The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded.
The aggregate demand curve is downward sloping for two reasons. The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ and firms’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.
The aggregate demand curve shifts because of changes in expectations, changes in wealth not due to changes in the aggregate price level, and the effect of the size of the existing stock of physical capital. Policy-
The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied.
The short-run aggregate supply curve is upward sloping because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profit per unit of output and increased aggregate output supplied in the short run.
Changes in commodity prices, nominal wages, and productivity lead to changes in producers’ profits and shift the short-run aggregate supply curve.
In the long run, all prices, including nominal wages, are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise. So the long-run aggregate supply curve is vertical at potential output.
Changes in the stock of physical capital, the stock of human capital, the size of the labour force, and productivity shift the long-
In the AD-AS model, the intersection of the short-
Economic fluctuations occur because of a shift of the aggregate demand curve (a demand shock) or the short-
Demand shocks and supply shocks have only short-
The high cost—
Negative supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.