Long Run Adjustment

Here is the long run adjustment. As before, the long-run aggregate supply (NAIRGDP) is shown in dark red, labeled "LAS." With production below the NAIRGDP, inflation will slow -- perhaps it will become negative, with deflation. As people learn that prices are going to be lower than they had previously expected, and expect lower input costs, they shift their short run supply curves rightward. This continues until production is back at the NAIRGDP, as seen here in the new long run equilibrium. We see that the short-run aggregate supply curve has shifted to "SAS₂."

Figure 4: A Decrease in Aggregate Demand in the Short Run

This gives a new long-run equilibrium with the price level "p₂ ," and production at the NAIRGDP. What has happened here, behind the scenes, is that the drop in the price level has increased the real value of the money supply, which increases the real supply of loans, pushes down the real interest rate, and thus stimulates investment. Thus, the increase in investment has replaced the autonomous consumption, absorbing the increased in saving that people had in mind when they cut their consumption spending.

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