Equilibrium Equilibrium price and quantity are found where the AD and AS curves intersect. –At any price level above equilibrium sellers are faced with surpluses and are forced to reduce production and price level. –At any price level below equilibrium buyers are faced with shortages and are forced to pay more, encouraging suppliers to produce more.

Changes in Equilibrium Changes in AD have different effects on price level and output depending on which range of the AS curve the economy is in –If price levels increase this is known as demand-pull inflation Increases in AS have a positive effect on both price level and output. –When AS shifts right, price levels fall or stabilize, but output increases. Decreases in AS have a negative effect on both price level and output. –When AS shifts left, price levels rise, and output decreases (known as cost-push inflation or stagflation).

Policy Responses to Recession u Policymakers may respond to a recession (a decrease in aggregate demand) in one of the following ways: u Take action to increase aggregate demand by using monetary and fiscal policy u Output and employment rise, but so do price levels. u Do nothing and wait for prices and wages to adjust.

1. A decrease in aggregate demand… AD 2 A Contraction in Aggregate Demand with NO Government Response... Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply Aggregate demand, AD 1 A P1P1 Y1Y1 B P2P2 Y2Y2 2. …causes output to fall in the short run… AS 2 C P3P3 3. …but over time, the short-run aggregate-supply curve shifts… 4. …and output returns to its natural rate. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Effects of an Adverse Shift in Aggregate Supply: Stagflation uAdverse shifts in aggregate supply cause stagflation—a combination of recession and inflation. u Output falls and prices rise. u Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

AS 2 1. When short-run aggregate supply falls… Accommodating an Adverse Shift in Aggregate Supply... Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply, AS 1 Aggregate demand, AD 1 Long-run aggregate supply A P1P1 P2P2 P3P which causes the price level to rise 4. …but keeps output at its natural rate. C 2. …Policymakers can increase AD AD 2

THE INFLATION-UNEMPLOYMENT RELATIONSHIP Normally, there is a short-run trade-off between the rate of inflation and the rate of unemployment Aggregate supply shocks though can cause both higher rates of inflation and higher rates of unemployment Regardless, over the long-run there is no significant trade-off between inflation and the rate of unemployment