Assume that initially the economy is in long-run equilibrium at Point A with output at potential output and the price level at P 1 . In the short-run, the economy goes to Point B. Output goes above potential output. The price level goes up to P S . Point B is only a short-run equilibrium because over time input prices will increase. As input prices increase the short-run aggregate supply curve starts to shift up until it gets to SRAS 2 .
Output is back at potential output.
Unless the aggregate demand curve shifts again. The effect of a decrease in aggregate demand works the same way, but in the opposite direction. When the economy is at potential output, the unemployment rate is at the natural rate of unemployment. This can be seen in Figure L1-5. Notice that in order to do this, the U axis must be backward from the Y axis.