The interaction of aggregate demand and aggregate supply, macroeconomic equilibrium, and the Keynesian and Neo-Classical views of long-run aggregate supply.

What this dot point is asking

WJEC wants you to combine AD and AS to find macroeconomic equilibrium, to analyse the effects of demand and supply shifts on output and the price level, and to contrast the Keynesian and Neo-Classical views of long-run aggregate supply.

The answer

Macroeconomic equilibrium

Just as in a single market, equilibrium is found where the two curves intersect. If planned spending exceeds output, firms run down stocks and raise output and prices; if output exceeds planned spending, stocks build up and firms cut output and prices, until equilibrium is restored. A shift in AD or AS moves the equilibrium. The key macroeconomic question is what happens to real output (and hence employment and growth) versus the price level (inflation) when a shift occurs, and that depends on the shape of the aggregate supply curve.

Demand and supply shifts

This is why the state of the economy matters so much for policy. In a deep recession with idle factories and high unemployment, a boost to AD can raise output substantially with little inflation. Near full capacity, the same boost mostly raises prices. Supply-side improvements that shift AS right are attractive because they raise output and ease inflation at once, which is the appeal of supply-side policy. The disagreement is over what AS looks like in the long run.

The Keynesian and Neo-Classical views

The two views give opposite policy advice. On the Neo-Classical LRAS, an increase in AD raises only the price level in the long run, with no lasting rise in real output, so demand management is futile or harmful and the focus should be on supply-side reform. On the Keynesian AS, an increase in AD raises real output and employment with little inflation when there is spare capacity, so demand management is justified in a recession but becomes purely inflationary once full capacity is reached. Which view is more useful depends on where the economy is in the cycle.

Examples in context

Example 1. Stimulus in the 2008-09 recession. With large spare capacity and rising unemployment after the financial crisis, the UK and other governments boosted aggregate demand through fiscal and monetary expansion. The Keynesian case was that this would raise output and employment without much inflation, because the economy was in the flat range of aggregate supply. The episode is often cited as supporting demand management when an economy operates well below capacity.

Example 2. Stimulus near capacity and inflation. When large demand support was provided as economies reopened after the pandemic, with supply constrained and capacity tight, the result was a surge in inflation rather than a lasting rise in real output. This is closer to the Neo-Classical warning: when AD rises near full capacity, the effect falls mainly on the price level. The contrast with 2008-09 shows why the position of the economy determines which view applies.

Try this

Q1. Define macroeconomic equilibrium. [2 marks]

• Cue. The level of real output and the price level at which aggregate demand equals aggregate supply.

Q2. Explain why, on a vertical long-run aggregate supply curve, an increase in aggregate demand only raises the price level. [3 marks]

• Cue. Vertical LRAS means output is fixed at full capacity, so higher AD cannot raise real output and instead bids up prices, causing inflation with no lasting change in output.