Macroeconomic Equilibrium

Aggregate Demand and Aggregate Supply meet to yield a unique short-run equilibrium for aggregate levels of prices and outputs. This is illustrated in Figure 9 with an equilibrium price level of Pe and equilibrium output equal to Qe (point e). To see why this is an equilibrium point, consider the consequences of the lower price level P1. This price level is below equilibrium, so consumers will demand output level  Q2—more than the Q1 currently supplied. Retailers will experience growth in sales and declining inventories, and will order more from wholesalers and manufacturers.

Manufacturers react to growing orders by boosting both production and their own orders for raw materials and intermediate goods. Some may expand output by paying overtime wages to current employees; others will hire additional workers. But this additional output will be increasingly costly, raising the prices firms charge. The economy moves from Q1 to Qe as aggregate output and employment expand. Equilibrium is achieved at Qe and Pe (point e), and economy-wide excess demands for goods evaporate.

Pressures in the opposite direction would occur if this economy were at price level P2. Sales fall and inventories rise, precipitating layoffs and declining aggregate output. Ultimately, these pressures again result in an economy-wide equilibrium at point e.

Comparing equilibrium points when Ag-gregate Demand and Aggregate Supply curves shift provides insights into problems macroeconomic policymakers face. All major American depressions before World War II were periods when the price level, output, and employment all declined. Note that in Panel A of Figure 10, if Aggregate Demand falls from AD0 to AD1 both the price level (P) and the level of real national income (Q) decline. Thus, one explanation for recessions or depressions is a drop in Aggregate Demand. Conversely, if Aggregate Demand rises from AD1 to AD0 (Panel A), the price level and real output both rise. Thus, real growth accompanied by mild inflation conform to expansion of Aggregate Demand relative to Aggregate Supply.

In a similar vein, changes in Aggregate Supply can lead to growth or stagflation. First, as Panel B of Figure 10 illustrates, growth that exerts downward pressure on prices (called deflationary growth) can occur if Aggregate Supply increases faster than Aggregate Demand. This pattern prevailed between 1865 and 1890, when growth was stimulated by new inventions, the settling of the west, and waves of immigration. Alternatively, if Aggregate Supply shrinks, rising prices accompany declines in output and more unemployment, a condition known as stagflation, shown in Panel B by a shift in Aggregate Supply from AS2 to AS0. Prices rise from P2 to P0 while real output falls from Q2 to Q0—an incumbent politician’s nightmare.