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Complete AS-AD Model

Unlike the aggregate demand curve, the
aggregate supply curve does not usually shift
independently. This is because the equation for the
aggregate supply curve contains no terms that are
indirectly related to either the price level or
output. Instead, the equation for aggregate supply
contains only terms derived from the AS-AD model.
For this reason, to understand how the aggregate
supply curve shifts, we must work from the AS-AD
model as a whole.

Figure %: Graph of the AS-AD model

depicts the AS-AD model. The intersection of the
short-run aggregate supply curve, the long-run
aggregate supply curve, and the aggregate demand
curve gives the equilibrium price level and the
equilibrium level of output. This is the
starting point for all problems dealing with the AS-
AD model.

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Shifts in Aggregate Demand in the AS-AD Model

The primary cause of shifts in the economy is
aggregate demand. Recall that aggregate demand can
be affected by consumers both domestic and foreign,
the Fed, and the government. For a review of the
shifters of aggregate demand, see the SparkNote on
aggregate demand. In
general, any expansionary policy shifts the
aggregate demand curve to the right while any
contractionary policy shifts the aggregate demand
curve to the left. In the long run, though, since
long-term aggregate supply is fixed by the factors of
production, short-term aggregate supply shifts to the
left so that the only effect of a change in aggregate
demand is a change in the price level.

Figure %: Graph of an expansionary shift in the AS-AD
model.

Let's work through an example. For this example,
refer to .
Notice that we begin at point A where short-run
aggregate supply curve 1 meets the long-run aggregate
supply curve and aggregate demand curve 1. The point
where the short-run aggregate supply curve and the
aggregate demand curve meet is always the short-run
equilibrium. The point where the long-run aggregate
supply curve and the aggregate demand curve meet is
always the long-run equilibrium. Thus, we are in
long-run equilibrium to begin.

Now say that the Fed pursues expansionary monetary
policy. In this case, the aggregate demand curve
shifts to the right from aggregate demand curve 1 to
aggregate demand curve 2. The intersection of short-
run aggregate supply curve 1 and aggregate demand
curve 2 has now shifted to the upper right from point
A to point B. At point B, both output and the price
level have increased. This is the new short-run
equilibrium.

But, as we move to the long run, the expected price
level comes into line with the actual price level as
firms, producers, and workers adjust their
expectations. When this occurs, the short-run
aggregate supply curve shifts along the aggregate
demand curve until the long-run aggregate supply
curve, the short-run aggregate supply curve, and the
aggregate demand curve all intersect. This is
represented by point C and is the new equilibrium
where short-run aggregate supply curve 2 equals the
long-run aggregate supply curve and aggregate demand
curve 2. Thus, expansionary policy causes output and
the price level to increase in the short run, but
only the price level to increase in the long run.