1. How the macroeconomy works
Macroeconomic equilibrium

2. Learning objectives
To be able to confidently approach the following question :
Assess the view that inflation is always caused by an increase in aggregate demand.
Jun 2009 Qn 4 (25 marks)

3. Macroeconomic equilibrium
A state of national economic activity where aggregate demand is met by aggregate supply.

4. Macroeconomic equilibrium
Macroeconomic equilibrium is said to exist where total demand in the economy for goods and services (AD) intersects with the total supply of resources to the economy (AS). This gives a real output figure (Q1) at a given price level (P1)
Price level AS P1 AD Q1
Real output

5. Shifting the AD curve 1 AD = C + I + G +(X-M)
A positive change in the components of AD shifts the AD curve to the right from AD1 to AD2
AS responds to this increased demand for goods and services giving Q2. Due to spare capacity in the 4 factors, the economy is able to supply the extra without an increase in production costs. Consequently there is no increase in the price of goods and services and the price level (RPI) remains the unchanged.
Price level AS
AD1
AD2 P1
Real output A B Q1 Q2
OCO
FCO

6. Shifting the AD curve 2 AD = C + I + G +(X-M) Price level AS P2 P1
A positive change in the components of AD shifts the AD curve to the right from AD1 to AD2
AS responds to this increased demand for goods and services giving Q2. As the economy has passed the optimum capacity output (OCO) resources are showing scarcity. Scarcity leads to businesses bidding for the diminishing resources and their cost starts to rises. This leads to an increase in production costs. Consequently there is an increase in the price of goods and services and the price level (RPI) rises from P1 to P2.
Price level AS
AD1
AD2 P2 P1
Real output Q1 Q2
OCO
FCO

7. Shifting the AD curve 3 AD = C + I + G +(X-M) Price level AS P2 P1
A positive change in the components of AD shifts the AD curve to the right from AD1 to AD2
At AD1 the economy is operating at full capacity output (FCO) resources are now exhausted. AS cannot responds to any increased demand for goods and services and Q remains at Q!
Excess demand leads to businesses bidding for resources from other firms This leads to an increase in production costs. Businesses may decide to ration their stock by putting up prices. Consequently there is an increase in the price of goods and services and the price level (RPI) rises from P1 to P2.
Price level AS P2 P1
AD1
AD2
Real output Q1
OCO
FCO

8. Review of learning objectives
Can you confidently approach the following question :
Assess the view that inflation is always caused by an increase in aggregate demand.
Jun 2009 Qn 4 (25 marks)