How do prices, real output, and unemployment behave as the economy responds to a change in aggregate demand?

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How do prices, real output, and unemployment behave as the economy responds to a change in aggregate demand?




Answer: Beginning from a state of long run equilibrium, an increase in real aggregate demand will, in the short run, because the economy to move up and to the right along its short run aggregate supply curve. As it does so, the prices of final goods will rise, a positive output gap will develop as real output rises above its natural level, and unemployment will fall below its natural rate. After a time, the expected level of input prices will begin to rise as a result of the increases that have taken place in the prices of final goods. As that happens, the economy will move up and to the left along the aggregate demand curve, assuming no further shift in that curve. The price level of final goods will continue to rise, real output will fall back toward its natural level, and unemployment will rise back toward its natural rate. If, after the economy reaches its new equilibrium, aggregate demand shifts to the left, a negative output gap will develop as real output drops below its natural level, and unemployment will rise above its natural rate. The level of final goods prices will fall below the expected level of input prices. Soon, the expected level of input prices, too, will begin to fall. If there is no further change in aggregate demand, the economy will return to equilibrium at the natural level of real output.

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