The Economy in the Short-Run

In one sense, we are all Keynesians now; in another, nobody is any longer a Keynesian.
— Milton Friedman

7.1 From Individual Markets to the Macroeconomy

In microeconomics, supply and demand help us understand the price and quantity of a particular good or service. We can use supply and demand to analyze the market for gasoline, coffee, automobiles, housing, or nearly any other individual product.

Macroeconomics asks a different set of questions. Instead of asking:

What determines the price and quantity of gasoline?

we might ask:

What determines the total amount of goods and services produced throughout the economy?

Instead of studying the price of one product, we study the overall price level. Instead of studying the quantity of one product, we study real GDP. Economists use the Aggregate Demand–Aggregate Supply Model, usually abbreviated the AD–AS Model, to organize these relationships.

The AD-AS Model will allow us to analyze short-run and long-run macroeconomic equilibrium.

Before introducing them individually, however, we must understand exactly what the axes of the AD–AS model measure.

The Horizontal Axis: Growth in Real GDP

The horizontal axis of the AD–AS model measures growth in real GDP, represented by $\% \Delta Y$.

Recall from Chapter 4 that real GDP measures the value of final goods and services produced within an economy after adjusting for changes in the price level. Thus: $$Y=Real\ GDP$$ and $$\% \Delta Y= \% \Delta Real\ GDP.$$

When we move to the right along the horizontal axis, the economy is producing more real goods and services at a faster rate. When we move to the left, the economy is producing more real goods and services at a lower rate, or the economy is producing fewer real goods and services when the growth rate is negative.

This is fundamentally different from the horizontal axis of an ordinary supply-and-demand graph. In a market for pizza, the horizontal axis might measure the number of pizzas produced. In the AD–AS model, the horizontal axis represents the combined real output of the entire economy. It includes the production of:

• food,

• automobiles,

• housing services,

• medical care,

• computers,

• education,

• transportation,

• entertainment,

• and millions of other final goods and services.

The AD–AS model therefore does not measure a physical quantity such as “10 million units.” Instead, it uses real GDP to combine many different types of production into a single measure of growth.

The Vertical Axis: The Price Level

The vertical axis measures the economy’s change overall price level or inflation, represented by $\% \Delta P$. Thus: $$P=Price\ Level.$$ and $$\%\Delta P\ = \ Inflation.$$

The inflation rate summarizes the average change in the level of prices across the economy. It can be measured using a price index such as the Consumer Price Index or GDP Deflator introduced in Chapter 5.

AD–AS Is Not Ordinary Supply and Demand

The AD–AS model may look similar to a traditional supply-and-demand graph, but the two models answer different questions.

Consider the comparison:

Students should therefore resist the temptation to interpret AD and AS exactly like ordinary demand and supply curves. They look similar, but the economic reasoning behind them is different.

The Three Curves

The complete AD–AS model contains three curves.

Aggregate Demand

The Aggregate Demand curve represents the total quantity of domestically produced final goods and services that households, businesses, governments, and foreign buyers wish to purchase at different price levels. We represent aggregate demand as: $$AD.$$ The aggregate demand curve slopes downward. We will explain why in Section 9.2.

Short-Run Aggregate Supply

The Short-Run Aggregate Supply curve represents the quantity of real output firms are willing to produce at different price levels when some production costs, particularly wages, have not yet fully adjusted. We represent short-run aggregate supply as: $$SRAS.$$ The SRAS curve slopes upward. We will explain why in Section 9.3.

Long-Run Aggregate Supply

The Long-Run Aggregate Supply curve represents the economy’s productive capacity when wages and other input prices have fully adjusted. We represent long-run aggregate supply as: $$LRAS.$$ The LRAS curve is vertical at the economy’s potential level of output. We will develop this idea in Section 9.4 and connect it directly to the Solow Model from Chapter 7.

Short Run Versus Long Run

One of the most important features of the AD–AS model is the distinction between the short run and the long run. In everyday conversation, these phrases refer to particular amounts of time. A few months might seem like the short run, while several years might seem like the long run.

Economists use the terms somewhat differently. The distinction depends on whether prices and production costs have had time to adjust. In the short run, some input prices—particularly wages—may adjust slowly. In the long run, wages and other production costs have had sufficient time to adjust to economic conditions.

This distinction will explain why the economy can temporarily produce more or less than its long-run productive capacity.

Potential Growth

The long-run growth capacity of the economy is called the Solow Rate or the potential growth rate. We represent the Solow Rate as: $$\% \Delta Y^*.$$ The Solow Rate is the amount the economy grows when labor and capital are being used at normal long-run levels.

The Solow Rate does not mean the absolute maximum amount an economy could physically grow. Factories could operate around the clock. Workers could work extremely long hours. Machines could be used without sufficient maintenance. Such production might temporarily increase real growth, but it would not be sustainable. The Solow Rate instead represents the economy’s normal growth capacity.

Chapter 7 helps us understand what determines it. Recall the production function: $$Y=AF(K,L).$$ The economy’s productive capacity depends on:

• physical capital $K$,

• labor $L$,

• productivity $A$.

Chapter 8 then explained how institutions can influence productivity. These ideas now become part of the AD–AS model.

What the AD–AS Model Will Allow Us to Explain

Once the three curves are combined, the AD–AS model will allow us to distinguish among several important economic situations.

The economy may grow at exactly its potential output:

$$\% \Delta Y=\% \Delta Y^*.$$ It may temporarily grow less than potential: $$\% \Delta Y< \% \Delta Y^*.$$ Or it may temporarily grow more than potential: $$\% \Delta Y>\% \Delta Y^*.$$ These situations will eventually allow us to understand:

• recessions,

• economic expansions,

• changes in the price level,

• short-run fluctuations in real GDP,

• the economy’s return toward long-run equilibrium.

For now, however, our goal is simply to understand the structure of the model. We will introduce each curve individually before combining them.

7.2 Aggregate Demand

In the previous section, we introduced the Aggregate Demand–Aggregate Supply Model. We now introduce the first curve in the model: Aggregate Demand.

Aggregate demand describes the relationship between inflation and the growth of real spending on domestically produced final goods and services.

The aggregate demand curve slopes downward. This means that, holding other relevant factors constant: $$Inflation\uparrow \quad\Longrightarrow\quad Real\ GDP\ Growth\downarrow.$$ Likewise: $$Inflation\downarrow \quad\Longrightarrow\quad Real\ GDP\ Growth\uparrow.$$ To understand why this relationship exists, we can return to an equation introduced in Chapter 5.

