Short-run Macroeconomic Equilibrium above or below Full Employment

Short-run macroeconomic equilibrium only occurs when the amount of real GDP demand is equal to the amount of GDP supply. Graphically, this happens at the point where the AD curve intersects the short-run average supply curve exactly on the long-run aggregate supply curve:

Short-run-macroeconomic-equilibrium

Decrease in the Short-Run Aggregate Demand

In the short-run, aggregate demand can decrease unexpectedly leading to an excess of goods and services. As a result, the price of goods and services will fall. With a fall in prices, unemployment will increase. Moreover, as prices go down, the amount of output produced will also go down.

The aggregate supply curve will shift to the left but, as time passes, resource costs will end up falling. This will subsequently shift the aggregate supply curve to the right. The level of output will, therefore, revert back to the initial levels when the economy was at full employment, with low price levels.

Increase in the Short-Run Aggregate Demand

If aggregate demand increases suddenly in the short-run, the output level becomes greater than the normal price levels at full employment. This is due to the differences between current prices and the anticipated prices by the resource providers.

The unemployment rate will be lower than the naturally expected level. Price levels will decline in the long-run to the point consistent with full employment. Prices will then increase causing inflation.

Decrease in the Short-Run Aggregate Supply

A decrease in the short-run aggregate supply lowers the available resources. As a result, the prices of acquiring these resources will rise and consequently, the aggregate supply curve will shift upwards and leftwards. Output levels will fall at higher prices.

Increase in the Short-Run Aggregate Supply

In the short-run, an unexpected increase in aggregate supply most likely shifts the SRAS curve to the right. Output and income are expected to expand beyond the consistent level in relation to full employment and at lower prices. If the shift in the SRAS curve is temporal, then the SRAS curve will, with time, return to its normal levels. Output and prices will also go back to their initial levels.

However, if an event causes a permanent change in the economy, both the SRAS and LRAS will shift to the right. As a result, output increases at lower prices.

Question

When both aggregate supply and aggregate demand increase, which of the following most likely occurs?

A.  A rise in inflation

B. An increase in the employment level

C. GDP stays constant

Solution

The correct answer is B.

Higher aggregate demand and aggregate supply raise GDP, hence lowering unemployment. As a result, the employment level increases.

Reading 14 LOS 14k:

Explain how a short-run macroeconomic equilibrium may occur at a level above or below full employment.

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