Understanding equilibrium national income helps students analyse how macroeconomic stability is achieved and sustained when aggregate demand and aggregate supply are perfectly balanced.
What is equilibrium national income?
The equilibrium level of real national income occurs when aggregate demand (AD) equals aggregate supply (AS) in an economy. This is the level at which the total amount of goods and services demanded equals the total amount produced. At this point, there is no pressure for output or the general price level to change, assuming other conditions remain constant.
In other words:
All output produced by firms is bought by consumers, government, firms, or foreign buyers.
There are no unintended changes in inventories—firms are not left with unsold goods nor are they failing to meet demand.
This point of equilibrium is fundamental in macroeconomics as it determines the level of national income, employment, and output. When the economy is in equilibrium, there is a sense of short-term stability. However, this does not mean the economy is operating at full employment—equilibrium can occur with unemployment or spare capacity.
The role of equilibrium in short-run macroeconomic stability
In the short run, prices and wages are often sticky, meaning they do not adjust immediately to changes in demand or supply. Therefore, the economy can reach an equilibrium where AD = AS, even though there may still be unemployment, inflation, or underutilised resources.
Key points about short-run equilibrium:
It reflects a temporary state of balance in the economy.
Firms are producing the amount that is demanded at current price levels.
There is no immediate incentive for firms to change output or for prices to adjust further.
Short-run equilibrium is useful for understanding how the economy responds to demand or supply shocks. When AD or AS changes, the economy moves to a new short-run equilibrium. Government policies, consumer confidence, investment levels, or global trade conditions can all influence these movements.
The aggregate demand and aggregate supply model (AD/AS)
The AD/AS model is a core tool for illustrating and analysing equilibrium national income.
Components of the model
Aggregate demand (AD) represents the total spending on an economy’s goods and services at different price levels. It includes:
Consumption (C)
Investment (I)
Government spending (G)
Net exports (X - M)
Aggregate supply (AS) represents the total output of goods and services that firms are willing and able to supply at different price levels.
In the short run, AS typically slopes upward because higher prices may incentivise increased production.
In the long run, AS is considered vertical, representing full capacity output.
Initial equilibrium
An initial equilibrium is established where the AD curve intersects the AS curve. This point determines two crucial variables:
The equilibrium price level (Pₑ)
The equilibrium level of output or national income (Yₑ)
At this intersection:
There is no excess demand or supply in the economy.
Firms are selling all their output without building up or drawing down stocks.
There are no pressures for prices or output to change unless AD or AS shifts.
Changes in aggregate demand and their effects
Shifts in the aggregate demand curve result from changes in any of the components of AD (C, I, G, or X - M). A shift in AD leads to a new equilibrium.
Rightward shift in AD
AD shifts to the right (from AD1 to AD2) when:
Consumers are more confident and increase spending.
Interest rates fall, encouraging borrowing and investment.
The government increases spending or cuts taxes.
Exports rise due to improved competitiveness or global demand.
Effects of a rightward shift in AD:
Equilibrium output increases (from Yₑ to Y₁).
The price level rises (from Pₑ to P₁).
This creates demand-pull inflation.
Firms expand production in response to increased demand.
Unemployment tends to fall as firms hire more workers.
Leftward shift in AD
AD shifts to the left (from AD1 to AD3) when:
Taxes rise or government spending falls.
Consumers or firms reduce spending due to pessimism.
Interest rates rise, discouraging investment.
Imports increase or exports decline.
Effects of a leftward shift in AD:
Equilibrium output falls (from Yₑ to Y₂).
The price level drops (from Pₑ to P₂).
This results in deflationary pressure.
Firms may cut back production, increasing unemployment.
These shifts demonstrate how aggregate demand plays a central role in determining national income and macroeconomic outcomes.
Changes in aggregate supply and their effects
Shifts in aggregate supply reflect changes in the costs of production, resource availability, or efficiency within the economy.
Rightward shift in AS
AS shifts to the right (from AS1 to AS2) when:
Input costs fall (e.g., oil prices drop or wages decrease).
