THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 663

CHAPTER 24
Aggregate
Price Level, P

Aggregate Demand and Supply Analysis

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AS2

LRAS

AS1
P2

2

P1*

1*

P1

AD2

1

AD1
Yn

Y 1'

Aggregate Output, Y

FIGURE 24-6

Response of Output and the Price Level to a Shift in the Aggregate
Demand Curve

A shift in the aggregate demand curve from AD1 to AD2 moves the economy from point 1 to
point 1*. Because Y1* + Yn , the short-run aggregate supply curve begins to shift leftward, eventually reaching AS2, where output returns to Yn and the price level has risen to P2.

of the rightward shift in the aggregate demand curve is a rise in both the
price level and output, the ultimate long-run effect is only a rise in the
price level.

Changes in the
Equilibrium
Caused by
Aggregate
Supply Shocks

Our understanding of the distinction between short-run and long-run equilibria allows
us to analyze what happens when there are aggregate supply shocks that shift the
short-run aggregate supply curve. Suppose that the economy is initially at the natural
rate level of output at point 1 when the short-run aggregate supply curve shifts from
AS1 to AS2 in Figure 24-7, because of a negative supply shock (a sharp rise in energy
prices, for example). The economy will move from point 1 to point 2, where the price
level rises but aggregate output falls. A situation of a rising price level but a falling
level of aggregate output, as pictured in Figure 24-7, has been labelled stagflation (a
combination of the words stagnation and inflation). At point 2, output is below the
natural rate level, so wages fall and shift the short-run aggregate supply curve back

to where it was initially at AS1. The result is that the economy slides down the aggregate demand curve AD1 (assuming that the aggregate demand curve remains in the
same position), and the economy returns to the long-run equilibrium at point 1.
Although a leftward shift in the short-run aggregate supply curve initially
raises the price level and lowers output, the ultimate effect is that output and
price level are unchanged (holding the aggregate demand curve constant).

Shifts in the
Long-Run
Aggregate
Supply Curve:
Real Business
Cycle Theory
and Hysteresis

To this point we have assumed that the natural rate level of output Yn and hence the
long-run aggregate supply curve are given. However, over time, the natural rate level
of output increases as a result of economic growth. If the productive capacity of the
economy is growing at a steady rate of 3% per year, for example, this means that every
year Yn will grow by 3% and the long-run aggregate supply curve at Yn will shift to
the right by 3%. To simplify the analysis when Yn grows at a steady rate, Yn and the
long-run aggregate supply curve are drawn as fixed in the aggregate demand and supply diagrams. Keep in mind, however, that the level of aggregate output pictured in