Economies experience short-run fluctuations in economic activity, measured most broadly by real GDP. These fluctuations are associated with movement in many macroeconomic variables. In particular, when GDP growth declines, consumption growth falls (typically by a smaller amount), investment growth falls (typically by a larger amount), and unemployment rises. Although economists look at various leading indicators to forecast movements in the economy, these short-run fluctuations are largely unpredictable.
The crucial difference between how the economy works in the long run and how it works in the short run is that prices are flexible in the long run but sticky in the short run. The model of aggregate supply and aggregate demand provides a framework to analyze economic fluctuations and see how the impact of policies and events varies over different time horizons.
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The aggregate demand curve slopes downward. It tells us that the lower the price level, the greater the aggregate quantity of goods and services demanded.
In the long run, the aggregate supply curve is vertical because output is determined by the amounts of capital and labor and by the available technology but not by the level of prices. Therefore, shifts in aggregate demand affect the price level but not output or employment.
In the short run, the aggregate supply curve is horizontal, because wages and prices are sticky at predetermined levels. Therefore, shifts in aggregate demand affect output and employment.
Shocks to aggregate demand and aggregate supply cause economic fluctuations. Because the Fed can shift the aggregate demand curve, it can attempt to offset these shocks to maintain output and employment at their natural levels.