From 1929 to 1933, the Canadian economy moved down the short-run aggregate supply curve as the aggregate price level fell. In contrast, from 1979 to 1982 the Canadian economy moved up the aggregate demand curve as the aggregate price level rose. In each case, the cause of the movement along the curve was a shift of the other curve. In 1929-1933, it was a leftward shift of the aggregate demand curve—a major fall in consumer spending. In 1979-1982, it was a leftward shift of the short-run aggregate supply curve—a dramatic fall in short-run aggregate supply caused by the oil price shock.

So to understand the behaviour of the economy, we must put the aggregate supply curve and the aggregate demand curve together. The result is the AD-AS model, the basic model we use to understand economic fluctuations.

We’ll begin our analysis by focusing on the short run. Figure 12-12 shows the aggregate demand curve and the short-run aggregate supply curve on the same diagram. The point at which the AD and SRAS curves intersect, E_SR, is the short-run macroeconomic equilibrium, the point at which the quantity of aggregate output supplied is equal to the quantity demanded by domestic households, businesses, the government, and the rest of the world. The aggregate price level at E_SR, P_E, is the short-run equilibrium aggregate price level. The level of aggregate output at E_SR, Y_E, is the short-run equilibrium aggregate output, which represents real GDP at one given time period.

In the supply and demand model of Chapter 3 we saw that a shortage of any individual good causes its market price to rise but a surplus of the good causes its market price to fall. These forces ensure that the market reaches equilibrium. The same logic applies to short-run macroeconomic equilibrium. If the aggregate price level is above its equilibrium level, the quantity of aggregate output supplied exceeds the quantity of aggregate output demanded. This leads to a fall in the aggregate price level and pushes it toward its equilibrium level. If the aggregate price level is below its equilibrium level, the quantity of aggregate output supplied is less than the quantity of aggregate output demanded. This leads to a rise in the aggregate price level, again pushing it toward its equilibrium level. In the discussion that follows, we’ll assume that the economy is always in short-run macroeconomic equilibrium.

We’ll also make another important simplification based on the observation that in reality there is a long-term upward trend in both aggregate output and the aggregate price level. We’ll assume that a fall in either variable really means a fall compared to the long-run trend. For example, if the aggregate price level normally rises 4% per year, a year in which the aggregate price level rises only 3% would count, for our purposes, as a 1% decline. In fact, since the Great Depression there have been very few years in which the aggregate price level of any major nation actually declined—Japan’s period of deflation since 1995 is one of the few exceptions. We’ll explain why in Chapter 16. There have, however, been many cases in which the aggregate price level fell relative to the long-run trend.

Short-run equilibrium aggregate output and the short-run equilibrium aggregate price level can change either because of shifts of the AD curve or because of shifts of the SRAS curve. Let’s look at each case in turn.

An event that shifts the aggregate demand curve, such as a change in expectations or wealth, the effect of the size of the existing stock of physical capital, or the use of fiscal or monetary policy, is known as a demand shock. The Great Depression was caused by a negative demand shock, the collapse of wealth and of business and consumer confidence that followed the stock market crash of 1929 and the banking crisis of 1930-1931. The Depression was ended by a positive demand shock—the huge increase in government purchases during World War II. In late 2008 the Canadian economy experienced another significant negative demand shock as consumer and business confidence fell due to the financial crisis that started in the U.S., leading consumers and firms to scale back their spending.

Figure 12-13 shows the short-run effects of negative and positive demand shocks. A negative demand shock shifts the aggregate demand curve, AD, to the left, from AD₁ to AD₂, as shown in panel (a). The economy moves down along the SRAS curve from E₁ to E₂, leading to lower short-run equilibrium aggregate output and a lower short-run equilibrium aggregate price level. A positive demand shock shifts the aggregate demand curve, AD, to the right, as shown in panel (b). Here, the economy moves up along the SRAS curve, from E₁ to E₂. This leads to higher short-run equilibrium aggregate output and a higher short-run equilibrium aggregate price level. Demand shocks cause aggregate output and the aggregate price level to move in the same direction.

