Macroeconomic Equilibrium

With the help of aggregate demand curve and the aggregate supply we can simultaneously determine the equilibrium level of GDP and the equilibrium price level. As is shown in Fig. the point of intersection E0 of the aggregate demand (AD) curve and short-run aggregate supply (SRAS) curve gives equilibrium level of national income Y₀ and price level P0 as simultaneously determined by these two curves. This point of equilibrium E₀ which simultaneously determines equilibrium level of GDP and price level is called the point of macroeconomics equilibrium. The point E0 shows equilibrium of the level of output that the firms with to produce at price P0 as implicit in the AD curve and the GDP level consistent with this price level P₀. Thus, the macroeconomic equilibrium is the point of consistency between the price level, output level and the expenditure level in an economy.

The equilibrium level GDP (Y₀) and price level (P₀) represent the macroeconomic equilibrium because, with the given AD and AS curves, any other price level will not be consistent with aggregate spending and aggregate production decisions. Let us take a price level P₁, which is below the equilibrium price P₀. At this lower price P1, the aggregate output that the producers as a whole wish to produce is Y₁, which is below the equilibrium price P₀, At this lower price P_1, the aggregate output that the producers as a whole wish to produce is Y₁, which is lower the Y0 as shown by the SRAS curve.

At the lower price P1 the aggregate output that the firms wish to produce (Y₁) is less than the desired aggregate spending (Y₂) as given by the AD curve. This excess of aggregate spending over aggregate output causes the price level to increase to P0 where AD = AS (SRAS). Hence, there can be no equilibrium of aggregate spending, desired output and price level below the price P₀.

Similarly, at any price level above P₀, there can be no macroeconomic equilibrium. For example, when price level is high P₂, the output that producers as a whole would be willing to produce would be larger at Y₄, but at higher price level, expenditure that the buyers as a whole are willing to make as shown by AD curve will be much smaller at Y₃. The excess of output over expenditure will push down the price level of P₀ where supply decision, expenditure decision, GDP is consistent with price level.

Only at the combination of GDP and price level given by intersection of the SRAS and AD curves are spending (demand) behavior and production (supply) activity consistent.