In the short-run, an unanticipated decrease in aggregate demand will lead to an excess supply of resources, which will lead to a decline in resource prices. Unemployment will increase, prices will go down and output will be reduced. Over a longer period of time, lower resource costs will cause a shift to the right in aggregate supply. The economy will move to producing a level of output consistent with full employment (as was the case before the decrease in aggregate demand), but at a lower price level.
An unanticipated increase in aggregate demand will, in the short-run, lead to an output level that is greater than what is consistent with full employment. This occurs because price levels are different that what was anticipated by resource providers. There will be less unemployment than the "natural rate" of unemployment. There will be upward pressure on resource prices and interest rates, which will, over the long-run, result in a decrease in aggregate demand. Resource providers will make adjustments to the new price levels and output will decline to what is consistent with full employment. A new market equilibrium will occur at a higher price level. So in the long-run, inflation (higher prices) will be the major effect of the increase in aggregate demand.
In the short-run, an unanticipated decrease in SAS will lower the availability of resources. This will lead to an increase in resource prices, which will in turn cause the aggregate supply curve of goods and services to shift up and to the left. A reduced level of output will be produced at higher prices. If the cause of the unanticipated decrease in SAS is temporary, then there should be no changes in prices or output over the long-run. If the cause is more important, then the long-run supply curve will shift to the left. The economy would produce a lower level output at higher prices.
An unanticipated increase in aggregate supply will, in the short-run, lead to a shift to the right in SAS. Output and income will expand beyond what is consistent with full employment at a lower price level. If what produced the increase in aggregate supply is only temporary, the SAS curve will return to normal levels and prices and output will be as before. If what produced the change is permanent, then both SAS and LAS will shift to the right. There will be a greater amount of output, at lower prices.
Three aspects of a market economy that help to stabilize the economy and lessen the impact of economic shocks include:
1.Changes in Resource Prices - If the economy is operating at less than full employment, there will be downward pressure on prices for labor and other resources. That effect will stimulate short-run aggregate supply. If the economy is operating above full employment, prices for labor and other resources will get bid up, and short-run aggregate supply will be reduced.
2. Change in Real Interest Rates - During recessions, business demand for capital funding declines, causing a lowering of real interest rates. The lower interest rates in turn stimulate consumers to buy large items and cost of business investment projects are reduced, which stimulates business investment spending. Economic booms lead to higher interest rates, thereby lowering demand for consumer durable goods and funding for business investment projects. Therefore, interest rate movements work to stabilize aggregate demand.
3.Relative Stability of Consumption - The permanent income hypotheses states that household consumption is mainly a function of expected long-range (permanent) income. Since long-run income has more of an impact on spending than temporary changes in current income, consumption spending stays relatively the same across business cycles. During economic boom times, consumers will increase their savings; during a recession, temporary declines in income will induce households to draw on their savings so as to maintain a level of consumption in line with their expected long-run incomes.
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