An event that shifts the short-run aggregate supply curve, such as a change in commodity prices, nominal wages, or productivity, is known as a supply shock. A negative or adverse supply shock raises production costs and reduces the quantity producers are willing to supply at any given aggregate price level, leading to a leftward shift of the short-run aggregate supply curve. The Canadian economy experienced severe negative supply shocks following disruptions to world oil supplies in 1973 and 1979. In contrast, a positive supply shock reduces production costs and increases the quantity supplied at any given aggregate price level, leading to a rightward shift of the short-run aggregate supply curve. Canada experienced a positive supply shock in the late 1990s and early 2000s, when the increasing use of the Internet and other information technologies caused productivity growth to surge.³

The effects of a negative supply shock to the short-run aggregate supply curve are shown in panel (a) of Figure 12-14. The initial equilibrium is at E₁, with aggregate price level P₁ and aggregate output Y₁. The disruption in the oil supply causes the short-run aggregate supply curve to shift to the left, from SRAS₁ to SRAS₂. As a consequence, aggregate output falls and the aggregate price level rises, an upward movement along the AD curve. At the new equilibrium, E₂, the short-run equilibrium aggregate price level, P₂, is higher, and the short-run equilibrium aggregate output level, Y₂, is lower than before.

The combination of rising prices (higher inflation) and falling aggregate output shown in panel (a) has a special name: stagflation, for “stagnation plus inflation.” When an economy experiences stagflation, it’s very unpleasant: falling aggregate output leads to rising unemployment, and people feel that their purchasing power is squeezed by rising prices. Stagflation in the 1970s led to a mood of national pessimism. It also, as we’ll see shortly, poses a dilemma for policy-makers.

A positive supply shock, shown in panel (b), has exactly the opposite effects. A rightward shift of the SRAS curve from SRAS₁ to SRAS₂ results in a rise in aggregate output and a fall in the aggregate price level, a downward movement along the AD curve. The favourable supply shocks of the late 1990s led to a combination of higher employment and lower prices compared with the long-run trend (i.e., declining inflation). This combination produced, for a time, a great wave of national optimism.

The distinctive feature of supply shocks, both negative and positive, is that, unlike demand shocks, they cause the aggregate price level and aggregate output to move in opposite directions.

There’s another important contrast between supply shocks and demand shocks. As we’ve seen, monetary policy and fiscal policy enable the government to shift the AD curve, meaning that governments are in a position to create the kinds of shocks shown in Figure 12-13. It’s much harder for governments to shift the AS curve. Are there good policy reasons to shift the AD curve? We’ll turn to that question soon.

As noted in Tables 12-2 and 12-3, changes in productivity can shift both the SRAS and LRAS curves simultaneously. Let’s examine the effects of such a positive supply shock on the economy. When the economy experiences an increase in total factor productivity, each worker can produce more output for any given level of inputs. For example, the widespread use of information technologies in the past 20 years has greatly increased workers’ productivity, and this change has shifted the SRAS curve to the right. The LRAS curve also shifts to the right because once this new technology has been adopted it will have a long-lasting effect on the economy.

The effects of an increase in productivity are shown in Figure 12-15. The initial equilibrium is at E₁, with aggregate price level P₁ and aggregate output Y₁. Here the rise in productivity causes both the short-run and long-run aggregate supply curves to shift to the right by differing magnitudes from SRAS₁ to SRAS₂ and from LRAS₁ to LRAS₂, respectively. As a consequence, aggregate output rises and the aggregate price level falls, a downward movement along the AD curve. At the new short-run equilibrium, E₂, the short-run equilibrium aggregate price level, P₂, is lower, and the short-run equilibrium aggregate output level, Y₂, is higher than before.

The level of potential output has risen from Y₁ to Y₃ and the new level of potential output is higher than the new short-run level, Y₂; therefore, even though the economy experienced an increase in aggregate output in the short run, its short-run level of aggregate output is now below the economy’s long-run level.

Figure 12-16 combines the aggregate demand curve with both the short-run and long-run aggregate supply curves. The aggregate demand curve, AD, crosses the short-run aggregate supply curve, SRAS, at E_LR. Here we assume that enough time has elapsed that the economy is also on the long-run aggregate supply curve, LRAS. As a result, E_LR is at the intersection of all three curves—SRAS, LRAS, and AD. So short-run equilibrium aggregate output is equal to potential output, Y_P. Such a situation, in which the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve, is known as long-run macroeconomic equilibrium.

