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.
Sign up to view the full answer