Macroeconomic equilibrium occurs when the real GDP that is demanded by the different economic sectors equals the real GDP that producers supply. Short-run equilibriums occur when AD equals SRAS, and long-run equilibriums occur when AD equals LRAS. Changes in macroeconomic equilibrium occur when there are changes in AD, SRAS, or LRAS.
Increases in AD relative to SRAS result in both increased price level and increased real GDP in the short run, but just increased price level in the long run. As consumers, businesses, government, and the foreign sector demand more scarce output, firms respond to the increased price level by increasing output. In the long run, wages adjust to the increased price level, and GDP returns to its long-run potential at a higher price level. Demand-pull inflation results from increases in AD. Decreases in AD result in the opposite. As AD decreases relative to SRAS, both real GDP and price level fall. In the long run, wages and other input prices adjust to the lower price level and the economy returns to its long-run potential GDP at a lower price level than when the process began.
What happens to unemployment as aggregate demand changes?
Increases in AD lead to increases in real GDP. The increase in real GDP creates more demand for labor and reduces the unemployment rate. The reduced unemployment causes an increase in the price level.
Change in SRAS relative to AD also leads to changes in real GDP and price level. Unlike AD changes, which lead to GDP and price level moving in the same direction, SRAS changes result in GDP and price level moving opposite from each other. An increase in SRAS relative to AD will lead to a higher real GDP at a lower price level because as production costs fall, firms are more willing to produce more output at each and every price level. Decreases in SRAS relative to AD lead to the economic condition previously described as stagflation. Stagflation occurs when GDP decreases are combined with increases in the price level. When the costs of production rise, firms produce less output at each and every price level.