Figure %: Graph of a positive supply shock 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. Thus, we
are in long-run equilibrium to begin.

Now say that a positive supply shock occurs: a
reduction in the price of oil. In this case, the
short-run aggregate supply curve shifts to the right
from short-run aggregate supply curve 1 to short-run
aggregate supply curve 2. The intersection of short-
run aggregate supply curve 2 and aggregate demand
curve 1 has now shifted to the lower right from point
A to point B. At point B, output has increased and
the price level has decreased. This is the new
short-run equilibrium.

However, as we move to the long run, aggregate demand
adjusts to the new price level and output level.
When this occurs, the aggregate demand curve shifts
along the short-run aggregate supply 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, a positive
supply shock causes output to increase and the price
level to decrease in the short run, but only the
price level to decrease in the long run.

Figure %: Graph of an adverse supply shock in the AS-
AD model

Let's work through another 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. Thus, we
are in long-run equilibrium to begin.

Now say that an adverse supply shock occurs: a
terrifying increase in the price of oil. In this
case, the short-run aggregate supply curve shifts to
the left from short-run aggregate supply curve 1 to
short-run aggregate supply curve 2. The intersection
of short-run aggregate supply curve 2 and aggregate
demand curve 1 has now shifted to the upper left from
point A to point B. At point B, output has decreased
and the price level has increased. This condition is
called stagflation. This is also the new short-
run equilibrium.

However, as we move to the long run, aggregate demand
adjusts to the new price level and output level.
When this occurs, the aggregate demand curve shifts
along the short-run aggregate supply 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, an adverse
supply shock causes output to decrease and the price
level to increase in the short run, but only the
price level to increase in the long run.

This is the logic that is applied to all shifts in
short-run aggregate supply. 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 short-run aggregate supply 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 short-run aggregate
supply shift, or supply shock, in both the short run
and in the long run.

This section has served a number of purposes. First,
we covered how and why the short-run aggregate supply
curve shifts. Second, we reviewed how and why the
aggregate demand curve shifts. Third, we introduced
the mechanism that moves the economy from the long
run to the short run and back to the long run when
there is a change in either aggregate supply or
aggregate demand. At this stage, you have the
ability to use the highly realistic model of the
macroeconomy provided by the AS-AD diagram to analyze
the effects of macroeconomic policies. This will
prove to be the most powerful tool in your collection
for understanding the macroeconomy. Use it wisely!