AD-AS Model: Shifts in Aggregate Demand - Online Tutor, Practice Problems & Exam Prep

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

So now, let's see what happens with the equilibrium in the short run and the long run when we have a shift in our aggregate demand. When we're shifting aggregate demand, we always follow a three-step process. The first thing is that our aggregate demand is going to shift. The problem will tell you something that affects aggregate demand, and we have to decide: Was it a good thing that's going to shift it to the right or a bad thing that will shift it to the left? That's very similar to what you're used to from supply and demand, shifting curves, looking for equilibrium, all of that good stuff, right? So, that's the first thing we're going to do. Next, we're going to find the short-run equilibrium. First, is shift aggregate demand. Next, is short-run equilibrium. And third, we already know how to find our short-run equilibrium, we're going to shift that aggregate demand and we're going to see where that new aggregate demand curve intersects with our short-run aggregate supply. So that will be our short-run equilibrium. Third, an opposite shift occurs in short-run aggregate supply. This is the economy adjusting for this short-run disequilibrium that's not the long-run equilibrium. So we're going to see what that looks like on the graph. But note that this third step doesn't happen immediately. It takes time for this third step to occur. But when we're looking at it on the graph, what we're looking for is what the short-run equilibrium is going to be and what the new long-run equilibrium will be after this shift. And what we're going to note is that the short-run aggregate supply is going to shift to find our new long-run equilibrium. It's easier to see this in an example, but this three-step process is: first, shifting the aggregate demand, second, we find our short-run equilibrium, and third, we find our long-run equilibrium with a shift in short-run aggregate supply. Alright? So, let's start here with a decrease in aggregate demand, which is something like when we have a recession or cyclical unemployment. We're going to see that a decrease in aggregate demand leads to a recession and cyclical unemployment. There's less demand. So, let's go ahead and see what happens here. A decrease in expected future profit has led to decreased investment spending. This is the key here. Decreased investment spending is going to affect our aggregate demand curve. So, let's go ahead and draw here on the graph. Remember, we've got our price level and our real GDP over here. The key here is that there's decreased investment spending, and remember, aggregate demand is made up of consumption, investment spending, government purchases, and net exports. So if there's decreased investment spending, there's going to be decreased aggregate demand. So let's go ahead and draw this in. Let's draw our original situation. Which one's aggregate demand here? Remember, we've got our downward demand, short-run aggregate supply, and long-run aggregate supply. So, I'm going to put a D1 because we're shifting our aggregate demand curve. So what I'm going to do now is I'm going to draw our new aggregate demand curve to the left. We're going to shift it to the left because we have a decrease in our aggregate demand, and I'm going to draw it down here. First, actually, I want to show you where our long-run equilibrium was initially. Right here was our initial price level. And now we're going to shift to the left. So if we shift our aggregate demand curve to the left, to AD2, what's going to happen here? Where's our new short-run equilibrium? So right here is short-run equilibrium, where our new aggregate demand curve is touching the short-run aggregate supply curve. So this decrease in investment spending has caused the aggregate demand to shift to the left, leading to a lower price level in the short run. There's a lower price level, and this was our original GDP right here when we were in long-run equilibrium. And now, we've got this GDP right here, which is lower because of this decrease in aggregate demand. So, these are steps 1 and 2. Step 1, we shifted the aggregate demand to the left. Step 2, we found our new equilibrium, and we're able to analyze what happened: We had a decrease in the price level in the short-run equilibrium and a decrease in equilibrium GDP in the short run as well. So, step 3 is going to be our aggregate supply reacting. Our aggregate supply is going to react to this short-run shift to get us back to a long-run equilibrium. So what we're going to do is we're going to shift our short-run aggregate supply curve the opposite way. So if our aggregate demand had shifted to the left, our aggregate supply is going to shift to the right. Short-run aggregate supply, which was aggregate supply 1, we're going to draw a new short-run aggregate supply going to the right because the aggregate demand went to the left. Aggregate supply is going to go to the right. This is the key point right here. This is where we want to shift it to get it back into long-run equilibrium. Remember, our long-run equilibrium had the X with the straight line going up, the long-run star shape equilibrium. So, our new long-run equilibrium is going to pass through this point where our new aggregate demand, the red line, is going to be touching the long-run aggregate supply that's not shifting. So let's go ahead and draw that here. This would be our short-run aggregate supply shifting to the right to meet that new long-run equilibrium, short-run aggregate supply 2. This doesn't happen immediately, as I said. This short-term aggregate demand shifted to the left, and over time, this aggregate supply is going to shift to the right to adjust for this. Here is our new long-run equilibrium, right here in green, new long-run equilibrium. What is this new long-run equilibrium? What is affected? We've gotten back to the same level of long-run GDP and remember, that's always based on the factors of production in the economy. But where we end up with is at a lower price level. In the short run: lower price level, lower GDP. And then, in the long run, we're back to an equal GDP at a lower price level. So, this is an extra step compared to what we're used to when we're shifting curves in our market demand and supply, but it's not so crazy. All we're doing is having an opposite shift in our short-run aggregate supply, which is always going to be the one that adjusts back to our long-run equilibrium. Let's go ahead and pause here, and then we'll talk about an increase in aggregate demand.

