Aggregate Supply

Aggregate Supply and Aggregate Demand

Summary Aggregate Supply and Aggregate Demand
Figure %: Graph of a contractionary shift in the AS- AD model

The opposite case exists when the aggregate demand curve shifts left. For example, say the Fed pursues contractionary monetary policy. For this example, refer to . Notice that we begin again at point A where short-run aggregate supply curve 1 meets the long-run aggregate supply curve and aggregate demand curve 1. We are in long-run equilibrium to begin.

If the Fed pursues contractionary monetary policy, the aggregate demand curve shifts to the left from aggregate demand curve 1 to aggregate demand curve 2. The intersection of short-run aggregate supply curve 1 and the aggregate demand curve has now shifted to the lower left from point A to point B. At point B, both output and the price level have decreased. 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 down 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 meets the long-run aggregate supply curve and aggregate demand curve 2. Thus, contractionary policy causes output and the price level to decrease in the short run, but only the price level to decrease in the long run.

This is the logic that is applied to all shifts in aggregate demand. The long-run equilibrium is always dictated by the intersection of the vertical long-run aggregate supply curve and the aggregate demand curve. The short-run equilibrium is always dictated by the intersection of the short-run aggregate supply curve and the aggregate demand curve. When the aggregate demand curve shifts, the economy always shifts from the long-run equilibrium to the short-run equilibrium and then back to a new long-run equilibrium. By keeping these rules and the examples above in mind it is possible to interpret the effects of any aggregate demand shift in both the short run and in the long run.

Shifts in the short-run aggregate supply curve are much rarer than shifts in the aggregate demand curve. Usually, the short-run aggregate supply curve only shifts in response to the aggregate demand curve. But, when a supply shock occurs, the short-run aggregate supply curve shifts without prompting from the aggregate demand curve. Fortunately, the correction process is exactly the same for a shift in the short-run aggregate supply curve as it is for a shift in the aggregate demand curve. That is, when the short-run aggregate supply curve shifts, a short- run equilibrium exists where the short-run aggregate supply curve intersects the aggregate demand curve. Then the aggregate demand curve shifts along the short-run aggregate supply curve until the aggregate demand curve intersects both the short-run and the long-run aggregate supply curves. Once the economy reaches this new long-run equilibrium, the price level is changed but output is not.

There are two types of supply shocks. Adverse supply shocks include things like increases in oil prices, a drought that destroys crops, and aggressive union actions. In general, adverse supply shocks cause the price level for a given amount of output to increase. This is represented by a shift of the short-run aggregate supply curve to the left. Positive supply shocks include things like decreases in oil prices or an unexpected great crop season. In general, positive supply shocks cause the price level for a given amount of output to decrease. This is represented by a shift of the short-run aggregate supply curve to the right.

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