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As far as I'm aware, in the absence of any changes in the long run aggregate supply LRAS, any changes in the level of aggregate demand AD or short run aggreagete supply SRAS should eventually in the long run see the economy return to full employment, as per monetarist theory. How does the economy return to full employment when there is a change in the SRAS, when, for example, SRAS decreases?

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I guess it depends on the model you are considering, but in the basic AS-AD model it should happen via adjustment in the labour market: if $Y_t > \bar{Y}$, then there will be upward pressure on the nominal wages (employment is higher than equilibrium employment, therefore workers ask for higher wages), to which firms respond by increasing prices, inducing an increase in inflation. As inflation expectations adjust, the SRAS shifts leftward. The adjustment stops when workers' real wage demands are met by firms (which is, when inflation expectations are realised) and output is back at $\bar{Y}$.

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  • $\begingroup$ I presume $Y_t$ is equilibrium output and $\bar{Y}$ is full output. So are you saying if initially SRAS shifts rightwards, resulting in a positive output gap then eventually it will shift leftwards back to $\bar{Y}$? $\endgroup$ – user98937 May 26 '17 at 11:05
  • $\begingroup$ $Y_t$ is actual output. If there is a shock resulting in a positive output gap (ie $Y_t > \bar{Y}$) then the story above follows (in the model at least) $\endgroup$ – simone May 26 '17 at 11:06
  • $\begingroup$ To Simone's answer, shouldn't we start with horizontal aggregate a curve and then move onto positive sloped aggregate supply curve? $\endgroup$ – Shoaib Ashraf Aug 24 '18 at 13:23

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