of price and the equilibrium level of output move in opposite directions following an AS shock.
This particular​ case, where both inflation and unemployment​ rise, is known as
stagflation
.