Returning to the Quantity Theory of Money

Recall the growth-rate form of the Equation of Exchange: $$\%\Delta M+\%\Delta V = \%\Delta P+\%\Delta Y.$$ where:

• $\%\Delta M$ = growth rate of the money supply,

• $\%\Delta V$ = growth rate of the velocity of money,

• $\%\Delta P$ = inflation rate,

• $\%\Delta Y$ = growth rate of real GDP.

The left-hand side represents the growth of nominal spending: $$\%\Delta M+\%\Delta V.$$ The right-hand side divides that spending growth between:

• growth in prices,

• growth in real production.

Suppose, for the moment, that money growth and velocity growth are fixed. Then total nominal spending growth is fixed. If more of that spending growth appears as inflation, less can appear as real GDP growth.

This gives us the downward-sloping aggregate demand curve: $$\%\Delta P = \%\Delta M+\%\Delta V - \%\Delta Y.$$

Figure 7.1 shows the aggregate demand curve. Notice that as the inflation rate decreases on the Y-axis that the growth rate of the economy increases, as shown by the X-axis. At an economic growth rate of 0%, the inflation rate is 6%. Therefore, the level of spending growth in the economy is 6%.

A Numerical Example

Suppose the money supply grows by 6% and velocity does not change. Then: $$\%\Delta M=6\%$$ and: $$\%\Delta V=0\%.$$ The Equation of Exchange becomes: $$6\%=\%\Delta P+\%\Delta Y.$$

Now consider several possible combinations of inflation and real GDP growth.

Every row satisfies: $$6\%=Inflation+Real\ GDP\ Growth.$$

As inflation increases, real GDP growth decreases. These combinations trace out a downward-sloping Aggregate Demand curve.

What Determines Aggregate Spending?

The Quantity Theory of Money gives us one way to understand Aggregate Demand. The expenditure approach to GDP gives us another.

Recall from Chapter 4: $$Y=C+I+G+NX,$$ where:

• $C$ = consumption,

• $I$ = investment,

• $G$ = government purchases,

• $NX$ = net exports.

Aggregate Demand therefore reflects spending by four broad groups:

1. households,

2. businesses,

3. governments,

4. foreign buyers.

Changes in the growth of this spending can shift the Aggregate Demand curve.

For example, if households become more willing to spend, consumption growth may increase. If businesses become more optimistic about future profitability, investment growth may increase. If government purchases grow more rapidly, aggregate spending may increase. If foreign demand for domestic goods increases, net exports may increase. These changes affect Aggregate Demand because they alter the growth of total spending in the economy.

Movements Along Aggregate Demand

It is essential to distinguish between a movement along the Aggregate Demand curve and a shift of the curve. A movement along the AD curve occurs when the inflation rate changes while the underlying growth of nominal spending remains constant.

Suppose again: $$\%\Delta M+\%\Delta V=6\%.$$ If inflation rises from 2% to 4%, real GDP growth falls from: $$4\%$$ to: $$2\%.$$

The economy has moved along the same Aggregate Demand curve.

Shifts in Aggregate Demand

The Aggregate Demand curve shifts when the growth rate of nominal spending changes. Return to: $$\%\Delta M+\%\Delta V = \%\Delta P+\%\Delta Y.$$ Suppose nominal spending initially grows at: $$6\%.$$ At an inflation rate of 2%, real GDP growth is: $$4\%.$$ Now suppose nominal spending growth increases to: $$9\%.$$ At the same 2% inflation rate, real GDP growth can now equal: $$7\%.$$ The Aggregate Demand curve has shifted to the right.

The distinction is important. A change in inflation produces a movement along AD. A change in the underlying growth of aggregate spending shifts the entire AD curve.

What Can Shift Aggregate Demand?

Several economic changes can alter the growth of aggregate spending. These include changes in:

• money growth,

• velocity,

• household consumption,

• business investment,

• government purchases,

• net exports.

For now, we will simply identify these as potential sources of Aggregate Demand shifts. We will postpone detailed analysis of two especially important causes. In Chapter 10, we will examine how monetary policy affects Aggregate Demand. In Chapter 11, we will examine how fiscal policy affects Aggregate Demand. For Chapter 9, our goal is simply to understand what an Aggregate Demand shift means.

An Increase in Aggregate Demand

Suppose households, businesses, governments, and foreign buyers collectively increase the growth of their spending.

Aggregate Demand shifts to the right: $$AD_1\rightarrow AD_2.$$ At any given inflation rate, the growth rate of real GDP demanded is now higher. For example: $$AD_1: \quad 6\%=Inflation+Real\ GDP\ Growth.$$ At 2% inflation: $$Real\ GDP\ Growth=4\%.$$ Now suppose spending growth rises to 9%: $$AD_2: \quad 9\%=Inflation+Real\ GDP\ Growth.$$ At the same 2% inflation rate: $$Real\ GDP\ Growth=7\%.$$ This is a rightward shift of Aggregate Demand.

A Decrease in Aggregate Demand

The opposite occurs when nominal spending growth decreases. Suppose nominal spending growth falls from: $$6\%$$ to: $$3\%.$$ At 2% inflation, real GDP growth falls from: $$4\%$$ to: $$1\%.$$ The Aggregate Demand curve shifts to the left: $$AD_1\leftarrow AD_2.$$ At every inflation rate, the growth rate of real GDP demanded is now lower.

Aggregate Demand Is About Growth

Because we are using the growth-rate AD–AS model, it is important to interpret Aggregate Demand correctly. A rightward shift of AD does not simply mean that households are purchasing “more stuff” in an absolute sense. It means that aggregate nominal spending is growing more rapidly. Likewise, a leftward shift does not necessarily mean total spending is falling. It may simply mean that spending is growing more slowly. For example:

• Spending growth falling from 8% to 4% shifts AD left.

• Spending growth increasing from 4% to 8% shifts AD right.

In both cases, total spending may still be increasing. The difference is the growth rate. This distinction will become extremely important when we analyze monetary and fiscal policy.

7.3 Short-Run Aggregate Supply

In Section 7.2, we introduced Aggregate Demand and explained the combinations of inflation and real GDP growth consistent with different rates of nominal spending growth. Aggregate Demand, however, tells us only how much real output buyers wish to purchase.

To determine what actually happens to inflation and real GDP growth, we must also understand the production side of the economy. We begin with Short-Run Aggregate Supply, or $SRAS$.