Productivity improves through technology or better training.
Government implements supply-side reforms such as tax cuts or deregulation.
There is greater availability of resources.
Effects of a rightward shift in AS:
Equilibrium output increases (from Yₑ to Y₃).
The price level falls (from Pₑ to P₃).
This leads to non-inflationary economic growth.
Firms are more willing and able to supply more at each price level.
Consumers benefit from lower prices and greater output.
Leftward shift in AS
AS shifts to the left (from AS1 to AS3) due to:
Rising production costs (e.g., raw materials or wages).
Supply chain disruptions or resource shortages.
Natural disasters or political instability.
Reduced labour productivity or increased regulation.
Effects of a leftward shift in AS:
Equilibrium output decreases (from Yₑ to Y₄).
The price level rises (from Pₑ to P₄).
This results in cost-push inflation.
Economy may experience stagflation: falling output and rising prices.
Firms reduce production due to higher costs, leading to increased unemployment.
Movement to a new equilibrium
Any shift in AD or AS leads to a new equilibrium with different levels of output and price. The economy responds to these changes dynamically.
Mechanism of adjustment
If there is a positive demand shock (e.g., rise in consumer confidence), then:
AD increases.
Firms notice growing demand and respond by raising output and prices.
Resources are reallocated to meet higher demand.
If there is a negative supply shock (e.g., oil price spike), then:
AS decreases.
Output falls and prices rise.
Firms face higher costs and may lay off workers or reduce production.
The process continues until a new point of intersection between AD and AS is reached. This new equilibrium determines the revised levels of national income and the general price level.
Role of expectations and feedback loops
Changes in national income affect employment, which influences consumer spending.
Higher incomes can lead to multiplier effects, increasing AD further.
Rising prices may reduce real incomes, dampening demand.
Expectations about inflation or economic growth can influence both AD and AS.
These interactions mean the movement to a new equilibrium is not always smooth or instantaneous—it may involve lags, over- or under-shooting, and policy responses.
Short-run vs long-run equilibrium
Short-run equilibrium
Prices and wages are sticky and may not adjust immediately.
Equilibrium output can be above or below full employment.
Government intervention (fiscal or monetary policy) can help restore equilibrium.
Example:
If AD falls, the government may increase G to shift AD back rightward.
If AS rises, policymakers may allow output to grow without triggering inflation.
Long-run equilibrium
In the long run, prices and wages are flexible and adjust to restore full employment.
The AS curve becomes vertical at the full employment level of output.
Economy returns to its potential output, even if temporarily disrupted.
Key features:
Long-run equilibrium occurs where long-run AS intersects AD.
Output remains fixed at full capacity (Yₚ), but price levels adjust.
Any deviation from full employment output is corrected over time by wage and price adjustments.
FAQ
Yes, equilibrium national income can occur at a level below full employment. This situation is known as a deflationary or negative output gap. It arises when aggregate demand is insufficient to purchase the full-employment level of output, resulting in an equilibrium where actual real GDP is less than potential GDP. Although the economy is in equilibrium in the short run—meaning aggregate demand equals aggregate supply at prevailing price levels—resources such as labour and capital remain underutilised. This often leads to cyclical unemployment, where people willing and able to work cannot find jobs due to weak demand. In this state, the economy is not maximising its productive potential. Governments and central banks may respond with expansionary fiscal or monetary policies to increase aggregate demand and move the economy closer to its full employment level. The key point is that equilibrium does not always imply economic optimality or full capacity usage.
Persistent disequilibrium in national income—where aggregate demand and aggregate supply are not equal—can have serious macroeconomic implications. If aggregate demand consistently exceeds aggregate supply, it leads to demand-pull inflation, where rising prices erode purchasing power and may trigger interest rate hikes by central banks. Conversely, if aggregate demand is persistently lower than aggregate supply, the economy may face a prolonged downturn marked by unemployment, reduced output, and underused resources. Persistent disequilibrium also distorts investment and consumption patterns, leading to economic inefficiency. For example, uncertainty caused by fluctuating output and prices can deter firms from investing or expanding. It can also result in government budget deficits, as lower tax receipts and higher welfare spending increase fiscal pressure. In open economies, persistent disequilibrium can worsen trade balances and undermine currency stability. Maintaining equilibrium, or at least minimising disequilibrium, is therefore crucial for economic stability, efficient resource allocation, and sustained growth.
