The short-run in macroeconomics is a length of time over which input prices—wages in particular—are fixed, even as the aggregate price level changes. Accordingly, short-run increases in the price level will increase firms' revenues and profits. Such increases expand production and employment beyond the level consistent with "full employment" of resources. However, should prices remain high, workers and other input suppliers will demand increased rewards for supplying their resources. These higher input prices will reduce aggregate supply, restoring unemployment to its "natural" rate.

Exploration: How do short-run changes in aggregate demand and supply affect output and the price level in the long run?

The graph shows the economy's aggregate demand curve and both its aggregate supply and long-run aggregate supply curves. The economy is currently at potential output of Q_f at price level P. To use the graph, drag the aggregate demand or aggregate supply curve left or right by dragging the corresponding label. The potential output can be changed by dragging the blue triangle either left or right. Click on Self Correcting Equilibrium to observe the long-run adjustment to equilibrium; click on AD Policy Adjustment to observe how potential output may be restored using demand-side policy tools.

1		How will an increase in aggregate demand affect GDP in the short run? How does this compare to the long-run change in GDP?
2		Suppose the economy experiences a dramatic increase in oil prices. How will this affect real GDP and the price level in the short run? Compare and contrast the effects of a "laissez-faire" policy with an active demand-side policy to restore the economy to its potential output.
3		Experiment on your own. If there is an increase in potential output, how might the economy achieve a stable price level?

Graphing Exercise: Monetary Policy

The Bank of Canada can control the money supply by controlling the amount of bank reserves. It has two tools at its disposal using open market operations. Monetary policy consists of deliberate changes in the money supply to influence interest rates and thereby the level of aggregate spending and employment in the economy.

The three graphs in the window illustrate the cause-effect chain that links changes in the money supply, the interest rate, investment spending, and aggregate demand. The Bank of Canada can, through its control of the money supply, influence aggregate demand, thereby influencing equilibrium real GDP and the price level. To use the graphs, increase or decrease the money supply by dragging the green triangle at the base of the S_m curve. The other two graphs track the interest-rate induced changes in investment spending and aggregate demand. Click on the Price Adjustment button to see the impact of changes in the money supply on equilibrium GDP and the price level.

4		Suppose the Bank of Canada buys bonds on the open market in sufficient quantities to increase the money supply by $60 billion. What impact will this have on the interest rate, investment spending, real GDP, and the price level?
5		Suppose the Bank of Canada sells a sufficient number of bonds to reduce the money supply by $30 billion. What impact will this have on the interest rate, investment spending, real GDP, and the price level?
6		Experiment on your own. How might the Bank of Canada respond to a problem of substantial unemployment? How might the Bank of Canada respond to a problem of high inflation? Can the Bank of Canada fight both inflation and unemployment at the same time?

The short-run in macroeconomics is a length of time over which nominal input prices—wages in particular—are fixed, even as the aggregate price level changes. Accordingly, short-run increases in the price level will increase firms' revenues and profits. Such increases expand production and employment beyond the level consistent with "full employment" of resources. However, should prices remain high, workers and other input suppliers will demand increased rewards for supplying their resources. These higher input prices will reduce aggregate supply, restoring unemployment to its "natural" rate.

Exploration: How do short-run changes in aggregate demand and supply affect output and the price level in the long run?

The graph shows the economy's aggregate demand curve and both its short-run and long-run aggregate supply curves. The economy is currently at the full-employment long-run equilibrium GDP of Q_f at price level P. To use the graph, drag the aggregate demand or short-run aggregate supply curve left or right by dragging the corresponding label. The full-employment level of GDP can be changed by dragging the blue triangle either left or right. Click on Self Correcting Equilibrium to observe the long-run adjustment to equilibrium; click on AD Policy Adjustment to observe how full employment may be restored using demand-side policy tools.

7		How will an increase in aggregate demand affect GDP in the short run? How does this compare to the long-run change in GDP?
8		Suppose the economy experiences a dramatic increase in oil prices. How will this affect real GDP and the price level in the short run? Compare and contrast the effects of a "laissez-faire" policy with an active demand-side policy to restore the economy to full employment.
9		Experiment on your own. If there is an increase in long-run aggregate supply, how might the economy achieve a stable price level?