Short-Run Aggregate Supply describes the relationship between inflation and real GDP growth when some production costs—especially wages—have not yet fully adjusted to changing economic conditions.

An upward-sloping SRAS curve means: $$Inflation\uparrow \quad\Longrightarrow\quad Real\ GDP\ Growth\uparrow$$ along a given SRAS curve. Likewise: $$Inflation\downarrow \quad\Longrightarrow\quad Real\ GDP\ Growth\downarrow.$$ The key to understanding this relationship is recognizing that output prices can sometimes change more rapidly than the costs firms pay to produce their goods and services.

Why Short-Run Aggregate Supply Slopes Upward

Consider a business that sells its output for a price $P$. The business must also pay production costs, including:

• wages,

• rent,

• raw materials,

• energy,

• interest expenses,

• other input costs.

Suppose the prices businesses receive for their products begin rising more rapidly. If wages and other input costs immediately rise at exactly the same rate, the firm’s profitability does not necessarily change. But in the short run, some production costs adjust slowly.

Wages are particularly important. Workers and firms frequently establish wages through contracts, annual salary agreements, or other arrangements that remain in place for some period of time. If output prices rise more rapidly than wages, firms temporarily receive higher prices relative to their labor costs. Production becomes more profitable. Firms therefore have incentives to:

• increase production,

• increase worker hours,

• hire additional workers,

• use existing capital more intensively.

Real GDP growth increases.

Figure 7.2 displays the Short-Run Aggregate Supply curve. The curve is positively sloped for all of the stated reasons above. However, in addition to the positive slope, the slope gets progressively steeper as inflation increases. This means that inflation alone cannot drive unlimited amounts of economic growth, even in the short-run. Moreover, when inflation expectations are too high, firms may quickly adjust production schedules and the economic growth rate may be substantially decreased. This phenomenon is the reason why some economists worry that disinflation may impose costs on the economy, although evidence on this phenomenon is mixed.

Sticky Wages

A price is described as sticky when it adjusts slowly to changing economic conditions. Wages are one of the most important sticky prices in the economy.

Suppose workers agree at the beginning of the year to wage growth of 3%. Now suppose inflation unexpectedly rises to 6%. Firms’ selling prices may increase faster than their wage costs. For some firms, production becomes temporarily more profitable. They respond by expanding production. The important word is temporarily. Workers will eventually recognize that prices are rising faster than their wages. When contracts are renegotiated, workers will seek higher wages to restore their purchasing power. The firm’s costs then begin catching up with the higher price level. This is one reason the relationship represented by SRAS is a short-run relationship.

Expected Inflation

Workers and businesses do not negotiate wages without thinking about future prices. Their expectations about inflation therefore matter.

Suppose workers expect inflation to be: $$2\%.$$ They may negotiate wage increases consistent with approximately 2% inflation. If actual inflation unexpectedly rises to: $$5\%,$$ firms may initially experience faster growth in selling prices than in wages. Production becomes more profitable, and firms increase output growth. But suppose workers had expected 5% inflation from the beginning. They would likely have negotiated higher wages before production decisions were made. The same 5% inflation rate would then provide much less reason for firms to expand real production. This means that Short-Run Aggregate Supply depends not only on actual inflation but also on expected inflation.

A useful way to think about SRAS is:

Unexpected changes in inflation can temporarily change real economic growth because some production costs were established using earlier expectations.

A Numerical Example

Suppose workers and businesses expect inflation of 2%. Wage contracts are established accordingly. Now consider several possible actual inflation rates.

When actual inflation exceeds expected inflation, firms may temporarily experience higher output prices relative to predetermined costs. Real GDP growth increases. When actual inflation falls below expectations, firms may experience weaker selling-price growth relative to previously negotiated costs. Real GDP growth decreases. These relationships help produce the upward-sloping SRAS curve.

Movements Along Short-Run Aggregate Supply

As with Aggregate Demand, we must distinguish between movement along a curve and a shift of the entire curve. A movement along SRAS occurs when actual inflation changes while the underlying determinants of Short-Run Aggregate Supply remain unchanged. For example, suppose expected inflation remains 2%. If actual inflation rises from: $$2\%$$ to: $$4\%,$$ firms may increase real production growth. The economy moves upward and to the right along the existing SRAS curve.

Shifts in Short-Run Aggregate Supply

The entire SRAS curve shifts when firms’ production costs or inflation expectations change independently of current inflation. Several factors can shift SRAS:

• expected inflation,

• wage growth,

• energy prices,

• raw-material costs,

• taxes or regulations affecting production costs,

• temporary changes in productivity,

• supply disruptions.

A favorable change in production conditions shifts SRAS to the right. An unfavorable change shifts SRAS to the left.

Expected Inflation and SRAS

Expected inflation is particularly important because it affects wage negotiations and other contracts.

Suppose expected inflation increases. Workers anticipate that prices will rise more rapidly and negotiate faster wage growth. Businesses may also negotiate contracts with suppliers that incorporate higher expected costs. At any given actual inflation rate, firms now face faster-growing production costs. SRAS shifts to the left. Thus: $$Expected\ Inflation\uparrow$$ causes: $$SRAS\leftarrow.$$ The opposite occurs if expected inflation falls: $$Expected\ Inflation\downarrow$$ causes: $$SRAS\rightarrow.$$ This relationship will become important when we examine how the economy returns to long-run equilibrium.

Supply Shocks

Short-Run Aggregate Supply can also shift because of a supply shock.

Examples include:

• a sudden increase in oil prices,

• a major natural disaster,

• a disruption to important supply chains,

• a sudden shortage of an important input,

• an unusually favorable harvest.

Suppose oil prices suddenly increase. Energy and transportation costs rise for many businesses. At any given inflation rate, production becomes less profitable. SRAS shifts left: $$SRAS\leftarrow.$$

A favorable supply shock produces the opposite effect. If energy prices fall sharply or a temporary productivity improvement lowers production costs: $$SRAS\rightarrow.$$

Supply Shocks and Inflation

The discussion of supply shocks connects directly to Chapter 5.

Suppose an oil shock shifts SRAS to the left. When we eventually combine SRAS with Aggregate Demand, the economy may temporarily experience:

• higher inflation,

• lower real GDP growth.

This does not contradict the Quantity Theory of Money.

Chapter 5 distinguished between temporary movements in inflation caused by changes in relative prices and persistent monetary inflation. A supply shock can temporarily increase the measured inflation rate. But a one-time supply disruption cannot generate permanently accelerating inflation unless aggregate spending conditions also allow the higher rate of price growth to continue. This distinction will remain important throughout our analysis of AD–AS.