Expectations play a crucial role in determining how quickly and effectively the economy adjusts to a new equilibrium following a shock to aggregate demand or supply. If firms and consumers expect that an economic shock—such as a fall in AD—will be short-lived, they may not significantly alter their behaviour, slowing the adjustment process. For instance, firms might be reluctant to cut prices or lay off workers if they expect demand to recover soon. On the other hand, if they anticipate a prolonged downturn, they may act quickly to reduce output, lower wages, or cancel investment plans. Similarly, consumer expectations about inflation, interest rates, or job security influence spending and saving decisions, which in turn affect aggregate demand. Expectations can also lead to self-fulfilling prophecies; for example, widespread fear of inflation can cause higher wage demands, pushing costs up and triggering the inflation feared. Therefore, managing economic expectations is a key task for policymakers.
The economy may fail to automatically return to long-run equilibrium after a shock due to rigidities and frictions in the market. One key reason is wage and price stickiness—prices and wages do not always adjust swiftly or fully in response to changes in demand or supply. Labour contracts, minimum wage laws, and social expectations can prevent wages from falling, even when unemployment is high. Similarly, firms may resist cutting prices due to menu costs or fear of undermining their brand image. In addition, imperfect information means consumers and firms may not immediately recognise changes in economic conditions or may respond slowly. Hysteresis effects can also arise, where long-term unemployment erodes workers’ skills and attachment to the labour force, making recovery harder. In such cases, government intervention via fiscal stimulus or monetary easing may be required to steer the economy back to its potential output. Hence, automatic adjustment cannot be assumed to always occur effectively.
Global economic changes can have a profound effect on a country’s equilibrium national income by influencing both aggregate demand and aggregate supply. On the demand side, a global recession reduces demand for exports, causing the AD curve to shift left and lowering equilibrium output and price levels. Conversely, strong global growth boosts export demand, increasing AD and shifting the economy to a higher equilibrium income. Exchange rate fluctuations also matter—an appreciation makes exports less competitive and imports cheaper, reducing AD, while depreciation does the opposite. On the supply side, global commodity price shocks, such as rising oil prices, increase production costs and shift AS leftward, reducing output and raising prices. Global supply chain disruptions can also limit input availability, affecting productive capacity. In a highly interconnected world, capital flows, international investment, and geopolitical tensions can also influence confidence, trade patterns, and therefore a country’s macroeconomic equilibrium. Policymakers must monitor global trends to anticipate and manage such impacts.
Practice Questions
Explain how a decrease in aggregate demand might affect the equilibrium level of real national income and the price level in the short run.
A decrease in aggregate demand shifts the AD curve leftward. In the short run, this causes the equilibrium level of real national income to fall as firms respond to reduced demand by lowering output. Simultaneously, the general price level is likely to decrease due to excess supply, leading to downward pressure on prices. This new equilibrium reflects lower output and price level, potentially increasing unemployment. Since prices and wages are sticky in the short run, the economy may remain below full employment without immediate adjustments unless corrective policy measures are introduced to stimulate demand and restore equilibrium.
Analyse the likely effects of an increase in aggregate supply on the UK economy’s short-run equilibrium national income.
An increase in aggregate supply shifts the AS curve to the right, leading to a new short-run equilibrium where real national income rises and the price level falls. This change allows the economy to produce more goods and services at lower prices, encouraging consumption and investment. Unemployment may decrease as firms expand output, requiring more labour. The economy experiences non-inflationary growth, enhancing economic efficiency. However, the extent of the effect depends on the magnitude of the AS shift and whether it is matched by corresponding increases in aggregate demand to sustain the higher output level over time.
