Let’s start with an economy in long run equilibrium, with the price level equal to that anticipated by decision makers. The long run equilibrium is shown by the green dot (1) with the price level at 105.
Then, suppose a change in short run equilibrium occurs. For example, there may be an decrease in aggregate demand due to a sudden decrease in optimism about the economy (one of the six things that decreases aggregate demand). Producers and consumers will still make decisions based on their assumptions about the price level (in this case, it seems that buyers and producers still believe the price level will remain at 105, its old level). However, buyers are buying less than they previously did, since consumers are fearful. The following short run equilibrium results.
In this short run equilibrium, which is shown as point (2):
1. the price level is lower than what was expected (it’s 103 instead of 105)
2. the price level is lower than in the (previous) long run equilibrium
3. as a result of the lower price level, producers will produce less output in the short run than in the previous long run equilibrium, since resource costs will not fall along with the falling price level for products (see below)
4. output (real GDP) will be lower than in long run equilibrium (and lower than the potential, sustainable, full employment level).
5. employment is less than full employment
6. unemployment is higher than the natural rate (this can occur temporarily)
7. cyclical unemployment is positive
8. the real values of wages and resource prices will be higher than their long run equilibrium levels (due to the lower than expected price level)
9. real interest rates will be higher than long run equilibrium values (due to the lower than expected price level
Self Correcting Mechanism in Response to Lower Employment
Once again, the short run equilibrium will affect the resource market, only these effects are the reverse of those that occur when the aggregate demand increases.
As the aggregate demand begins to move left, producers reduce their production in response, and thus reduce demand for resources. However, most resource owners and workers will not realize that prices of goods and services are falling. They supply their labor and resources based on the assumption that the price level will stay at its original level (105 in this example). As a result, they will expect to sell their labor and other resources at prices that will not take the lower price level (103) into account:
In nominal (money) terms, the wage and resource prices may even go down. However, the decrease will not be as great as the fall in the price level for goods and services. In real terms, wages and resource prices actually rise in the short run as the price level falls.
Something similar is happening in the market for loans (which is why the real interest rate will be higher in the short run equilibrium), but it is resource prices that hold the important key to what happens next.
Return to the Long Run Equilibrium
Since the price level is not what was anticipated, this short run equilibrium is essentially built on decisions that will be altered in the long run, as the true price level is recognized, and as people have time to change their decisions (and anticipations). All decisions that were based on the incorrect anticipated price level will eventually be altered. This includes decisions by workers and other resource sellers to sell supply their resources to producers. Over time, as workers and owners of resources realize that the price level is lower, they will be willing to work for much lower wages (or sell resources at much lower prices).
Real wages will fall (back to their original level):
The New Long Run Equilibrium
As the supply for labor and resources reflects more realistic price level expectations, real wages and resource prices will fall. This will cause the short run aggregate supply to rise. It will also result in less unemployment of resources (a return to full employment).
Eventually, a new long run equilibrium will be established, reflecting the restored real wages and resource prices.
At the final long run equilibrium (3),
1. the price level is as expected (it’s 98 now, and that’s consistent with expectations)
2. the price level is lower than in the (previous) long run equilibrium
3. even though the price level is lower than the previous equilibrium, producers do not want to produce less than the long run potential GDP, since resource prices have fallen by the same proportion as product prices.
4. output (real GDP) will be the potential, sustainable, full employment level.
5. employment is equal to full employment
6. unemployment is at the natural rate
7. cyclical unemployment is zero
8. real wages return to their original level, even though nominal wages are lower than before.
9. real interest rates will fall back to their original level, as the economy slides down the aggregate demand curve to the new long run equilibrium.