Economics Online Tutor
| Aggregate Demand & Aggregate Supply Equilibrium |
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The aggregate demand curve slopes downward. The short run aggregate
supply curve slopes upward. The point where these two curves intersect
indicates the short run equilibrium price level and real GDP.
If this is also long run equilibrium, then it would indicate a level of real GDP
that is equal to potential GDP. The long run aggregate supply curve would
be a vertical line that runs through this point.
What happens to the equilibrium price level and equilibrium real GDP when
changes in the economy cause the positions of these curves to shift?
Consider two scenarios. First, one in which the change in the economy is
created by a change in aggregate demand. Second, one in which the
change in the economy is created by a change in aggregate supply.
These scenarios assume an initial position of short run and long run
equilibrium.
supply curve slopes upward. The point where these two curves intersect
indicates the short run equilibrium price level and real GDP.
If this is also long run equilibrium, then it would indicate a level of real GDP
that is equal to potential GDP. The long run aggregate supply curve would
be a vertical line that runs through this point.
What happens to the equilibrium price level and equilibrium real GDP when
changes in the economy cause the positions of these curves to shift?
Consider two scenarios. First, one in which the change in the economy is
created by a change in aggregate demand. Second, one in which the
change in the economy is created by a change in aggregate supply.
These scenarios assume an initial position of short run and long run
equilibrium.
Shift in aggregate demand
If aggregate demand increases due to changes in any of the non-price
determinants of aggregate demand, the aggregate demand curve shifts
to the right. This intersects the short run aggregate supply curve at a
different point, creating a new short run equilibrium situation with a
higher price level and a higher real GDP than the original equilibrium.
In this case, the equilibrium real GDP will be above potential GDP. But
this is not long run equilibrium. This point is away from the long run
aggregate supply curve.
In the long run, as input prices adjust to the new (higher) price level, the
short run aggregate supply curve will shift leftward, until it intersects
the new aggregate demand curve along the long run aggregate supply
curve.
At this point, the initial increase in real GDP has not been sustained. The
new long run equilibrium is at the original level of real GDP. The only
change in long run equilibrium is a higher price level. This higher price
level represents inflation.
Since the initial cause of the change in equilibrium is an increase in
aggregate demand, this type of inflation is called demand-pull inflation.
If aggregate demand increases due to changes in any of the non-price
determinants of aggregate demand, the aggregate demand curve shifts
to the right. This intersects the short run aggregate supply curve at a
different point, creating a new short run equilibrium situation with a
higher price level and a higher real GDP than the original equilibrium.
In this case, the equilibrium real GDP will be above potential GDP. But
this is not long run equilibrium. This point is away from the long run
aggregate supply curve.
In the long run, as input prices adjust to the new (higher) price level, the
short run aggregate supply curve will shift leftward, until it intersects
the new aggregate demand curve along the long run aggregate supply
curve.
At this point, the initial increase in real GDP has not been sustained. The
new long run equilibrium is at the original level of real GDP. The only
change in long run equilibrium is a higher price level. This higher price
level represents inflation.
Since the initial cause of the change in equilibrium is an increase in
aggregate demand, this type of inflation is called demand-pull inflation.
Shift in aggregate supply
If the initial change in equilibrium is a sudden increase in the price of a key
input, the short run aggregate supply curve shifts to the left. This
intersects the aggregate demand curve at a different point, creating a new
equilibrium with a higher price level and a lower real GDP than the original
equilibrium. In this case, the result is both higher prices and lower output.
This situation is called stagflation. The type of inflation caused by a
decrease in aggregate supply is called cost-push inflation.
Stagflation caused by a sudden leftward shift in the aggregate supply curve
is called supply shock.
In the long run, this leftward shift in the aggregate supply curve may or may
not be permanent. It is unlikely that such a supply shock will continue to
push the aggregate supply curve further to the left. Events that create
supply shock tend to be independent, one-time events.
If the initial cause of the supply shock is a weather event or a natural
disaster, the aggregate supply curve will eventually shift back to the
original equilibrium position.
If the cause of the supply shock is man-made, such as a decision by oil
producers to decrease global supplies, the shift in the short run aggregate
supply curve could shift the long run aggregate supply curve to the left as
well. This would mean that the price level increase could be permanent,
long run equilibrium real GDP could be lower, and the natural rate of
unemployment could increase.
If the initial change in equilibrium is a sudden increase in the price of a key
input, the short run aggregate supply curve shifts to the left. This
intersects the aggregate demand curve at a different point, creating a new
equilibrium with a higher price level and a lower real GDP than the original
equilibrium. In this case, the result is both higher prices and lower output.
This situation is called stagflation. The type of inflation caused by a
decrease in aggregate supply is called cost-push inflation.
Stagflation caused by a sudden leftward shift in the aggregate supply curve
is called supply shock.
In the long run, this leftward shift in the aggregate supply curve may or may
not be permanent. It is unlikely that such a supply shock will continue to
push the aggregate supply curve further to the left. Events that create
supply shock tend to be independent, one-time events.
If the initial cause of the supply shock is a weather event or a natural
disaster, the aggregate supply curve will eventually shift back to the
original equilibrium position.
If the cause of the supply shock is man-made, such as a decision by oil
producers to decrease global supplies, the shift in the short run aggregate
supply curve could shift the long run aggregate supply curve to the left as
well. This would mean that the price level increase could be permanent,
long run equilibrium real GDP could be lower, and the natural rate of
unemployment could increase.
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