The Price Level and Inflation: Macroeconomic Equilibrium

Macroeconomic Equilibrium The preceding analysis of aggregate demand and aggregate supply shows that both the amounts buyers are willing to buy and the amounts sellers are willing to produce depend on the price level. But what determines the actual price level and the level of real GNP that will prevail over a given period? Will actual real GNP be equal to potential real GNP over the period? Will increases in aggregate demand cause inflation that will send the price level skyrocketing, or will they merely result in an increase in aggregate production? How will an oil embargo affect real GNP and the price level over the year? To answer these questions we have to examine whether the spending plans of buyers match the production plans of sellers over a given period. We must also examine how changes in aggregate demand and aggregate supply will affect the balance between aggregate quantity demanded and aggregate quantity supplied. In this way we can forecast how changes in the economy will affect unemployment and inflation. We can also examine the way government stabilization policies can affect the economy through their impact on the balance between aggregate quantities demanded and supplied. A macroeconomic equilibrium is attained when the aggregate quantity demanded equals the aggregate quantity supplied. When aggregate supply and demand balance at the equilibrium price level, there is neither widespread unplanned buildup of product inventories, nor are inventories unexpectedly being rapidly drawn down because businesses cannot fill orders quickly enough. When a macroeconomic equilibrium is achieved, the aggregate production made available for sale over a given period is, on average, willingly purchased in markets at the prevailing price level. The phrase on average is important when discussing macroeconomic equilibrium, because both the price level and real GNP are aggregates. Some individual markets can be out of equilibrium during the year even when a macroeconomic equilibrium is attained. For example, the demand for personal computers may fall, resulting in a surplus of computers and unanticipated buildup of inventories. At the same time, an increase in the demand for compact discs may result in unanticipated depletion of producer inventories. During the year there would therefore be downward pressure on the price of personal computers and upward pressure on the price of compact discs as these markets move to a new equilibrium. When a macroeconomic equilibrium exists, there may be shortages in some product markets but there will also be surpluses in other product markets. In the aggregate there will be neither upward nor downward pressure on the price level or the level of real GNP once macroeconomic equilibrium is attained. The graph in Box 11 illustrates the concept of macroeconomic equilibrium using aggregate demand and aggregate supply curves prevailing for a given year. The macroeconomic equilibrium corresponds to the point at which the aggregate demand and aggregate supply curves intersect. The equilibrium level of real GNP corresponding to the point of intersection, E, is $5,000 billion. Aggregate production of $5,000 billion (measured in 1982 dollars) will also correspond to the quantity of final products demanded at the equilibrium price level of 120 as measured by a price index such as the GNP deflator. Because the entire aggregate quantity supplied of $5,000 billion is willingly purchased at the current price level of 120, there is no upward or downward pressure on prices or production, on average.