Equilibrium Between AD and AS

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

At price level P, 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.

A Shift In Aggregate Supply

Suppose that increased efficiency and productivity together with lower input costs causes the short run aggregate supply curve to shift outwards. (Assume no shift in aggregate demand).

The diagram below 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.

Aggregate supply would shift inwards if there is a rise in the unit costs of production in the economy. For example there might be a rise in unit wage costs perhaps caused by higher wages not compensated for by higher labour productivity.

External economic shocks might also cause the aggregate supply curve to shift inwards. For example a sharp rise in global commodity prices. If AS shifts to the left, assuming no change in the aggregate demand curve, we expect to see a higher price level (this is known as cost-push inflation) and a lower level of real national output.

A Shift In Aggregate Demand

In the diagram below we see the effects on an inward shift in aggregate demand in the economy. This might be caused for example by a decline in business confidence (reducing planned investment demand) or a fall in exports following a global downturn. It might also be caused by a cut in government spending or a rise in interest rates.

The result of the inward shift of AD is a contraction along the short run aggregate supply curve and a fall in the real level of national output (i.e. a recession). This causes downward pressure on the general price level.

If aggregate demand shifts outwards (perhaps due to increased business confidence, an economic upturn in another country, or higher levels of government spending), we expect to see both a rise in the price level and higher national output.

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