Short-Run Growth Can Differ from Long-Run Growth

The SRAS curve allows real GDP growth to temporarily differ from the economy’s sustainable long-run growth rate. For example, firms may temporarily:

• add overtime shifts,

• operate factories for longer hours,

• postpone maintenance,

• hire workers unusually rapidly.

These actions can increase real GDP growth in the short run.

But they do not necessarily increase the economy’s long-run productive capacity. That distinction will be the focus of Section 9.4. Long-run economic growth depends on the factors studied in Chapters 7 and 8: $$K,\quad L,\quad A.$$ Short-run production can fluctuate around that long-run growth path because prices, wages, expectations, and production costs do not adjust instantaneously.

7.4 Long-Run Aggregate Supply

In the previous section, we learned that real GDP growth can temporarily rise above or fall below its normal long-run rate. Sticky wages, unexpected inflation, and temporary changes in production costs can cause firms to change production in the short run. These short-run fluctuations raise an important question:

What determines how rapidly an economy can grow over the long run?

The answer comes from Chapters 7 and 8. Chapter 7 introduced the production function: $$Y=AF(K,L),$$ and Chapter 8 explained why institutions can influence productivity $A$. These same ideas determine the economy’s long-run growth rate. In the AD–AS model, the Long-Run Aggregate Supply curve represents the economy’s sustainable rate of real GDP growth.

Unlike Short-Run Aggregate Supply, LRAS does not describe a temporary relationship between inflation and production. It describes how rapidly the economy can sustainably expand its real productive capacity.

Returning to the Production Function

Recall: $$Y=AF(K,L).$$ An economy can produce more real output when: $$K\uparrow,$$ $$L\uparrow,$$ or: $$A\uparrow.$$ Therefore, long-run real GDP growth depends on how rapidly these productive factors increase. We can summarize the idea as: $$Long-Run\ Real\ GDP\ Growth = f(Growth\ in\ K,\ Growth\ in\ L,\ Growth\ in\ A).$$

An economy that accumulates productive capital, expands its workforce, and improves productivity can sustain faster real GDP growth. An economy in which these factors grow slowly will have a lower sustainable growth rate.

Why LRAS Is Vertical

The Long-Run Aggregate Supply curve is vertical. To understand why, remember the axes of our model. The horizontal axis measures: $$\%\Delta Y=Real\ GDP\ Growth,$$ while the vertical axis measures: $$\%\Delta P=Inflation.$$

Suppose the economy can sustainably grow at: $$3\%$$ per year. Would permanently increasing inflation from 2% to 5% allow the economy to sustainably grow faster than 3%? No. Higher inflation does not automatically create:

• more factories,

• more workers,

• better technology,

• better institutions,

• more productive machines.

The economy’s sustainable real growth rate therefore does not depend on the inflation rate. Whether inflation is: $$1\%,\quad 3\%,\quad 5\%,\quad or \quad 10\%,$$ the economy’s long-run growth rate remains determined by its productive capacity. This is why LRAS is vertical.

Figure 7.3 displays the Long-Run Aggregate Supply curve. As shown, the LRAS curve is vertical because inflation alone is not able to impact the long-run growth rate in the economy.

The Long-Run Growth Rate

We will represent the economy’s sustainable long-run real GDP growth rate, also known as the Solow Rate, as:

$$g^*.$$

Suppose: $$g^*=3\%.$$ If actual real GDP growth is also: $$3\%,$$ the economy is growing at its sustainable long-run rate. If actual growth temporarily rises to: $$5\%,$$ the economy is growing faster than its productive capacity can sustainably expand. If actual growth falls to: $$1\%,$$ the economy is growing more slowly than its long-run capacity. These differences will become important when we combine AD, SRAS, and LRAS.

Growth Above the Long-Run Rate

Can an economy temporarily grow faster than $g^*$? Yes.

Suppose the economy’s long-run growth rate is: $$g^*=3\%.$$ During a strong expansion, actual real GDP growth might rise to: $$5\%.$$ Businesses may:

• hire workers rapidly,

• increase overtime,

• operate factories for longer hours,

• use equipment more intensively,

• postpone maintenance.

These actions can temporarily increase real GDP growth. But they do not necessarily increase the rate at which the economy’s underlying productive capacity is expanding. Growth above $g^*$ therefore cannot continue indefinitely unless something also increases the growth of capital, labor, or productivity.

Growth Below the Long-Run Rate

The opposite can also occur. Suppose: $$g^*=3\%,$$ but actual real GDP growth falls to: $$0\%.$$ Factories may operate below capacity. Businesses may reduce hiring. Workers may become unemployed. Capital may remain unused. The economy is producing less additional output than its productive capacity would allow. This does not necessarily mean that the economy’s long-run productive potential has disappeared. Instead, actual growth has temporarily fallen below its sustainable rate.

What Shifts LRAS?

The LRAS curve shifts only when the economy’s sustainable long-run growth rate changes. Because: $$Y=AF(K,L),$$ anything that changes the long-run growth of capital, labor, or productivity can shift LRAS.

Capital Growth

Faster accumulation of productive physical capital can increase productive capacity. Examples include greater investment in:

• machinery,

• factories,

• infrastructure,

• productive equipment.

However, Chapter 7 taught us an important limitation: capital has diminishing marginal productivity. Capital accumulation can contribute to growth, but capital accumulation alone cannot permanently generate ever-increasing growth rates.

Labor Growth

An increase in the productive workforce can increase the economy’s capacity to produce. Long-run labor growth can be affected by:

• population growth,

• immigration,

• labor force participation,

• demographic changes.

A larger productive workforce can allow total real GDP to grow more rapidly. However, increases in the labor force also face diminishing marginal productivity.

Productivity Growth

Productivity growth is particularly important. If $$A\uparrow,$$ the economy can produce more output from the same capital and labor. Productivity can improve because of:

• technological innovation,

• improved education and human capital,

• better production methods,

• improved organization,

• institutions that encourage productive activity.

Chapter 8 explained why property rights, competition, prices, economic liberty, and other institutions can affect productivity.

