Impact of Changes in Aggregate Supply and Demand

Let’s say that the economy is initially in short run and long run equilibrium as shown below:

Now let’s say that the aggregate demand increases and the aggregate demand curve shifts to the right (AD’). A new short run equilibrium will be formed at point B. 

In the new equilibrium, the real GDP is greater than potential GDP. At the new equilibrium the price levels are high, which means lower real wage rate. Now two phenomenons will take place: 1) Businesses will want to produce more to meet increased demand at higher price levels, and 2) They will need to hire new workers. Both these factors will lead to an increase in money wage rates. An increase in money wage rates and other resource prices means that businesses will be willing to supply less at each price level. Slowly, the SRAS will shift to the left and the long run macroeconomic equilibrium will be restored at point C.

In the opposite situation, the aggregate demand falls and the aggregate demand curve shifts to the left, forming a new equilibrium at a lower price level. Slowly the SRAS will shift to the right to restore the long run macroeconomic equilibrium.

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