In the classical model a rightward shift in the aggregate demand curve will in the long run

Learning Objectives

  • Explain how productivity growth and changes in input prices change the aggregate supply curve

In this section we introduce supply shocks. Supply shocks are events that shift the aggregate supply curve. We defined the AS curve as showing the quantity of real GDP producers will supply at any aggregate price level. When the aggregate supply curve shifts to the right, then at every price level, a greater quantity of real GDP is produced. This is called a positive supply shockWhen the AS curve shifts to the left, then at every price level, a lower quantity of real GDP is produced. This is a negative supply shock. This module discusses two of the most important supply shocks: productivity growth and changes in input prices.

How Productivity Growth Shifts the AS Curve

In the long run, the most important factor shifting the AS curve is productivity growth. Productivity means how much output can be produced with a given quantity of inputs. One measure of this is output per worker or GDP per capita. Over time, productivity grows so that the same quantity of labor can produce more output. Historically, the real growth in GDP per capita in an advanced economy like the United States has averaged about 2% to 3% per year, but productivity growth has been faster during certain extended periods like the 1960s and the late 1990s through the early 2000s, or slower during periods like the 1970s. A higher level of productivity shifts the AS curve to the right, because with improved productivity, firms can produce a greater quantity of output at every price level. The interactive graph below (Figure 1) shows an outward shift in productivity over two time periods. The AS curve shifts out from SRAS0 to SRAS1 and LRAS0 to LRAS1, reflecting the rise in potential GDP in this economy, and the equilibrium shifts from E0 to E1.


Figure 1 (Interactive Graph). Shifts in Aggregate Supply. Productivity growth shifts AS to the right.

A shift in the SRAS curve to the right will result in a greater real GDP and downward pressure on the price level, if aggregate demand remains unchanged. However, productivity grows slowly, at best only a few percentage points per year. As a consequence, the resulting shift in SRAS, increase in Q and decrease in P will be relatively small over a few months or even a couple of years.

How Changes in Input Prices Shift the AS Curve

Higher prices for inputs that are widely used across the entire economy, such as labor or energy, can have a macroeconomic impact on aggregate supply. Increases in the price of such inputs represent a negative supply shock, shifting the SRAS curve to shift to the left. This means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits. The interactive graph below (Figure 2) shows the aggregate supply curve shifting to the left, from SRAS0 to SRAS1, causing the equilibrium to move from E0 to E1. The movement from the original equilibrium of E0 to the new equilibrium of E1 will bring a nasty set of effects: reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and an inflationary higher price level as well. For example, the U.S. economy experienced recessions in 1974–1975, and 1980–1981 that were each preceded or accompanied by a rise in oil prices. In the 1970s, this pattern of a shift to the left in AS leading to a stagnant economy with high unemployment and inflation was nicknamed stagflation.


Figure 2 (Interactive Graph). Shifts in Aggregate Supply. Higher prices for key inputs shifts AS to the left.

Conversely, a decline in the price of a key input like oil, represents a positive supply shock shifting the SRAS curve to the right, providing an incentive for more to be produced at every given price level for outputs. From 1985 to 1986, for example, the average price of crude oil fell by almost half, from $24 a barrel to $12 a barrel. Similarly, from 1997 to 1998, the price of a barrel of crude oil dropped from $17 per barrel to $11 per barrel. In both cases, the plummeting price of oil led to a situation like that presented earlier in Figure 1, where the outward shift of SRAS to the right allowed the economy to expand, unemployment to fall, and inflation to decline.

Along with wages and energy prices, another source of supply shocks is the cost of imported goods that are used as inputs for domestically-produced products. In these cases as well, the lesson is that lower prices for inputs cause SRAS to shift to the right, while higher prices cause it to shift back to the left.

Similarly, an unexpected early freeze could destroy a large number of agricultural crops, a shock that would shift the AS curve to the left since there would be fewer agricultural products available at any given price.

When Does A Supply Shock Shift Potential GDP?

This important question really answers itself. Suppose there is a decrease in aggregate demand, which is shown by a leftward shift in AD, as shown in Figure 2. In the short term, wages are sticky and output decreases along the SRAS, as we move from E1 to E2. Over time, wages decrease and as they do, the SRAS shifts to the right due to the decrease in firms’ cost of production. The SRAS continues to shift until GDP has returned to potential. Graphically, we move from E2 to E3.  Because this event was caused by a demand shock (i.e. a shift in AD), it had no effect on potential GDP. The supply of labor didn’t change, nor did labor productivity so LRAS stays constant, though SRAS shifted. LRAS shifts only when the potential GDP increases or decreases.

In the classical model a rightward shift in the aggregate demand curve will in the long run

Figure 3. A Demand Shock. When AS shifts in response to a shift in AD, potential GDP (and LRAS) is unchanged. Rather, the model adjusts back to the original potential GDP, moving from E1 to E3.