Equilibrium and Shifts in Aggregate Demand

So now let's see what an increase in aggregate demand does. We call this demand pull inflation. You'll see why when we get into it. We're going to see that the prices are going to be going up with this increase in aggregate demand. Okay? It's going to shift leading to higher long run equilibrium price. Okay? So let's go ahead and get down to the graph and let's see how a shift in our aggregate demand to the right is going to affect our long run equilibrium. So, in this example, we're saying there's an increase in defense spending by the government. Okay? So, there's an increase in government purchases and remember government purchases are a part of our aggregate demand, right? We have consumption, investment, government spending, and net exports. So, if the government spending is going up, our aggregate demand is going to shift to the right. So let's go ahead and start with our star-shaped equilibrium for the original situation. Right? And you're going to notice this is how a lot of these go. We're just going to start with an equilibrium and see what happens when we shift. So here's our downward demand, known as double Ds, Short run aggregate supply, and long run aggregate supply. Okay? So here's our original equilibrium right here where we have this price level, price level 1, and GDP 1. Right? Our long run GDP equilibrium, and now we're going to shift our aggregate demand to the right. So our increase in defense spending by the government is going to shift our aggregate demand to the right, and we're going to have a new aggregate demand curve somewhere out here. Okay? Aggregate demand. So this was aggregate demand 1. Here's aggregate demand 2. Okay? So where's our short run equilibrium going to be? Can you guys find it? Well, it's where our new aggregate demand curve touches our short run aggregate supply curve. That's going to be right here where the red line crosses the short run aggregate supply curve right at this point right here. This is our short run equilibrium. Short run. I'll put EQ, short run equilibrium for our short run, equilibrium right there. So what's happened to the price level in the short run? The shift in aggregate demand is going to increase our prices, right? There's more demand for all the goods and services available, so it's going to push the prices up and that's why we call it the demand pull inflation. The demand is pulling those prices up in this situation leading to a higher level of GDP. And notice what's happening at this point. This GDP is beyond our long run equilibrium. How is that even possible? Well, the trick here is that it shouldn't be possible. But what's happening is that there's over-employment in the economy. There's overuse of our resources that's actually leading to what we call a hot economy. We're actually past our long run equilibrium for a short period of time here. In this short run, what we're seeing is that there's over-employment. Maybe people are working. There's a little bit higher wages or something causing people to work more. Businesses are seeing more profit and they're able to justify, having this higher higher than normal GDP beyond our potential GDP in the long run, okay? So in the short run, we're able to push the price level up and the GDP past our long run equilibrium there. Alright, so now that we found our short run equilibrium, what did we say was going to happen? The final step is that the short run aggregate supply is going to react to get us back to our long run equilibrium. So in this case, our aggregate demand has shifted to the right. What's going to happen with our short run aggregate supply? It's going to shift to the left, right? So now, we're going to draw a new short run aggregate supply where this was our 1st short run aggregate supply. Let's draw a new one. And remember, we're going to be keeping our long run aggregate supply constant in these examples. So we're looking to find our this point right here. That is going to be our new long run equilibrium where our aggregate demand curve is touching that long run equilibrium. So what we're going to do is we're going to draw a new short run aggregate supply to the left here that goes through that point. Let me draw it a little better. Just like that and that's going to be our new short run aggregate supply that remember, it takes a little time for this shift to occur for it to adjust back into our long run equilibrium. So now, we've reached our long run equilibrium up here. Long run equilibrium. And what's happened to the price? Because of this increase in aggregate demand, what we have another increase in the price and our long run equilibrium has a higher price level at the same long run GDP here. Okay? So what's happened here? In the short run, we had higher price higher GDP, right? We were able to push past our long run equilibrium GDP And in the long run, what's happening here? The price increases again, higher price, back to our stable amount of long run GDP there. Okay? So we're back to this GDP, our long run equilibrium GDP, GDP 1 in this situation. Cool? So notice, this isn't too tough. We're following that 3 step process. 1st, we're going to shift the aggregate demand either left or right. We're going to find our new equilibrium in the short run and then we're going to shift the short run aggregate supply the opposite way from the aggregate demand. All right? Let's pause here and let's move on.

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.