Demand Shocks To see the significance of long-run macroeconomic equilibrium, let’s consider what happens if a demand shock moves the economy away from long-run macroeconomic equilibrium. In Figure 12-17, we assume that the initial aggregate demand curve is AD₁ and the initial short-run aggregate supply curve is SRAS₁. So the initial macroeconomic equilibrium is at E₁, which lies on the long-run aggregate supply curve, LRAS. The economy, then, starts from a point of short-run and long-run macroeconomic equilibrium, and short-run equilibrium aggregate output equals potential output at Y₁.

Now suppose that for some reason—such as a sudden worsening of business and consumer expectations—aggregate demand falls and the aggregate demand curve shifts leftward to AD₂. This results in a lower equilibrium aggregate price level at P₂ and a lower equilibrium aggregate output level at Y₂ as the economy settles in the short run at E₂. The short-run effect of such a fall in aggregate demand is what the Canadian economy experienced during the Great Depression and in the recent recession of 2008-2009: a falling aggregate price level and falling aggregate output.

Aggregate output in this new short-run equilibrium, E₂, is below potential output. When this happens, the economy faces a recessionary gap. A recessionary gap inflicts a great deal of pain because it corresponds to high unemployment. The large recessionary gap that had opened up in Canada by 1933 caused intense social and political turmoil. And the devastating recessionary gap that opened up in Germany at the same time played an important role in Hitler’s rise to power.

But this isn’t the end of the story. In the face of high unemployment, nominal wages eventually fall, as do any other sticky prices, ultimately leading producers to increase output. As a result, a recessionary gap causes the short-run aggregate supply curve to gradually shift to the right over time. This process continues until SRAS₁ reaches its new position at SRAS₂, bringing the economy to equilibrium at E₃, where AD₂, SRAS₂, and LRAS all intersect. At E₃, the economy is back in long-run macroeconomic equilibrium; it is back at potential output Y₁ but at a lower aggregate price level, P₃, reflecting a long-run fall in the aggregate price level. In the end, the economy is self-correcting in the long run.

Figure 12-18 shows the results of an increase in aggregate demand. In the short run, a rightward shift in aggregate demand leads to a rise in both aggregate price level and aggregate output. Since the short-run equilibrium level of output, Y2, is above the level of potential output, the economy is said to be in an inflationary gap. Such a gap lowers unemployment and puts upward pressure on nominal wages. This, in the longer term, shifts the short-run aggregate supply curve up to the left. When the economy settles into its new long-run equilibrium, E₃, output falls back to potential output and the aggregate price level increases farther to P₃. Just as in the case of a reduction in aggregate demand, the economy corrects itself.

To summarize the analysis of how the economy responds to recessionary and inflationary gaps, we can focus on the output gap, the percentage difference between actual aggregate output and potential output. The output gap is calculated as follows:

Our analysis says that the output gap always tends toward zero.

If there is a recessionary gap, so that the output gap is negative, nominal wages eventually fall, moving the economy back to potential output and bringing the output gap back to zero. If there is an inflationary gap, so that the output gap is positive, nominal wages eventually rise, also moving the economy back to potential output and again bringing the output gap back to zero. So in the long run the economy is self-correcting: shocks to aggregate demand affect aggregate output in the short run but not in the long run.

Supply Shocks We have examined the long-run adjustment following a demand shock, but what happens if there is supply shock that moves the economy away from long-run macroeconomic equilibrium? Let’s continue with the example of the simultaneous shifts in both the SRAS and LRAS curves discussed earlier.

The short-run and long-run effects of an increase in productivity are shown in Figure 12-19. The initial equilibrium is at E₁, with aggregate price level P₁ and aggregate output Y₁. The rise in productivity leads to a rightward shift in both the short-run and long-run aggregate supply curves to SRAS₂ and LRAS₂, respectively. This results in a lower equilibrium aggregate price level at P₂ and a higher equilibrium level of aggregate output at Y₂ as the economy settles in the short-run at E₂. Although the short-run equilibrium level of aggregate output has increased, it is now below the new level of potential output, Y₃. In the longer term, we will observe a fall in nominal wages and other sticky prices. This will further increase output as it causes the short-run aggregate supply curve to gradually shift to the right over time. This process continues until SRAS reaches its long-run position, SRAS₃, where AD, SRAS₃, and LRAS₂ all intersect. At the new long-run equilibrium, E₃, the economy finds its aggregate output has moved to the new level of potential output Y₃ and the aggregate price level has fallen farther to P₃. Once again, the economy is self-correcting in the long-run.