Macroeconomic Equilibrium: Understanding AD and AS | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll explore short-run and long-run macroeconomic equilibrium between aggregate demand (AD) and aggregate supply (AS).

Aggregate Demand and Aggregate Supply: A Quick Recap

From our previous lessons, we’ve learned that:

• The AD curve is downward sloping; factors like interest rate cuts or increases in consumer wealth shift it to the right.
• The long-run aggregate supply (LRAS) curve is vertical at the potential GDP level, where the economy is at full employment and all physical capital is fully utilized.
• The short-run aggregate supply (SRAS) curve is upward sloping; changes in input prices affect SRAS, while factors affecting resource capacity or productivity impact both SRAS and LRAS.

Long-Run Macroeconomic Equilibrium

When all three curves intersect at the same point, the economy is in long-run full-employment equilibrium. This means the economy is producing at its full potential, with no unemployment and all physical capital operating at full capacity. However, in reality, economies rarely operate at potential GDP due to various factors causing curve shifts and temporary output gaps.

Four Types of Fluctuations in Macroeconomic Equilibrium

We’ll discuss four types of fluctuations and their effects on the economy:

1. Decrease in aggregate demand
2. Increase in aggregate demand
3. Decrease in short-run aggregate supply
4. Increase in short-run aggregate supply

1. Decrease in Aggregate Demand: Recessionary Gap

High interest rates, a stock market crash, or a strong currency can cause aggregate demand to decrease, shifting the AD curve to the left. In the short run, the economy produces less at a lower price level, creating a recessionary gap.

Classical economists believe the economy will self-correct with lower wages increasing SRAS. Keynesian economists argue for expansionary fiscal and monetary policies to stimulate aggregate demand and restore GDP and prices.

2. Increase in Aggregate Demand: Inflationary Gap

Loose monetary policy or a real estate boom can increase aggregate demand, resulting in an inflationary gap. In the short run, GDP is greater than full-employment GDP and prices are higher.

Unchecked, this can lead to an inflationary loop. Policymakers should adopt contractionary fiscal and monetary policies to return the economy to full-employment GDP without increasing prices.

3. Decrease in Short-Run Aggregate Supply: Stagflation

Sudden increases in input prices, like energy prices, can push the SRAS curve to the left, resulting in stagflation—a combination of declining economic output and higher prices.

Resolving stagflation is challenging for policymakers. Stimulating aggregate demand can lead to even higher prices, while fighting inflation by decreasing aggregate demand can further reduce GDP. Ideally, policymakers should wait for input prices to decrease, allowing SRAS to shift back to the right.

4. Increase in Short-Run Aggregate Supply

A decrease in the price of important productive inputs can increase SRAS, resulting in a new short-run equilibrium where GDP is greater than full-employment GDP and the price level is lower. Eventually, a tight labor market may push wages up, increasing production costs and shifting SRAS back to its original equilibrium.

Simultaneous Fluctuations in Aggregate Demand and Aggregate Supply

More often than not, both AD and SRAS fluctuate simultaneously in the short run:

• If both AD and SRAS increase, real GDP increases, and the price level depends on the relative magnitude of the movements.
• If both AD and SRAS decrease, real GDP decreases, and the price level depends on the relative magnitude of the movements.
• If AD increases and SRAS decreases, the price level increases, and real GDP depends on the relative magnitude of the movements.
• If AD decreases and SRAS increases, the price level decreases, and real GDP depends on the relative magnitude of the movements.

Conclusion

And that wraps up our lesson on macroeconomic equilibrium. In our next lesson, we’ll delve into economic growth and its sustainability.