Aggregate Demand and Supply - Moves to Equilibrium

In the long run classical economists believe that the economy will settle at the full employment level of income. In the short run there may be changes in aggregate demand and supply, but the economy will always settle back at the equilibrium given by the LRAS curve.

Diagram: Aggregate Demand and Supply - Moves to Equilibrium

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Say there is an initial equilibrium where AD1 crosses the LRAS curve. If the government try to increase aggregate demand to AD2 through expansionary fiscal policy, then the economy will expand along SRAS1 to a higher level of output. However, as firms realise that the price level has risen and there has not been a real increase in demand the economy the economy will move back left along AD2 to a new long run equilibrium. This will be where AD2 crosses the LRAS curve. If the government attempts further expansionary policy then the process will start again with a shift to AD3. The end result will be a higher price level, but no long run increase in output.