From 1929 to 1933, the U.S. economy moved down the short-run aggregate supply curve as the aggregate price level fell. In contrast, from 1979 to 1980 the U.S. 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 1979–1980, 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 behavior 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 27-11 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.

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 31. 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 2008 the U.S. economy experienced another significant negative demand shock as the housing market turned from boom to bust, leading consumers and firms to scale back their spending.

Figure 27-12 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 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 U.S. 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. The United States experienced a positive supply shock between 1995 and 2000, when the increasing use of the internet and other information technologies caused productivity growth to surge.

The effects of a negative supply shock are shown in panel (a) of Figure 27-13. 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 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 favorable supply shocks of the late 1990s led to a combination of full employment and declining inflation. That is, the aggregate price level fell compared with the long-run trend. 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 27-12. 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. First, however, let’s look at the difference between short-run macroeconomic equilibrium and long-run macroeconomic equilibrium.

Figure 27-14 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.

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 27-15, 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 U.S. economy experienced in 1929–1933: 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 the United States 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.

What if, instead, there was an increase in aggregate demand? The results are shown in Figure 27-16, where we again assume that the initial aggregate demand curve is AD₁ and the initial short-run aggregate supply curve is SRAS₁, so that the initial macroeconomic equilibrium, at E₁, lies on the long-run aggregate supply curve, LRAS. Initially, then, the economy is in long-run macroeconomic equilibrium.

Now suppose that aggregate demand rises, and the AD curve shifts rightward to AD₂. This results in a higher aggregate price level, at P₂, and a higher aggregate output level, at Y₂, as the economy settles in the short run at E₂. Aggregate output in this new short-run equilibrium is above potential output, and unemployment is low in order to produce this higher level of aggregate output. When this happens, the economy experiences an inflationary gap.

As in the case of a recessionary gap, this isn’t the end of the story. In the face of low unemployment, nominal wages will rise, as will other sticky prices. An inflationary gap causes the short-run aggregate supply curve to shift gradually to the left as producers reduce output in the face of rising nominal wages. 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, but at a higher price level, P₃, reflecting a long-run rise in the aggregate price level. Again, the economy is self-correcting in the long run.

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.