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

Shifts in aggregate demand impact short-run and long-run equilibrium. An increase in aggregate demand, such as from government spending, leads to demand-pull inflation, raising prices and GDP temporarily above long-run potential. Conversely, a decrease in aggregate demand, like reduced investment, lowers both price levels and GDP. The economy adjusts through shifts in short-run aggregate supply, ultimately returning to long-run equilibrium with a new price level. Understanding these dynamics is crucial for grasping macroeconomic stabilization and the business cycle.

Equilibrium and Shifts in Aggregate Demand

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.

Equilibrium and Shifts in Aggregate Demand

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.

Here’s what students ask on this topic:

What causes shifts in aggregate demand?

Shifts in aggregate demand (AD) are caused by changes in the components of AD: consumption, investment, government spending, and net exports. For example, an increase in consumer confidence can boost consumption, shifting AD to the right. Conversely, a decrease in business investment due to lower expected future profits can shift AD to the left. Government policies, such as increased defense spending, can also shift AD to the right, while a reduction in government spending can shift it to the left. Changes in net exports, influenced by exchange rates and global economic conditions, also affect AD.

How does a decrease in aggregate demand affect the economy in the short run?

A decrease in aggregate demand (AD) in the short run leads to a lower price level and a reduction in real GDP. This shift to the left in the AD curve results in a new short-run equilibrium where the AD curve intersects the short-run aggregate supply (SRAS) curve at a lower output and price level. This can cause cyclical unemployment and a recession, as businesses reduce production and lay off workers due to decreased demand for goods and services.

What is demand-pull inflation and how is it related to shifts in aggregate demand?

Demand-pull inflation occurs when an increase in aggregate demand (AD) leads to higher price levels. This happens when AD shifts to the right, often due to factors like increased government spending, higher consumer confidence, or rising investment. The increased demand for goods and services pushes prices up, resulting in inflation. In the short run, this can also lead to higher GDP and overemployment, but the economy eventually adjusts as the short-run aggregate supply (SRAS) shifts to the left, stabilizing at a higher price level in the long run.

How does the economy adjust to a new long-run equilibrium after a shift in aggregate demand?

After a shift in aggregate demand (AD), the economy adjusts to a new long-run equilibrium through changes in short-run aggregate supply (SRAS). If AD decreases, SRAS shifts to the right over time, lowering prices and restoring long-run GDP. Conversely, if AD increases, SRAS shifts to the left, raising prices and stabilizing GDP at its long-run potential. This adjustment process ensures that the economy returns to its long-run equilibrium output, although the price level may be different from the initial state.

What are the three steps to analyze shifts in aggregate demand in the AD-AS model?

To analyze shifts in aggregate demand (AD) in the AD-AS model, follow these three steps: First, identify the cause of the shift and determine whether AD will shift to the left or right. Second, find the new short-run equilibrium where the new AD curve intersects the short-run aggregate supply (SRAS) curve. Third, determine the long-run adjustment by shifting the SRAS curve in the opposite direction of the AD shift to find the new long-run equilibrium. This process helps understand the short-run and long-run impacts on price levels and GDP.