Determining the price level and equilibrium level of real output

In O Level tutorials, we learned about individual demand and supply curves and how equilibrium is determined at micro-economic level. Now, let us look at how price level and equilibrium level of real output is determined at macro-economic level.

Macroeconomic equilibrium for an economy in the short run is established when aggregate demand intersects with aggregate supply. This is shown in the diagram below.

At the price level P, the aggregate demand for goods and services is equal to the aggregate supply of output. The output and the general price level in the economy will tend to adjust towards this equilibrium position.

If the price level is too high, there will be an excess supply of output. If the price level is below equilibrium, there will be excess demand in the short run. In both situations there should be a process taking the economy towards the equilibrium level of output.

Shift in Aggregate Demand

AD-AS Curve 1

When the Aggregate Demand Curve shifts to its right from AD to AD1, the the price level increases from P to P1, and the output level increases from Y to Y1

Anything that affects the components of aggregate demand (consumption, investment, government spending and net exports) will shift the AD curve.

Aggregate Demand can increase or decrease depending on several things. In effect, these things will cause shifts up or down in the AD curve. These include:

Exchange Rates: When a country’s exchange rate increases, then net exports will decrease and aggregate expenditure will go down at all prices. This means that AD will decrease.

Distribution of Income: This is directly related to wages and profits. When worker’s real wages increase, then people will have more money on their hands because their overall income has increased. When this happens they tend to consume more causing the consumption expenditures to increase.

Expectations: Consumers tend to have certain expectations about the future of the economy and will adjust their spending accordingly. If they would expect the economy to not do so well in the future, saving would increase thus decrease overall expenditures. Rising price levels will cause aggregate demand to increase. If consumers foresee the price level to rise in the near future, they might just go out and buy that good now, increasing the consumption expenditures in AD. Many different expectations have the capacity to increase or decrease aggregate demand and it is not always clear as to how this will happen.

Foreign Income: This relates the country’s economic output with the income of its trading partners in the world. When foreign income rises, the country’s exports will increase causing aggregate demand to increase.

Monetary and Fiscal Policies: The government has some ability to impact AD. They can spend money or increase taxes in order to influence how consumers spend or save. An expansionary fiscal policy causes AD to increase, while a contractionary monetary policy causes AD to decrease.

Shift in Aggregate Supply

AS and AD Curve

Suppose that increased efficiency and productivity together with lower input costs (e.g. of essential raw materials) causes the short run aggregate supply curve to shift to its right. (i.e. an increase in supply – assume no shift in aggregate demand).

The diagram shows what is likely to happen. AS shifts outwards and a new macroeconomic equilibrium will be established. The price level has fallen and real national output (in equilibrium) has increased to Y2.

The Multiplier

An injection such as an increase in exports means that there is an immediate increase in AD. But the extra income raised by selling goods abroad will raise incomes of those making the goods and services, and this income will be spent in the economy. Whatever is not spent on withdrawals will cause second round increases in AD, which leads to further rounds of income and spending. These knock on effects are the multiplier effects of an increase in injections, and the process work in reverse when injections fall — a reverse multiplier, or multiplied contraction of AD.

Next topic: Causes, costs and constraints on economic growth

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