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In the standard model of Aggregate Demand and Aggregate Supply which display equilibrium in all the markets, I often get confused on how a change in one variable will shift curves. Say, output decreases - how can one determine the causality between a change in output with other variables?

For example, can prices change output and output change prices? What about other variables - GDP, interest rate?

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Rule of thumb: if the changed quantity does not appear on an axis of the graph, its effect (if any) will be a shift of the curve, rather than movement along the curve.

For example, an AD-AS graph has price and quantity on the axes. Interest rate does not appear on the axes, so an increase in the interest rate (say) could be associated with a decrease in the money supply, resulting in a decrease in demand that shows up as a shift of the aggregate demand curve to the left.

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  • $\begingroup$ Thank you! Just a doubt - if this is true, then why does an exogenous supply shock (positive or negative) shifts the Aggregate Supply curve even when output is on the X-axis? $\endgroup$ – user585380 Sep 17 at 3:09
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    $\begingroup$ The X-axis measures the quantity of goods exchanged in equilibrium. This arises from the intersection of supply and demand, and is a ruler you take out only once you have identified equilibrium (or are given an assumed price). The supply/demand curves represent sets of price-quantity pairs. These arise from something different - willingness to pay on the demand side (which depends on budget, tastes, etc), and a production cost curve on the supply side. $\endgroup$ – heh Sep 17 at 14:22
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    $\begingroup$ A supply shock can't affect the equilibrium outcome directly, but what it can do is raise production costs - resulting in a shift to the right of the supply curve, representing increased costs at all production levels. Then and only then do equilibrium outcomes change, usually to an increased price and reduced quantity demanded. $\endgroup$ – heh Sep 17 at 14:22
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    $\begingroup$ On the other hand, arbitrarily raising the price doesn't impact the cost of production, so the supply curve stays fixed. The equilibrium simply moves along it. $\endgroup$ – heh Sep 17 at 14:23
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    $\begingroup$ Yes. The rest of the thinking stands, assuming it's helpful. :) $\endgroup$ – heh Sep 17 at 15:34
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It is useful to write the equations out for your AD-AS curves, so you can easily see what the effect on the curve is (these would depend on the model you are using).

Also, you can't really start your analysis from "output decreases" or "price decreases" as they are endogenous veriable here so you would need to specify why it decreases.

GDP is usually intended as a measure of output and the interest rate is often also an endogenous variable (for example in the IS-LM-AS model).

Examples of exogenous variables may be: government expenditure, money supply, taxes etc. With these you can do comparative statics (ie.e asking if this changes then what happens). Which varibales are endogenous and which exogenous changes from model to model, for example in the classical model output is usually considered exogenous so the analysis becomes easier.

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  • $\begingroup$ If there is an exogenous (positive/negative) supply shock, how would that affect the economy? $\endgroup$ – user585380 Sep 16 at 16:52
  • $\begingroup$ In a classical model (keeping everything else constant), for a positive shock, you would expect prices to fall as the money supply remains constant. The effect on the interest rate may be ambiguous, depending on what causes, what model etc. But in the long run it may tend to fall as MPK falls (this requires more assumptions). In the short run (ie in a Keynesian framework) the analysis is very different). $\endgroup$ – Lorenzo Sep 18 at 13:40

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