THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 664

632

PA R T V I I Monetary Theory
Aggregate
Price Level, P

LRAS

AS2

AS1
P2

2

P1

1

AD1
Y2

FIGURE 24-7

Yn

Aggregate Output, Y

Response of Output and the Price Level to a Shift in Short-Run
Aggregate Supply

A shift in the short-run aggregate supply curve from AS1 to AS2 moves the economy from point 1
to point 2. Because Y2 * Yn, the short-run aggregate supply curve begins to shift back to the
right, eventually returning to AS1, where the economy is again at point 1.

these diagrams is actually best thought of as the level of aggregate output relative to
its normal rate of growth (trend).
The usual assumption when conducting aggregate demand and supply analysis
is that shifts in either the aggregate demand or aggregate supply curve have no effect
on the natural rate level of output (which grows at a steady rate). Movements of
aggregate output around the Yn level in the diagram then describe short-run (business cycle) fluctuations in aggregate output. However, some economists take issue
with the assumption that Yn is unaffected by aggregate demand and supply shocks.
One group, led by Edward Prescott of the University of Minnesota, has developed a theory of aggregate economic fluctuations called real business cycle
theory in which aggregate supply (real) shocks do affect the natural rate level of
output Yn. This theory views shocks to tastes (workers willingness to work, for
example) and technology (productivity) as the major driving forces behind shortrun fluctuations in the business cycle because these shocks lead to substantial
short-run fluctuations in Yn. Shifts in the aggregate demand curve, say as a result
of changes in monetary policy, by contrast, are not viewed as being particularly
important to aggregate output fluctuations. Because real business cycle theory
views most business cycle fluctuations as resulting from fluctuations in the natural rate level of output, it does not see much need for government intervention
to eliminate high unemployment. Real business cycle theory is highly controversial and is the subject of intensive research.5
Another group of economists disagrees with the assumption that the natural
rate level of output Yn is always at the full employment level and is unaffected by
aggregate demand shocks. These economists contend that the natural rate level
of unemployment and output are subject to hysteresis, a departure from full
employment levels as a result of past high unemployment.6 When unemployment
5

See Charles Plosser, Understanding Real Business Cycles, Journal of Economic Perspectives (1989):
51 77, for a nontechnical discussion of real business cycle theory.

6

For a further discussion of hysteresis, see Olivier Blanchard and Lawrence Summers, Hysteresis in
the European Unemployment Problem, NBER Macroeconomics Annual, 1986, 1, ed. Stanley Fischer
(Cambridge, Mass.: M.I.T. Press, 1986), pp. 15 78.