What happens if the economy is at its long-run equilibrium and aggregate demand increases?
The economy will initially move to a higher output level, along the short run aggregate supply curve. Since the economy is initially in a long term equilibrium (full capacity output), the increase of the aggregate demand will lead to a higher price level in the short term equilibrium where the short term aggregate demand and supply curve intersect. Because the increase in prices is higher than expected, the short term supply curve will shift as a result of the wage demands of the labor force to the left, until the economy is back in the long term equilibrium, where the aggregate demand curve intersects with the long term supply curve (assumed to be vertical in the classical case of full adjustment of price expectations). The net result, is an increase of the overall GDP of the economy in the short term, but if the economy is initially at the full capacity output, this increase will ultimately only result in a higher price level and the GDP will fall back to the original starting point.