Review things that shift aggregate supply in the following video.

You can view the transcript for “Short-Run Aggregate Supply- Macro Topic 3.3” here (opens in new window).

The video went over the following scenarios. Take a second look and quiz yourself on what will happen to aggregate supply in each situation.

  1. A significant increase in nominal wages.
  2. An increase in physical capital.
  3. A decrease in corporate taxes on producers.
  4. An increase in expected inflation.

These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions.

negative supply shock: a leftward shift in the SRAS and LRAS curves positive supply shock: a rightward shift in the SRAS and LRAS curves stagflation: an economy experiences stagnant growth and high inflation at the same time supply shock: an event that shifts both short run and long run aggregate supply curves

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Aggregate demand (AD) is the total amount of goods and services consumers are willing to purchase in a given economy and during a certain period. Sometimes aggregate demand changes in a way that alters its relationship with aggregate supply (AS), and this is called a "shift."

Since modern economists calculate aggregate demand using a specific formula, shifts result from changes in the value of the formula's input variables: consumer spending, investment spending, government spending, exports, and imports.

  • Aggregate demand (AD) is the total amount of goods and services in an economy that consumers are willing to purchase during a specific time frame.
  • When aggregate demand changes in its relationship with aggregate supply, this is known as a shift in aggregate demand.
  • Aggregate demand consists of the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.
  • When any of these aggregate demand inputs change, then there is a shift in aggregate demand.

A D = C + I + G + ( X − M ) where: C = Consumer spending on goods and services I = Investment spending on business capital goods G = Government spending on public goods and services X = Exports M = Imports \begin{aligned} &AD=C+I+G+(X-M)\\ &\textbf{where:}\\ &C = \text{Consumer spending on goods and services}\\ &I = \text{Investment spending on business capital goods}\\ &G = \text{Government spending on public goods and services}\\ &X = \text{Exports}\\ &M = \text{Imports} \end{aligned} AD=C+I+G+(XM)where:C=Consumer spending on goods and servicesI=Investment spending on business capital goodsG=Government spending on public goods and servicesX=ExportsM=Imports

Any aggregate economic phenomena that cause changes in the value of any of these variables will change aggregate demand. If aggregate supply remains unchanged or is held constant, a change in aggregate demand shifts the AD curve to the left or to the right.

In macroeconomic models, right shifts in aggregate demand are typically viewed as a sign that aggregate demand increased or is growing—typically viewed as positive. Shifts to the left, a decrease in aggregate demand, mean that the economy is declining or shrinking—typically viewed as negative.

However, this is not always the case. For example, a reduction in aggregate demand might be engineered by the government to reduce inflation, which is not necessarily something negative.

The aggregate demand curve tends to shift to the left when total consumer spending declines. Consumers might spend less because the cost of living is rising or because government taxes have increased.

Consumers may decide to spend less and save more if they expect prices to rise in the future. It might be that consumer time preferences change and future consumption is valued more highly than present consumption.

Contractionary fiscal policy can also shift aggregate demand to the left. The government might decide to raise taxes or decrease spending to fix a budget deficit. Monetary policy has less immediate effects. If monetary policy raises the interest rate, individuals and businesses tend to borrow less and save more. This could shift AD to the left.

The last major variable, net exports (exports minus imports), is less direct and more controversial. A country’s current account surplus is always balanced by the change in the capital account (that is, a trade surplus or positive net exports). This would imply a net influx of foreign currency or dollars held abroad to pay for the fact that foreigners are buying more U.S. goods than they are selling to the U.S. This situation would lead to an increase in U.S. foreign currency holdings or an influx of U.S. dollars held abroad and would generally positively shift aggregate demand.

According to macroeconomic theory, a demand shock is an important change somewhere in the economy that affects many spending decisions and causes a sudden and unexpected shift in the aggregate demand curve.

Some shocks are caused by changes in technology. Technological advances can make labor more productive and increase business returns on capital. This is normally caused by declining costs in one or more sectors, leaving more room for consumers to buy additional goods, save, or invest. In this case, the demand for total goods and services increases at the same time prices are falling.

Diseases and natural disasters can cause negative demand shocks if they limit earnings and cause consumers to buy fewer goods. For example, Hurricane Katrina caused negative supply and demand shocks in New Orleans and the surrounding areas. And post-WWII, it's commonly held that the United States experienced a positive demand shock, particularly with real commodities.

Aggregate demand is the total amount of goods and services in an economy that consumers are willing to pay for within a certain time period. Aggregate demand is calculated as the sum of consumer spending, investment spending, government spending, and the difference between exports and imports.

Whenever one of these factors changes and when aggregate supply remains constant, then there is a shift in aggregate demand. Utilizing the aggregate demand curve, a shift to the left, a reduction in aggregate demand, is perceived negatively, while a shift to the right, an increase in aggregate demand, is perceived positively.