AD-AS Model: Shifts in Aggregate Demand: Videos & Practice Problems

Understanding the dynamics of aggregate demand and supply is crucial for analyzing economic equilibrium in both the short run and long run. When aggregate demand shifts, it initiates a three-step process that helps determine the new equilibrium. The first step involves identifying the cause of the shift in aggregate demand, which can either be positive (shifting to the right) or negative (shifting to the left). This is similar to the principles of supply and demand, where shifts in curves lead to changes in equilibrium.

Once the aggregate demand curve is adjusted, the next step is to find the short run equilibrium. This is done by determining where the new aggregate demand curve intersects with the short run aggregate supply curve. This intersection point represents the short run equilibrium, indicating the price level and real GDP at that moment.

The final step involves the adjustment of short run aggregate supply in response to the new short run equilibrium. This adjustment does not occur instantaneously; it takes time for the economy to react. However, the short run aggregate supply will eventually shift to restore long run equilibrium, which is characterized by a stable price level and full employment output.

For instance, consider a scenario where there is a decrease in aggregate demand, often associated with a recession or cyclical unemployment. A decrease in expected future profits can lead to reduced investment spending, which in turn decreases aggregate demand. Graphically, this is represented by a leftward shift of the aggregate demand curve. As a result, the new short run equilibrium will show a lower price level and reduced GDP compared to the initial equilibrium.

In response to this decrease in aggregate demand, the short run aggregate supply will eventually shift to the right, moving towards a new long run equilibrium. This adjustment results in a return to the original level of long run GDP, but at a lower price level. Thus, the economy stabilizes at a new equilibrium characterized by lower prices while maintaining the same output level determined by the factors of production.

In summary, the process of shifting aggregate demand and adjusting aggregate supply is essential for understanding how economies respond to changes in demand. The interplay between these elements ultimately leads to new equilibria that reflect the underlying economic conditions.

When aggregate demand increases, it leads to a phenomenon known as demand-pull inflation, characterized by rising prices due to heightened demand for goods and services. This shift in aggregate demand can be illustrated through a graph where an increase in government spending, such as defense expenditures, causes the aggregate demand curve to shift to the right. This shift indicates a higher demand for goods and services, resulting in a new short-run equilibrium where the new aggregate demand curve intersects the short-run aggregate supply curve.

Initially, the economy operates at an equilibrium point with a specific price level and GDP. However, as aggregate demand increases, the new equilibrium reflects a higher price level and a GDP that exceeds the long-run equilibrium. This situation arises because the economy may experience overemployment and resource overuse, leading to a temporary state known as a "hot economy." In this state, businesses may see increased profits, justifying higher production levels and wages.

As the economy adjusts, the short-run aggregate supply will respond to the increased demand by shifting to the left. This adjustment process is essential for returning the economy to its long-run equilibrium. The long-run aggregate supply remains constant, and the new equilibrium will reflect a higher price level while stabilizing at the original long-run GDP. Thus, the overall effect of an increase in aggregate demand is a rise in prices, with the economy eventually returning to its long-run GDP but at a higher price level.

In summary, the process involves three key steps: shifting the aggregate demand curve, identifying the new short-run equilibrium, and adjusting the short-run aggregate supply to restore long-run equilibrium. This dynamic illustrates the interplay between demand, supply, and price levels in an economy.