Short Run Adjustment

Here is a diagram to illustrate the short-run adjustment of the economy to an increase in aggregate demand. Aggregate Demand before the increase in consumption is shown by the darker green curve labeled "AD₁." After the decrease in the interest rate, Aggregate Demand is shown by the lighter green curve labeled "AD₂." The horizontal distance between AD₁ and AD₂ is the increase in aggregate demand -- the increase in investment times the autonomous spending multiplier. But what about aggregate supply?

Figure 1: An Increase in Aggregate Demand in the Short Run

The long-run aggregate supply (NAIRGDP) is shown in dark red, labeled "LAS" and the short-run aggregate supply is shown in lighter red, labeled "SAS₁." Before the cut in interest rates, equilibrium is shown by the lower orange line and the price level "p₁ ," with production at the NAIRGDP. The new equilibrium is shown by the two orange lines at price level "p₂ ," and production is above the NAIRGDP. We see some inflation as a result of the increase in aggregate demand, but also some increase in employment and production, since Y is more than the NAIRGDP, the production level before the increase in the money supply.

Inflation Copyright