Equilibrium refers to a state in the economy where aggregate demand (AD) equals aggregate supply (AS), resulting in a stable price level and output. This balance signifies that the quantity of goods and services demanded matches the quantity supplied, leading to no inherent pressures for change. At equilibrium, the economy operates efficiently, reflecting optimal resource allocation and price stability.
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An increase in aggregate demand can lead to higher output and prices if the economy is initially below equilibrium.
A decrease in aggregate supply can create inflationary pressure, as prices rise while output may fall, disrupting the equilibrium.
Equilibrium can be temporarily disturbed by external shocks, such as natural disasters or changes in government policy, leading to shifts in AD or AS.
Long-run equilibrium occurs when the economy adjusts to potential output, where actual GDP equals full-employment GDP.
In a graphical representation, equilibrium is found at the intersection point of the AD and AS curves on a standard price-output graph.
Review Questions
How does an increase in aggregate demand affect equilibrium in an economy?
An increase in aggregate demand pushes the AD curve to the right, leading to a new equilibrium point at a higher output level and potentially higher prices. This shift reflects a greater desire for goods and services than what is currently being supplied at the existing price levels. If the economy was initially below its potential output, this can stimulate economic growth. However, if it exceeds the capacity of the economy, it could lead to inflation.
What are the implications of a shift in aggregate supply on equilibrium and how does this affect price levels?
A leftward shift in the aggregate supply curve indicates a decrease in overall production capabilities, which typically results in higher prices and lower output. This creates a new equilibrium where the price level rises due to scarcity while real GDP decreases. Such changes can lead to stagflation, a situation where inflation rises alongside stagnant economic growth, posing significant challenges for policymakers.
Evaluate how external shocks can disrupt equilibrium and the measures policymakers might take to restore it.
External shocks like sudden oil price spikes or natural disasters can displace equilibrium by shifting either the AD or AS curves. For instance, an oil shock may reduce AS due to increased production costs, raising prices while lowering output. Policymakers might respond by implementing fiscal or monetary policies to stimulate demand or provide support to affected industries. Such interventions aim to stabilize prices and restore equilibrium by shifting AD back up or managing supply constraints effectively.
The total quantity of goods and services that producers are willing and able to supply at a given price level.
Business Cycle: The fluctuations in economic activity characterized by periods of economic expansion and contraction around the long-term growth trend.