Aggregate Supply

Aggregate Supply and Aggregate Demand

Summary Aggregate Supply and Aggregate Demand
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!

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