Macroeconomics

F I G U R E  

1 4 - 5

Inflation, 

p

p

Income, output, Y

A

B

1. When the natural

level of output increases, . . .

DAS

t

DAD

t

DAS

t + 1

DAD

t + 1

Y

t

Y

t + 1

Y

t

Y

t + 1

2. . . . the dynamic AS

curve shifts to the right, . . . .

4. . . . leading to

growth in ouput . . .

5. . . . and

stable inflation.

3. . . . as does

the dynamic

AD curve, . . . 

An Increase in the Natural

Level of Output

If the nat-

ural level of output Y

−

t

increas-

es, both the dynamic aggre-

gate demand curve and the

dynamic aggregate supply

curve shift to the right by the

same amount. Output Y

t

increases, but inflation 

p

t

remains the same.

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run

The shifts in these curves move the economy’s equilibrium in the figure from

point A to point B. Output Y

t

increases by exactly as much as the natural level

Y

−

t

. Inflation is unchanged.

The story behind these conclusions is as follows: When the natural level of

output increases, the economy can produce a larger quantity of goods and ser-

vices. This is represented by the rightward shift in the dynamic aggregate supply

curve. At the same time, the increase in the natural level of output makes people

richer. Other things equal, they want to buy more goods and services. This is

represented by the rightward shift in the dynamic aggregate demand curve. The

simultaneous shifts in supply and demand increase the economy’s output with-

out putting either upward or downward pressure on inflation. In this way, the

economy can experience long-run growth and a stable inflation rate. 

A Shock to Aggregate Supply

Consider now a shock to aggregate supply. In particular, suppose that 

u

t

rises to 1

percent for one period and subsequently returns to zero. This shock to the Phillips

curve might occur, for example, because an international oil cartel pushes up prices

or because new union agreements raise wages and, thereby, the costs of production.

In general, the supply shock 

u

t

captures any event that influences inflation beyond

expected inflation E

t

−1

p

t

and current economic activity, as measured by Y

t

− Y−

t

.

Figure 14-6 shows the result. In period t, when the shock occurs, the dynam-

ic aggregate supply curve shifts upward from DAS

t

−1

to DAS

t

. To be precise, the