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Modeling Demand and Supply
Shocks using Aggregate Demand
(AD) and Aggregate Supply (AS)
Outline
•“Short-run” versus the long run.
•AD and AS Together: “Short-run” equilibrium
•Demand shocks in the short-run
•The long-run AS curve
•Adjustment to “long run” equilibrium
•Supply shocks in the short-run
•Long-run effects of supply shocks
Professors Hall and Lieberman
call the Keynesian model a
“short-run” model. Why?
Because it is possible for the
economy to be in equilibrium,
but at the same time real GDP
can be above or below potential
or full employment GDP
AE
Long-run equilibrium occurs when
the economy is in equilibrium at full
employment
H
AE3
AE2
•Point H is a shortrun equilibrium
since Y2 > YFE
AE1
E
Full
employment
GDP
K
•Point K is a shortrun equilibrium
since Y1 < YFE
•Point E is a longrun equilibrium
since equilibrium
GDP corresponds
to YFE
450
0
Y1
YFE
Y2
Real GDP
($Trillions)
Short run equilibrium is a
combination of price level
and GDP consistent with
both AS and AD curves
Price
Level
Why is point E a short-run
equilibrium?
AS
B
140
E
100
F
•At point B, the price
level is 140 and AS =
$14 trillion. But
equilibrium GDP is
equal to $6 trillion
when the price level
is 140—we know
this from the AD
curve.
•At point E, the price
level is consistent
with an output level
of $10 along both
AS and AD curves
AD
0
6
10
14
Real GDP
($Trillions)
Effect of a Demand Shock
Price
Level
Increase in
government
spending
AS
130
J
H
100
Issue: Why
did the
economy
move from
point E to
point H—
instead of E
to J?
E
AD2
AD1
0
10
12
13.5
Real GDP
($Trillions)
AD curve shifts rightward
G
GDP
Multiplier Effect
Movement along new AD curve
Unit
cost 
P
Money
Demand
Interest
rate 
a and
I P
Movement along AS curve
Net result: GDP increases, but by less due to the
effect of an increase in the price level
GDP 
Price
Level
100
Effect of a decrease in
the money supply
AS
K
E
S
AD1
0
6.5 8
10
AD2
Real GDP
($Trillions)
AD curve shifts Leftward
Interest
rate 
M
a and
IP
GDP 
Movement along new AD curve
Unit
cost 
P
Money
Demand 
Interest
rate 
a and
I P
GDP 
Movement along AS curve
Net result: GDP decreases, but by less due to the
effect of an decrease in the price level
Price
Level
Long run AS curve
Long run AS curve: A
vertical line
indicating all
possible output and
price level
combinations the
economy could end
up in the long run
0
YFE
Real GDP
($Trillions)
(How does it work?)
Some economists
(including Hall &
Lieberman) believe the
economy is “selfcorrecting”—that is, forces
are present that push the
economy to long-run (or
full-employment)
equilibrium.
Long Run AS Curve
AS2
Price
Level
AS1
P4
P3
P2
K
Let AD shift from
AD1 to AD2
J
H
P1
E
AD2
AD1
0
YFE Y3 Y2
Real GDP
($Trillions)
Change in short-run equilibrium
P and Y 
Positive demand shock
Y > YFE
Wage
Rate
Unit
Cost
P
Long-run adjustment process
Y
until Y
=YFE
The following factors could shift the (short-run)
aggregate supply schedule up to the left:
•An increase in the price of a basic commodity—e.g.,
petroleum, natural gas, wheat, soybeans.
•An increase in average money wages and benefits
not restricted to just one industry or sector of the
economy.
•An increase in the average markup over unit cost
not restricted to just one industry or sector of the
economy.
Effect of an increase in
petroleum prices
Price
Level
AS2
AS1
S
130
100
E
AD1
0
6.5 8
10
AD2
Real GDP
($Trillions)
Date
Jan. 1972
Dec. 1973
Jan. 1974
April 1979
June 1979
Nov 1979
Aug. 1980
Oct. 1981
Price ($)
1.79
4.68
10.84
14.55
18.00
24.00
30.00
34.00
Price of One Barrel of 340 crude oil
Source: The Petroleum Economist
I’d call that a shock,
wouldn’t you? The story
of Joseph (see Old Testament)
suggests buffer stocks
as the remedy for
supply-shock
inflation
Productivity () means
the average output of a worker
per year, or alternatively:
 = GDP/N
where N is total employment and Y
is real GDP.
 depends on
the efficiency with
which labor is employed
in the production of
goods & services
 Let  denote average annual compensation of
employees (including benefits). Thus unit labor
cost (UCL) is defined as:
ULC =  /
Notice that compensation
can rise with no effect on ULC,
so long as productivity
keeps pace
Productivity & Costs, Nonfarm Sector
Source: www.dismal.com
% change, annual rate
6
5
pe rce nt change
4
3
Productivity
2
Hourly Compensation
Unit Labor Cost
1
0
-1
-2
98.4
99.1
99.2
99.3
99.4
Productivity
4.1
2.7
0.6
5
5
Hourly Compensation
4.6
4.2
4.8
4.7
4
Unit Labor Cost
0.5
1.4
4.2
-0.3
-1
year/quarter