THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 663

CHAPTER 24 Aggregate Price Level, P Aggregate Demand and Supply Analysis 631 AS2 LRAS AS1 P2 P1* 1* P1 AD2 AD1 Yn Y 1' Aggregate Output, Y FIGURE 24-6 Response of Output and the Price Level to a Shift in the Aggregate Demand Curve A shift in the aggregate demand curve from AD1 to AD2 moves the economy from point to point 1* Because Y1* + Yn , the short-run aggregate supply curve begins to shift leftward, eventually reaching AS2, where output returns to Yn and the price level has risen to P2 of the rightward shift in the aggregate demand curve is a rise in both the price level and output, the ultimate long-run effect is only a rise in the price level Changes in the Equilibrium Caused by Aggregate Supply Shocks Our understanding of the distinction between short-run and long-run equilibria allows us to analyze what happens when there are aggregate supply shocks that shift the short-run aggregate supply curve Suppose that the economy is initially at the natural rate level of output at point when the short-run aggregate supply curve shifts from AS1 to AS2 in Figure 24-7, because of a negative supply shock (a sharp rise in energy prices, for example) The economy will move from point to point 2, where the price level rises but aggregate output falls A situation of a rising price level but a falling level of aggregate output, as pictured in Figure 24-7, has been labelled stagflation (a combination of the words stagnation and inflation) At point 2, output is below the natural rate level, so wages fall and shift the short-run aggregate supply curve back to where it was initially at AS1 The result is that the economy slides down the aggregate demand curve AD1 (assuming that the aggregate demand curve remains in the same position), and the economy returns to the long-run equilibrium at point Although a leftward shift in the short-run aggregate supply curve initially raises the price level and lowers output, the ultimate effect is that output and price level are unchanged (holding the aggregate demand curve constant) Shifts in the Long-Run Aggregate Supply Curve: Real Business Cycle Theory and Hysteresis To this point we have assumed that the natural rate level of output Yn and hence the long-run aggregate supply curve are given However, over time, the natural rate level of output increases as a result of economic growth If the productive capacity of the economy is growing at a steady rate of 3% per year, for example, this means that every year Yn will grow by 3% and the long-run aggregate supply curve at Yn will shift to the right by 3% To simplify the analysis when Yn grows at a steady rate, Yn and the long-run aggregate supply curve are drawn as fixed in the aggregate demand and supply diagrams Keep in mind, however, that the level of aggregate output pictured in