The aggregate demand and supply curves are only half the story. The interesting part is where they cross. That intersection is macroeconomic equilibrium — the price level and level of output at which total spending exactly matches total production, so there is no pressure to change.
In the short run, equilibrium sits where aggregate demand meets short-run aggregate supply. At that point the economy could be booming above its potential, slumping below it, or running right at full capacity. Short-run equilibrium tells you where the economy is today, not where it ought to be.
Long-run equilibrium is more demanding. It occurs only where all three lines meet at once: aggregate demand, short-run supply, and the vertical long-run supply curve at potential output. There the economy produces exactly what its resources allow, with no inflationary or recessionary gap. This is the economy's resting state.
What happens if a shock pushes the economy away from that resting state? The model predicts a built-in fix. Self-correction is the process by which wages and prices slowly adjust to drag output back to potential. Suppose a recession leaves workers idle. Over time their wages fall, which lowers firms' costs, shifts short-run supply outward, and restores full output. The mechanism is real but slow, which is exactly why governments often refuse to wait.
Shocks come in two flavors, and the difference matters enormously. A demand shock is a sudden change in total spending. It moves output and prices in the same direction. A collapse in spending, as in the Great Depression of the 1930s or the COVID lockdowns of 2020, drags both output and prices down together. A surge in spending pushes both up.
A supply shock behaves differently and far more nastily. It changes the cost of producing, so it pushes output and prices in opposite directions. A jump in oil prices, like the crises of the 1970s, raises costs across the economy, cutting output while driving prices up.
That perverse combination has its own name. Stagflation is the painful mix of stagnant output, rising unemployment, and high inflation at the same time. It shattered the old belief that inflation and unemployment always move in opposite directions. Stagflation is hard to fight, because the usual cure for one half of the problem makes the other half worse, which is why supply shocks frighten policymakers.