Reference no: EM132860219

This week we are discussing how economy returns to equilibrium in response to changes in aggregate demand (AD) and aggregate supply (AS) in both the short run and long run.

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For the AD/AS model, the equilibrium of AD and AS occurs where price level meets real GDP on the AD and AS curves. When in the short-run, the equilibrium point of real GDP is not necessarily the same as the full-employment level of real GDP, which is what we would use with the long-run aggregate supply. The LRAS is a vertical line on the model. In the long-run the price level at full-employment will still be determined by where AS and AD meet.

Changes that shift the AS and AD curves are those other than price level changes. Something like an increase in taxes could cause a negative shock to the AD and this will shift the curve to the left. The equilibrium in the short run will move when this happens, and the price level will fall. Because of the decrease of aggregate demand, nominal wages decrease which will reduce production costs. In turn firms can produce more (with lower production costs) and this shifts the AS curve to the right. It will bring the equilibrium back to where it once was on the LRAS curve.