A Shift in LRAS Is Not a Movement Along LRAS

Because LRAS is vertical, changes in inflation do not produce changes in the economy’s sustainable growth rate. Suppose: $$g^*=3\%.$$ If inflation rises from: $$2\%$$ to: $$6\%,$$ the economy does not move to a permanently higher real GDP growth rate. It simply moves to a different inflation rate while the sustainable growth rate remains: $$3\%.$$

For LRAS itself to shift, something must change the growth of productive capacity. For example, suppose a major technological breakthrough permanently increases productivity growth. The sustainable real GDP growth rate might rise from: $$3\%$$ to: $$4\%.$$ LRAS shifts right. The economy is now capable of sustaining faster real GDP growth.

Inflation and Long-Run Growth

The vertical LRAS curve illustrates an important principle:

An economy cannot permanently increase real economic growth simply by generating more inflation.

This connects directly to Chapter 5. Recall the Quantity Theory relationship: $$\%\Delta M+\%\Delta V = \%\Delta P+\%\Delta Y.$$ Suppose policymakers permanently increase nominal spending growth while the economy’s sustainable real GDP growth remains fixed. In the short run, some of the additional spending growth may temporarily appear as faster real GDP growth. But in the long run: $$\%\Delta Y\rightarrow g^*.$$ The remaining nominal spending growth must increasingly appear as: $$\%\Delta P\uparrow.$$ In other words, permanently faster nominal spending cannot permanently push real GDP growth beyond the rate permitted by capital, labor, and productivity.

Short-Run Growth Versus Long-Run Growth

We can now distinguish clearly between SRAS and LRAS.

SRAS explains temporary fluctuations in real GDP growth. LRAS explains the sustainable growth rate. The distinction between the two will allow us to understand both short-run and long-run macroeconomic equilibrium.

Connecting Chapters 7, 8, and 9

The LRAS curve brings together several major ideas from this textbook. Chapter 7 explained why capital accumulation affects production: $$K\uparrow \quad\Longrightarrow\quad Y\uparrow.$$ Chapter 7 also showed why diminishing marginal productivity limits growth from capital accumulation alone. Chapter 8 explained how institutions affect productivity: $$Institutions \rightarrow A \rightarrow Y.$$ Chapter 9 now incorporates those insights into the AD–AS model. The position of LRAS depends on the economy’s sustainable growth rate, which ultimately comes from growth in: $$K,\quad L,\quad A.$$ Short-run changes in spending can move actual growth away from this rate. But long-run prosperity requires increasing productive capacity.

7.5 Short-Run Macroeconomic Equilibrium

We have now developed the two curves necessary to analyze the economy in the short run. Aggregate Demand describes the relationship between inflation and the growth of real spending: $$AD.$$ Short-Run Aggregate Supply describes the relationship between inflation and real GDP growth when wages and other production costs have not yet fully adjusted: $$SRAS.$$

We can now combine these curves to answer two important questions:

What determines the economy’s actual inflation rate?

What determines the economy’s actual real GDP growth rate?

The answer is the intersection of Aggregate Demand and Short-Run Aggregate Supply. This intersection is called the short-run macroeconomic equilibrium.

Finding Short-Run Equilibrium

Recall the axes of our growth-rate AD–AS model. The horizontal axis measures: $$\%\Delta Y=Real\ GDP\ Growth,$$ and the vertical axis measures: $$\%\Delta P=Inflation.$$ Aggregate Demand slopes downward. Short-Run Aggregate Supply slopes upward. The point where the two curves intersect determines the economy’s short-run equilibrium.

Suppose the curves intersect at: $$\%\Delta Y=3\%$$ and: $$\%\Delta P=2\%.$$ The short-run equilibrium therefore consists of: $$Real\ GDP\ Growth=3\%$$ and: $$Inflation=2\%.$$

Why the Intersection Is an Equilibrium

Why does the intersection of AD and SRAS represent equilibrium? At any other combination of inflation and real GDP growth, the growth of real spending demanded would differ from the growth of output firms are willing to produce. At the intersection, the two are consistent. The amount of real production businesses are willing to provide matches the amount of real output buyers wish to purchase at that inflation rate. There is therefore no immediate pressure within the short-run model for inflation and real GDP growth to move to another point.

This does not mean the economy must remain there forever. Short-run equilibrium may differ from long-run equilibrium. That distinction will become important in the next section.

The numerical example is useful because it reinforces an important principle:

Macroeconomic outcomes are determined by the interaction of demand and supply.

Knowing only Aggregate Demand is not enough. Knowing only Short-Run Aggregate Supply is not enough. We need both.

What Happens When Aggregate Demand Shifts?

Suppose the economy begins in short-run equilibrium. Now nominal spending growth increases. Aggregate Demand shifts to the right: $$AD_1\rightarrow AD_2.$$ The SRAS curve has not changed. The new intersection occurs:

• farther to the right,

• higher on the graph.

Therefore: $$Real\ GDP\ Growth\uparrow$$ and: $$Inflation\uparrow.$$

At this stage, we are describing the mechanics of the model. We are not yet asking whether policymakers should deliberately shift Aggregate Demand. That question will be saved for Chapters 8 and 9.

What Happens When Short-Run Aggregate Supply Shifts?

Now suppose Aggregate Demand remains unchanged, but production conditions worsen. For example, a major supply disruption raises firms’ costs. SRAS shifts to the left: $$SRAS_1\leftarrow SRAS_2.$$ The new short-run equilibrium occurs:

• farther to the left,

• higher on the graph.

Therefore: $$Real\ GDP\ Growth\downarrow$$ while: $$Inflation\uparrow.$$ This combination is especially difficult because the economy experiences slower real growth and higher inflation simultaneously.

The opposite occurs after a favorable SRAS shift. If production becomes less costly or temporarily more productive: $$SRAS\rightarrow,$$ then: $$Real\ GDP\ Growth\uparrow$$ and: $$Inflation\downarrow.$$

Comparing Demand and Supply Shifts

One of the most useful features of the AD–AS model is that inflation alone does not tell us what happened to the economy.

Suppose inflation increases. There are at least two possible explanations.

Possibility 1: Aggregate Demand increased. Then: $$Inflation\uparrow$$ and: $$Real\ GDP\ Growth\uparrow.$$ Possibility 2: Short-Run Aggregate Supply decreased. Then: $$Inflation\uparrow$$ but: $$Real\ GDP\ Growth\downarrow.$$ The behavior of real GDP growth helps us distinguish the two situations.

This table is worth understanding rather than memorizing. Ask what changed first. Then follow the model to the new intersection.

