Economics Online Tutor
Aggregate Demand &
Aggregate Supply
Equilibrium
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.
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.
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.
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