Figure 5.3 Reaction to an Expansionary Shock The shock shifts AD to AD', and the economy reacts by moving from A toward B as prices rise, decreasing the real wage and enticing firms to hire more workers. When workers become aware that their real wage has fallen and are able to do something about it, the economy moves toward C. Higher wages shift SRAS up to SRAS'.
Analyzing each of these shocks permits exposition of the modem view of the economy's supply side and how the aggregate-supply/aggregate-demand diagram is used to portray business-cycle behavior.
5.5 Moving Into a Boom
Suppose an exogenous increase in aggregate demand shifts the AD curve to AD'. (Exogenous means resulting from an action that is external to the supply and demand forces under investigation; government policy actions are exogenous.) Inventories fall and business in the service industry is turned away, indicating to firms that demand for their good or service has risen. How are firms likely to react? Near the NRU, firms are operating at a high-capacity level, implying that extra output will involve higher per-unit cost. Consequently, firms are likely to increase prices. Once this price increase is in place, however, it is profitable for firms to increase output, and new firms may be enticed to appear. As a result, the demand for workers increases.