Equilibrium Does Not Mean Desirable

Economists use the word equilibrium in a very specific way. Equilibrium means that the forces represented by the model are consistent with one another. It does not mean that the outcome is necessarily good. For example, an economy could be in short-run equilibrium with: $$Real\ GDP\ Growth=-2\%$$ and: $$Inflation=5\%.$$ This would be an unpleasant economic situation. But it could still be an equilibrium if AD and SRAS intersect at that point.

This distinction will become especially important when we compare short-run equilibrium with the economy’s sustainable long-run growth rate.

Short-Run Equilibrium and the Long-Run Growth Rate

Recall from Section 7.4 that the economy has a sustainable long-run growth rate: $$g^*.$$ Short-run equilibrium growth does not necessarily equal $g^*$. The economy could have: $$\%\Delta Y_{SR}<g^*,$$ meaning actual real GDP growth is below its sustainable long-run rate. It could have: $$\%\Delta Y_{SR}>g^*,$$ meaning actual growth is temporarily above its sustainable rate. Or: $$\%\Delta Y_{SR}=g^*.$$ Only the final case is consistent with both short-run and long-run equilibrium. For now, we simply identify these possibilities. In the next section, we will add LRAS to the model and distinguish among:

• long-run equilibrium,

• recessionary conditions,

• inflationary conditions.

7.6 Long-Run Macroeconomic Equilibrium

In Section 7.5, we combined Aggregate Demand and Short-Run Aggregate Supply to determine the economy’s short-run inflation rate and real GDP growth rate. But short-run equilibrium does not necessarily mean the economy is growing at a sustainable rate. To determine whether the economy is also in long-run equilibrium, we must add the third curve in the AD–AS model: $$LRAS.$$

Recall from Section 7.4 that Long-Run Aggregate Supply is vertical at the economy’s sustainable long-run real GDP growth rate: $$g^*.$$ Long-run macroeconomic equilibrium occurs when all three curves intersect at the same point: $$AD=SRAS=LRAS.$$ At this point, actual real GDP growth equals the economy’s sustainable long-run growth rate.

The intersection also determines the economy’s equilibrium inflation rate. Thus, long-run equilibrium tells us both:

• how rapidly real GDP is sustainably growing,

• the inflation rate consistent with that equilibrium.

The Complete AD–AS Model

We can now put the entire model together. Aggregate Demand slopes downward. Short-Run Aggregate Supply slopes upward. Long-Run Aggregate Supply is vertical at: $$g^*.$$ When all three curves intersect at the same point, the economy is in both short-run and long-run equilibrium.

Suppose: $$g^*=3\%.$$ If AD and SRAS intersect LRAS at: $$\%\Delta Y=3\%$$ and: $$\%\Delta P=2\%,$$ then the economy is in long-run equilibrium with: $$Real\ GDP\ Growth=3\%$$ and: $$Inflation=2\%.$$ Neither the growth rate nor the inflation rate needs to be zero for an economy to be in long-run equilibrium.

Long-Run Equilibrium Does Not Mean Zero Inflation

This point deserves special emphasis. An economy can be in long-run equilibrium while experiencing positive inflation.

Suppose: $$g^*=3\%$$ and nominal spending grows at: $$5\%.$$ Using the Quantity Theory relationship: $$\%\Delta M+\%\Delta V = \%\Delta P+\%\Delta Y,$$ a long-run equilibrium could have: $$5\%=2\%+3\%.$$ Thus: $$Inflation=2\%$$ and: $$Real\ GDP\ Growth=3\%.$$ The economy is experiencing inflation, but it is still growing at its sustainable long-run rate.

When Short-Run Growth Is Below the Long-Run Rate

Now suppose AD and SRAS intersect to the left of LRAS. Then: $$\%\Delta Y_{SR}<g^*.$$ Actual real GDP growth is below the economy’s sustainable long-run growth rate. We will call this a recessionary growth gap.

Suppose: $$g^*=3\%,$$ but short-run equilibrium growth is: $$0\%.$$ The recessionary growth gap is: $$3\%-0\%=3$$ percentage points. The economy is not necessarily producing less than it produced last year if growth remains positive. Instead, it is expanding more slowly than its sustainable long-run rate.

A Recession Versus Slow Growth

Students should distinguish carefully between: $$\%\Delta Y<g^*$$ and: $$\%\Delta Y<0.$$

If: $$0<\%\Delta Y<g^*,$$ real GDP is still increasing, but more slowly than its sustainable long-run rate.

If: $$\%\Delta Y<0,$$ real GDP is actually declining. The second situation represents a much more severe contraction.For example, suppose: $$g^*=3\%.$$ If actual growth is: $$1\%,$$ the economy is growing below its long-run rate. But real GDP is still increasing. If actual growth is: $$-2\%,$$ real GDP is shrinking.

Both situations lie to the left of LRAS, but they are not economically identical.

When Short-Run Growth Is Above the Long-Run Rate

Now suppose AD and SRAS intersect to the right of LRAS. Then: $$\%\Delta Y_{SR}>g^*.$$ Actual real GDP growth exceeds the economy’s sustainable long-run growth rate. We will call this an inflationary growth gap.

Suppose: $$g^*=3\%,$$ but short-run equilibrium growth is: $$5\%.$$ The inflationary growth gap is: $$5\%-3\%=2$$ percentage points. This does not mean 5% growth is inherently bad.

If productivity growth permanently increased and $g^*$ also rose to 5%, then 5% growth could be sustainable. The problem arises when actual growth exceeds the rate at which productive capacity is expanding.

Why Above-Trend Growth Cannot Continue Forever

Suppose the economy’s productive capacity is growing at 3%, but actual real GDP grows at 6% year after year. Businesses would increasingly need to:

• hire workers faster than the labor force expands,

• increase overtime,

• use factories more intensively,

• postpone maintenance,

• compete aggressively for scarce inputs.

These conditions cannot continue indefinitely. Workers become increasingly scarce. Wage growth accelerates. Input costs rise. Businesses eventually face pressure that reduces the growth of real production. Thus: $$\%\Delta Y>g^*$$ can occur temporarily, but it cannot persist indefinitely unless: $$g^*\uparrow.$$

For sustainable faster growth, the economy must increase the growth of: $$K,\quad L,\quad or \quad A.$$

Expected Inflation and Long-Run Equilibrium

Recall from Section 7.3 that SRAS depends partly on expected inflation. At long-run equilibrium, workers and firms are no longer being systematically surprised by inflation.

