Macroeconomics

F I G U R E

1 3 - 1

Price level, P

Income, output, Y

P = EP

P > EP

P < EP

Y

 Y  a(P  EP)

Y

Short-run

aggregate supply

Long-run

aggregate

supply

The Short-Run Aggregate

Supply Curve

Output

deviates from its natural 

level Y− if the price level P

deviates from the expected

price level EP.

---

Now that we have a better understanding of aggregate supply, let’s put

aggregate supply and aggregate demand back together. Figure 13-2 uses our

aggregate supply equation to show how the economy responds to an unex-

pected increase in aggregate demand attributable, say, to an unexpected mon-

etary expansion. In the short run, the equilibrium moves from point A to point

B. The increase in aggregate demand raises the actual price level from P

1

to P

2

.

Because people did not expect this increase in the price level, the expected

price level remains at EP

2

, and output rises from Y

1

to Y

2

, which is above the

natural level Y

−

. Thus, the unexpected expansion in aggregate demand causes

the economy to boom.

Yet the boom does not last forever. In the long run, the expected price level

rises to catch up with reality, causing the short-run aggregate supply curve to

shift upward. As the expected price level rises from EP

2

to EP

3

, the equilibrium

of the economy moves from point B to point C. The actual price level rises from

P

2

to P

3

, and output falls from Y

2

to Y

3

. In other words, the economy returns to

the natural level of output in the long run, but at a much higher price level.

This analysis shows an important principle, which holds for both models of

aggregate supply: long-run monetary neutrality and short-run monetary non-

neutrality are perfectly compatible. Short-run nonneutrality is represented here

by the movement from point A to point B, and long-run monetary neutrality is

represented by the movement from point A to point C. We reconcile the short-

run and long-run effects of money by emphasizing the adjustment of expecta-

tions about the price level.

C H A P T E R   1 3

Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment

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