Macroeconomic Equilibrium (AQA A Level Economics)

• Real national output equilibrium occurs where aggregate demand (AD) intersects with short-run aggregate supply (SRAS)

Diagram: Classical Short-run Equilibrium

Aggregate demand and aggregate supply work together in an economy to create an equilibrium price of AP₁ and real output of Y₁

Diagram analysis

• This economy is in short run equilibrium at AP₁Y₁
• Any changes to the components of AD will cause the AD curve to shift left or right, creating a new short-run equilibrium
• Any changes to the determinants of SRAS will shift the SRAS curve left or right, creating a new short-run equilibrium

• Free market economists believe that the economy will always return to its normal capacity level of output
  • In the short-run, there will be fluctuations around this capacity level of output
  • In the long-run, the economy will return to this normal capacity level of output, but perhaps at a different average price level
    
    
• It is important to understand the long-run macroeconomic equilibrium as it is used to identify positive and negative output gaps in an economy (this is covered in more detail in Section 11)

Diagram: Long-run Macroeconomic Equilibrium

A diagram that shows the free market view of long-run equilibrium which occurs at the intersection of long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) & aggregate demand (AD)

Diagram analysis

• The LRAS curve demonstrates the normal capacity level of output of the economy using all of its scarce resources
• The SRAS intersects with AD at the LRAS curve
• This economy is producing at the full employment level of output (Y_FE)
• The average price level at Y_FE is AP₁

1. An Increase in Aggregate Demand (AD)

Diagram: The Impact of Increasing AD

An increase in aggregate demand (AD) leads to higher output and higher prices in the economy

Diagram analysis

• The initial equilibrium level of output was at AP₁Y₁
• An increase in one of the components of AD (e.g. consumption) causes the AD to increase AD₁→AD₂
• Average prices in the economy rise to AP₂ and the real level of output increases to Y₂
• The new short-run equilibrium is at AP₂Y₂
  

2. An increase in short run aggregate supply (SRAS)

Diagram: The Impact of Increasing SRAS

An increase in the short-run aggregate supply (SRAS) causes higher outputs and lower prices

Diagram analysis

• The initial equilibrium level of output was at AP₁Y₁
  • This equilibrium represents a negative output gap equal to Y₁Y_FE
• An increase in one of the determinants of SRAS (e.g. productivity) causes the SRAS to increase SRAS₁→SRAS₂
• Average prices in the economy fall to AP₂ and the real level of output increases to Y₂
• The new short-run equilibrium is at AP₂Y₂
• There is still a negative output gap but it is smaller (Y₂Y_FE)

• An economic shock is an unpredictable event that has macroeconomic consequences
  • They can have widespread positive or negative impacts on economic growth, inflation rate, unemployment levels
     
• The type of shock is classified by the sector it originates from 
  • Demand side shock: typically involves a sudden change in the levels of private spending, as seen in shifts in consumer spending or business investment
  • Supply side shock: When production across an economy is made more difficult
  • Both demand and supply side: the economy faces challenges on both the consumption and production fronts
     

A Table of Explaining Macroeconomic Shocks in the UK Economy

Macroeconomic Shock	Impacts on the UK Economy
Financial crisis 2007-2012	Banking instability led to a credit crunch as banks were reluctant to lend money. This resulted in reduced borrowing and, consequently, less investment and consumer spending. The outcome was a fall in aggregate demand, leading to a recession (economic contraction). Additionally, this situation contributed to increased unemployment
Pandemic 2020	The pandemic restrictions reduced consumer spending Businesses reduced investment as they adapt to pandemic-related challenges Supply chain disruptions affected the production and distribution of goods and services These disruptions, coupled with heightened demand for certain products, contributed to price fluctuations
Geopolitical tensions (Ukraine-Russia War)	Supply chain disruptions result in increased energy and food prices Increased costs of production leads to increased inflation rates Bank of England responded to increased inflation by increasing interest rates (monetary policy) Uncertainty about future has impacted consumer and business confidence  Has led to reduced consumer spending and delayed business investments