Suppose inflation is: $$4\%$$ and everyone correctly expects: $$4\%.$$ Workers negotiate wages consistent with 4% inflation. Businesses negotiate contracts knowing that prices and costs are likely to rise at approximately that rate. There is no reason for 4% inflation by itself to push real GDP growth permanently above $g^*$. Thus, in long-run equilibrium: $$Actual\ Inflation=Expected\ Inflation.$$

7.7 Returning to Long-Run Equilibrium

In the previous section, we learned that short-run equilibrium does not necessarily occur at the economy’s sustainable long-run growth rate. The economy may experience: $$\%\Delta Y<g^*,$$ or: $$\%\Delta Y>g^*.$$

Neither situation can continue indefinitely. The key reason is that wages, expectations, and other production costs eventually adjust. These adjustments shift Short-Run Aggregate Supply and push the economy back toward: $$\%\Delta Y=g^*.$$

When Growth Is Below the Long-Run Rate

Suppose: $$\%\Delta Y<g^*.$$ The economy is growing more slowly than its productive capacity would normally allow. Businesses have less difficulty finding workers. Workers have less bargaining power. Businesses also face weaker pressure from input costs. Over time, wage growth and other production costs tend to slow. Lower cost growth makes production more profitable at any given inflation rate. Therefore: $$SRAS\rightarrow.$$ As SRAS shifts right, real GDP growth increases until: $$\%\Delta Y=g^*.$$

The intuition is simple:

When the economy is growing too slowly relative to its productive capacity, unused resources create downward pressure on production costs, making expansion more attractive.

When Growth Is Above the Long-Run Rate

Now suppose: $$\%\Delta Y>g^*.$$ Businesses are expanding production faster than the economy’s productive capacity is growing. Workers become increasingly difficult to find. Businesses compete for employees. Wage growth accelerates. Other productive resources also become increasingly scarce. Production costs therefore rise more rapidly. As costs increase: $$SRAS\leftarrow.$$ Real GDP growth slows until: $$\%\Delta Y=g^*.$$

Again, the intuition is straightforward:

An economy cannot continually grow faster than its productive capacity without creating increasing pressure on wages and other production costs.

Expectations Adjust Too

Expected inflation reinforces this adjustment.

Suppose inflation unexpectedly rises above what workers anticipated. In the short run, firms may benefit because selling prices rise faster than wages. But workers eventually recognize that prices are rising more rapidly and negotiate faster wage growth. The temporary production incentive disappears. Likewise, if inflation is lower than expected, wage and cost growth eventually adjust downward. Thus: $$Actual\ Inflation \rightarrow Expected\ Inflation.$$ At long-run equilibrium: $$Actual\ Inflation=Expected\ Inflation$$ and: $$\%\Delta Y=g^*.$$

The Economy Can Self-Correct

The AD–AS model therefore contains a natural self-correcting mechanism.

This does not mean adjustment is immediate. Wages and contracts can be slow to change. Workers may remain unemployed during the adjustment. Businesses may operate below capacity for extended periods. The important point is that short-run growth rates above or below $g^*$ create economic pressures that tend to move the economy back toward long-run equilibrium.

Why This Matters for Policy

The existence of a self-correcting mechanism creates one of the central questions of macroeconomic policy. If the economy will eventually return to: $$\%\Delta Y=g^*,$$ should policymakers simply wait? Or should they attempt to accelerate the adjustment?

Those questions will motivate the next two chapters. Chapter 10 examines how monetary policy can influence Aggregate Demand. Chapter 11 examines how fiscal policy can influence Aggregate Demand.

Before deciding whether those policies should be used, however, it is important to recognize that the economy possesses its own adjustment mechanism even without policy intervention.

Chapter Summary

The Aggregate Demand–Aggregate Supply Model provides a framework for understanding short-run fluctuations in inflation and real economic growth and for distinguishing those fluctuations from the economy’s sustainable long-run growth rate.

Throughout this textbook, we use a growth-rate version of the AD–AS model.

The horizontal axis measures:

$$\%\Delta Y=Real\ GDP\ Growth,$$

while the vertical axis measures:

$$\%\Delta P=Inflation.$$

This convention connects the AD–AS model directly to the concepts developed in Chapters 2, 3, 5, and 6.

Section 7.1 introduced the structure of the AD–AS model and emphasized that it is not simply an ordinary supply-and-demand graph applied to the entire economy.

An ordinary supply-and-demand graph examines the price and quantity of one particular good or service. The AD–AS model examines the inflation rate and growth of real production throughout the entire economy.

The complete model contains three curves:

• Aggregate Demand ($AD$),

• Short-Run Aggregate Supply ($SRAS$),

• Long-Run Aggregate Supply ($LRAS$).

Section 7.2 introduced Aggregate Demand. The Aggregate Demand curve describes the relationship between inflation and real GDP growth demanded throughout the economy.

The downward slope of Aggregate Demand can be understood using the growth-rate form of the Equation of Exchange introduced in Chapter 5:

$$\%\Delta M+\%\Delta V = \%\Delta P+\%\Delta Y.$$

Holding the growth of nominal spending constant, faster inflation means that less of nominal spending growth can appear as real GDP growth.

Therefore:

$$Inflation\uparrow \quad\Longrightarrow\quad Real\ GDP\ Growth\downarrow.$$

The chapter also connected Aggregate Demand to the expenditure approach to GDP:

$$Y=C+I+G+NX.$$

Changes in consumption, investment, government purchases, net exports, money growth, or velocity can change the growth of aggregate spending.

A change in inflation causes a movement along a given AD curve.

A change in the underlying growth of nominal spending causes the entire AD curve to shift.

Faster nominal spending growth shifts AD to the right:

$$AD\rightarrow,$$

while slower nominal spending growth shifts AD to the left:

$$AD\leftarrow.$$

Section 7.3 introduced Short-Run Aggregate Supply. SRAS describes the relationship between inflation and real GDP growth when some production costs, especially wages, have not fully adjusted.

The SRAS curve slopes upward.

If inflation unexpectedly rises faster than wages and other production costs, firms may temporarily experience greater profitability. Businesses respond by increasing production, hiring workers, increasing hours, and using existing capital more intensively.

Thus, along a given SRAS curve:

$$Inflation\uparrow \quad\Longrightarrow\quad Real\ GDP\ Growth\uparrow.$$

The chapter emphasized the importance of sticky wages and expected inflation. Workers and businesses make contracts based partly on what they expect inflation to be. When actual inflation differs from expected inflation, real production can temporarily change.

Changes in actual inflation create movements along SRAS when other conditions remain constant.

Changes in expected inflation, wage growth, input costs, or temporary production conditions shift SRAS.

