Long Run Adjustment

Here is a diagram to illustrate the long-run adjustment of the economy to the increase in aggregate demand. As before, the long-run aggregate supply (NAIRGDP) is shown in dark red, labeled "LAS." We see that the short-run aggregate supply curve has shifted to "SAS₂."

Figure 2: An Increase in Aggregate Demand in the Long Run

With short-run aggregate supply curve at SAS₂ , both short and long run supply are equal to demand at the new long-run equilibrium with the price level "p₃ ," and production at the NAIRGDP. Inflation has now stabilized again, and prices go up each year just as much (and as little) as people expect them to. People can make their plans and carry them out as they had expected. (Remember, that's what we mean by macroeconomic equilibrium). But production is back where it was at start. The stimulus to production as a result of "expansionary monetary policy" has proved to be a temporary, short run stimulus; and on the other hand the price level has risen to p₃ , for a good deal more inflation than was experienced in the short run.

Assumptions Copyright