Macroeconomic Equilibrium

Question 1

Macroeconomic Equilibrium occurs where AS = AD

Answer 1

1. Macroeconomic equilibrium occurs where the AD and AS curves cross, e.g. at price level P and output Y on this SRAS curve
2. A shift of either curve will move this equilibrium to a different point, but shifts of AD and AS curves affect things in different ways

Question 2

An increase in AD alone can only increase output in the short run

Answer 2

1. The effect of a shift in AD on the equilibrium point depends on the slop of the AS curve. This means the effects of an increase in AD can be quite different in the short and long run.
   - This graph (pg. 148) shows an SRAS curve along with an AD curve.
   - When there’s an increase in AD 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 => an increase in derived demand, so more jobs are created an unemployment is reduced.
   - But there’s also been a rise in prices - this is ‘demand-pull inflation.
   - An 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.
   - This graph (in the red box on pg 148) 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 - because the economy is already running at full capacity.
   - so the only effect = prices rise - again, this is an example of ‘demand-pull’ inflation
2. In both cases, the rise in price levels means there will possibly be a worsening of the balance of payments
3. To improve all four macroeconomic policy indicators at the same time, there needs to be an increase in LRAS. - Keynesian economists wold only say that this was sometimes true.

Question 3

The amount of spare capacity can limit the effect of the multiplier

Answer 3

• If supply is already struggling to keep up with demand, then the multiplier effect after an increase in AD will probably be quite small - economy won’t be able to cope with any further large increases in demand.
  1. When AS is very elastic, there is a lot of spare capacity in the economy. In this case, after an initial injection shifts the AD curve, the multiplier can take effect to give a large rise in output. (see graph)
  2. When AS is very inelastic, there is much less spare capacity in the economy. The same initial shift in AD cannot be multiplied in the same way - there’s a smaller rise in output (but a large rise in prices e.g. inflation) see diagram.

Question 4

Shifts in AS affect All Four Macroeconomic indicators in the Same Way

Answer 4

A shift of the AS curve will either improve or worsen all four indicators at the same time.

• For example, an increase in AS, shown by a shift to the right from the SRAS to SRAS1, will => 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 economt 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.
• look at graph*
• If the LRAS increases, then you get similar results
• For example, if long run aggregate supply shifts 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 5

Keynesian AS curves mean changes in AS and AD have Different Effects

Answer 5

With a Keynesian LRAS curve, the effects of an increase in AD can be slightly different.

• If AD increases from AD1 to AD2, the effects are the same as those described on P148 - there’s an increase inprices but no increase in output. This corresponds to an economy thats already operating a 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 an prices. This corresponds to an economy operating just under full capacity.

With a Keynesian LRAS curve, the effects of an increase in AS can also be slightly different.

• If AS increases from LRAS to LRAS1, there is a change in the macroeconomic equilibrium if AD is at either AD1 or AD2.
• This is why Keynesian economists say that there is little point in aiming to increase AS during a depression -> the macroeconomic equilibrium will not be affected and there will be no increase in output or employment.