Higher expected inflation or an adverse supply shock shifts SRAS left:

$$SRAS\leftarrow.$$

Lower expected inflation or favorable production conditions shift SRAS right:

$$SRAS\rightarrow.$$

Section 7.4 introduced Long-Run Aggregate Supply. LRAS represents the economy’s sustainable long-run real GDP growth rate, denoted:

$$g^*.$$

The LRAS curve is vertical because inflation does not determine the economy’s long-run productive capacity.

Instead, long-run growth depends on the factors developed in Chapters 7 and 8:

$$Y=AF(K,L).$$

Sustainable economic growth therefore depends on growth in:

• physical capital $K$,

• labor $L$,

• productivity $A$.

Faster sustainable growth in these productive factors can shift LRAS to the right.

Higher inflation by itself does not shift LRAS.

An economy can temporarily grow faster or slower than $g^*$, but it cannot permanently grow faster than its productive capacity unless capital, labor, or productivity also begin growing more rapidly.

Section 7.5 combined AD and SRAS to determine short-run macroeconomic equilibrium.

Short-run equilibrium occurs where:

$$AD=SRAS.$$

The intersection simultaneously determines:

• short-run real GDP growth,

• short-run inflation.

A rightward shift of Aggregate Demand increases both real GDP growth and inflation in the short run:

$$AD\rightarrow \quad\Longrightarrow\quad \%\Delta Y\uparrow,\quad \%\Delta P\uparrow.$$

A leftward shift of Aggregate Demand reduces both:

$$AD\leftarrow \quad\Longrightarrow\quad \%\Delta Y\downarrow,\quad \%\Delta P\downarrow.$$

An adverse SRAS shift produces:

$$SRAS\leftarrow \quad\Longrightarrow\quad \%\Delta Y\downarrow,\quad \%\Delta P\uparrow.$$

This combination of weak economic growth and high inflation is known as stagflation.

A favorable SRAS shift produces:

$$SRAS\rightarrow \quad\Longrightarrow\quad \%\Delta Y\uparrow,\quad \%\Delta P\downarrow.$$

Section 7.6 added LRAS to the model and introduced long-run macroeconomic equilibrium.

Long-run equilibrium occurs where:

$$AD=SRAS=LRAS.$$

At this point:

$$\%\Delta Y=g^*.$$

Long-run equilibrium does not require zero inflation. The economy can experience positive inflation while growing at its sustainable long-run rate.

When short-run equilibrium growth is below the sustainable rate:

$$\%\Delta Y<g^*,$$

the economy has a recessionary growth gap.

When short-run equilibrium growth exceeds the sustainable rate:

$$\%\Delta Y>g^*,$$

the economy has an inflationary growth gap.

The chapter emphasized an important distinction between slow growth and negative growth.

If:

$$0<\%\Delta Y<g^*,$$

real GDP is still increasing, but more slowly than its sustainable rate.

Real GDP actually declines only when:

$$\%\Delta Y<0.$$

Section 7.7 explained the economy’s self-correcting mechanism.

When:

$$\%\Delta Y<g^*,$$

weak labor markets and underutilized resources tend to slow wage and input-cost growth.

As production costs adjust:

$$SRAS\rightarrow,$$

causing real GDP growth to move back toward:

$$g^*.$$

When:

$$\%\Delta Y>g^*,$$

businesses compete increasingly for workers and other scarce productive resources. Wage and input-cost growth accelerates.

As production costs rise:

$$SRAS\leftarrow,$$

causing real GDP growth to slow toward:

$$g^*.$$

Inflation expectations also adjust over time.

Thus:

$$\%\Delta Y\rightarrow g^*.$$

The economy possesses a natural mechanism for returning toward long-run equilibrium.

However, self-correction can take time. Workers may experience unemployment, businesses may fail, and output may be lost during the adjustment.

This observation creates the central question for the next two chapters:

If the economy eventually self-corrects, should policymakers attempt to make the adjustment occur more quickly?

Chapter 10 examines this question through monetary policy.

Chapter 11 examines it through fiscal policy.

Key Terms

Aggregate Demand ($AD$)

The relationship between inflation and the growth rate of real GDP demanded by households, businesses, governments, and foreign buyers.

Aggregate Demand–Aggregate Supply Model (AD–AS)

A macroeconomic model describing the interaction among aggregate spending, short-run production, and long-run productive capacity.

Aggregate Supply

The economy-wide relationship between inflation and real production.

Expected inflation

The inflation rate households, workers, and businesses anticipate when making economic decisions.

Growth-rate AD–AS model

A version of the AD–AS model in which the horizontal axis measures real GDP growth and the vertical axis measures inflation.

Inflationary growth gap

A situation in which short-run real GDP growth exceeds the sustainable long-run growth rate:

$$\%\Delta Y>g^*.$$

Long-run growth rate ($g^*$)

The sustainable rate of real GDP growth determined by growth in capital, labor, and productivity.

Long-Run Aggregate Supply ($LRAS$)

The vertical curve representing the economy’s sustainable long-run real GDP growth rate.

Long-run macroeconomic equilibrium

The condition:

$$AD=SRAS=LRAS,$$

where:

$$\%\Delta Y=g^*.$$

Movement along Aggregate Demand

A change in real GDP growth associated with a change in inflation while nominal spending growth remains unchanged.

Movement along Short-Run Aggregate Supply

A change in real GDP growth associated with a change in actual inflation while expected inflation and other SRAS determinants remain unchanged.

Nominal spending growth

The growth of total spending measured in current dollars. Using the Equation of Exchange, it can be represented as:

$$\%\Delta M+\%\Delta V.$$

Recessionary growth gap

A situation in which short-run real GDP growth is below the sustainable long-run growth rate:

$$\%\Delta Y<g^*.$$

Self-correcting mechanism

The process through which changes in wages, input costs, and inflation expectations shift SRAS and return real GDP growth toward $g^*$.

Short-Run Aggregate Supply ($SRAS$)

The relationship between inflation and real GDP growth when some production costs have not fully adjusted.

Short-run macroeconomic equilibrium

The intersection of Aggregate Demand and Short-Run Aggregate Supply:

$$AD=SRAS.$$

Stagflation

A combination of weak or negative real economic growth and high inflation.

Sticky wages

Wages that adjust slowly to changing economic conditions.

Supply shock

An unexpected event that significantly changes firms’ production costs or productive capacity in the short run.

Concept Check

Answer the following questions in your own words.

Problems and Applications

Thinking Like an Economist