Question

Starting from a full employment equilibrium,how do the real GDP and price level change in the short run and in the long run in response to a decrease in SAS ?

Answer 1

Short-run Aggregate supply (SAS) will decrease if, for example, price of oil, a input, increases, thus raising production cost, so firms will decrease output. This shifts SRAS curve leftward, increasing price level and decreasing output in short run, causing a Stagflation.

In long run, wages and prices are flexible, hence aggregate demand increases, shifting AD curve rightward, intersecting SRAS curve at further higher price level and restoring output to initial potential output level. Unemployment rate returns to full-employment level.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at initial long-run equilibrium point A with initial price level P0 and real GDP (potential GDP) Y0. A decrease in SAS shifts SRAS0 leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1 in short run. In long run, AD0 shifts rightward to AD1, intersecting SRAS1 at point C with further higher price level P2 but real GDP being restored at Y0.