How is macroeconomic equilibrium determined?

Macroeconomic equilibrium occurs at the point where aggregate demand (AD) intersects aggregate supply (AS). This intersection determines the economy’s overall output level and the average price level. When AD equals AS, firms produce exactly the amount that households, businesses, government, and foreign buyers wish to purchase. There is no pressure for output or prices to change, creating short-run stability. The AD–AS model therefore helps economists understand inflation, unemployment, and economic cycles.

In the short run, equilibrium is shaped by shifts in AD and short-run aggregate supply (SRAS). A rise in AD, driven by higher consumption or investment, increases output and raises prices. Conversely, a fall in AD reduces output and can lead to unemployment. Meanwhile, SRAS shifts occur due to changes in production costs such as wages, input prices, or supply chain conditions. These shifts alter output and the price level even if demand remains constant.

In the long run, macroeconomic equilibrium is ultimately determined by long-run aggregate supply (LRAS), which reflects an economy’s productive capacity. LRAS depends on factors such as technology, capital, institutions, and human capital. When AD changes, the economy may deviate from full employment output temporarily, but over time, wages and input prices adjust. This brings the economy back to its long-run equilibrium at potential output.

Macroeconomic equilibrium is dynamic, not fixed. It shifts continuously as economies respond to shocks, policy decisions, and global conditions. Understanding these interactions helps policymakers manage inflation, unemployment, and growth.

FAQs

Why does macroeconomic equilibrium change over time?

Equilibrium shifts because both AD and AS respond to evolving economic conditions. Changes in consumer confidence, technology, wages, or global demand alter spending and production. Policy decisions, such as interest-rate adjustments or government spending changes, also move the equilibrium. Because economies are constantly adjusting, equilibrium is not a single point but an ongoing process of balance.

What happens if AD rises above the level of long-run supply?

When AD rises beyond the economy’s productive capacity, firms cannot increase output significantly. Instead, prices rise, creating demand-pull inflation. In the short run, output may increase slightly as firms stretch resources, but this is unsustainable. Eventually, wages and input costs rise, shifting SRAS left and returning the economy to its long-run potential. The end result is higher inflation but little lasting increase in output.

What occurs when actual output differs from potential output?

If actual output is below potential, the economy experiences unemployment and spare capacity. Policymakers may use stimulus to raise AD. If output exceeds potential, inflationary pressure builds as resources become scarce. Central banks may tighten monetary policy to cool the economy. Closing output gaps is essential for maintaining stability and preventing long-term damage.

RevisionDojo Call to Action

Macroeconomic equilibrium is at the heart of IB Macroeconomics, and understanding it strengthens your ability to analyze inflation, unemployment, and policy impacts. RevisionDojo provides clear explanations, structured notes, and exam-focused support to help you think like an economist. Prepare smarter and score higher with RevisionDojo.