Inflation

But this can't go on indefinitely. As long as production is greater than the NAIRGDP, inflation will speed up. At first, the speedups will come as a surprise to producers -- remember, that's the reason why the short run aggregate supply curve is upward-sloping rather than vertical: because price increases come as a surprise. But people will learn that prices are going up faster. If their expectations are "rational," in fact, they may anticipate it right from the first. If their expectations are "adaptive," then it will take some time, perhaps a long time, for them to learn that the rate of inflation is now higher. But eventually they will learn.

Once they learn that prices are going up more rapidly, the short run aggregate supply curve will change. Remember, when people expect prices to rise, they immediately shift their SAS curves backward by the corresponding amount. The SAS curve will shift backward until a new long run equilibrium is reached. Here is what the new equilibrium will look like.

Long Run Adjustment