AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/3/3-6)
Unit 3 · Topic 3.6
3.6 Changes in the AD–AS Model in the Short Run
This topic is about what happens in the short run when aggregate demand or short-run aggregate supply shifts. A demand shock moves the price level and output in the same direction. A supply shock moves them in opposite directions. These cases explain demand-pull inflation, cost-push inflation and stagflation.
Key terms
- demand shock
- supply shock
- demand-pull inflation
- cost-push inflation
- stagflation
Demand shocks
A positive demand shock shifts AD right (AD1 to AD2). Along the upward-sloping SRAS, the new equilibrium has a higher price level (PL2 > PL1) and higher real output (Y2 > Y1). More output needs more workers, so employment rises and unemployment falls.
A negative demand shock shifts AD left. The price level falls, real output falls, and unemployment rises.
Inflation caused by AD growing faster than the economy can keep up is called demand-pull inflation: too much spending chasing too few goods.
Supply shocks
A negative supply shock shifts SRAS left (SRAS1 to SRAS2), for example when oil prices spike. The new equilibrium has a higher price level but lower real output, and unemployment rises. Inflation caused this way, by rising production costs, is called cost-push inflation.
Rising prices and falling output at the same time is called stagflation (stagnation plus inflation). It's hard for policymakers, because a policy that fights the inflation tends to make the output drop worse, and the reverse.
A positive supply shock shifts SRAS right, for example when energy gets much cheaper or productivity jumps. The price level falls while output and employment rise.
The four basic cases
| Shock | Curve shift | Price level | Real GDP | Unemployment |
|---|---|---|---|---|
| Positive demand shock | AD right | Up | Up | Down |
| Negative demand shock | AD left | Down | Down | Up |
| Positive supply shock | SRAS right | Down | Up | Down |
| Negative supply shock | SRAS left | Up | Down | Up |
Two shifts at once
When AD and SRAS shift together, one outcome is clear and the other depends on the sizes of the shifts, just as in 1.6.
AD right and SRAS left: both push the price level up, so it rises for sure; output is indeterminate. AD right and SRAS right: both push output up, so it rises for sure; the price level is indeterminate.
In the short run, LRAS doesn't move in any of these cases. Output can sit to the left or right of LRAS until the economy adjusts (3.7) or policy steps in (3.8).
To decide which curve a news story shifts, ask one question: does the event change how much people want to spend (AD), or how much it costs firms to produce (SRAS)? A stock-market crash, a change in government spending or a recession abroad are spending changes. A heat wave that ruins crops, a big jump in electricity prices, or cheaper shipping are cost changes.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
A drop in consumer confidence
An economy is in long-run equilibrium. Then households become much more pessimistic about the future and cut spending. Explain the short-run effects on AD, the price level, real GDP and unemployment, and describe the graph.
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- Step 1: Lower confidence lowers consumption (C), so AD shifts left from AD1 to AD2.
- Step 2: On the graph (price level vertical, real GDP horizontal), the new short-run equilibrium is where AD2 crosses the unchanged SRAS1. It's down and to the left of the original point: PL2 is below PL1, and Y2 is below Y1 = YF.
- Step 3: Y2 is now left of the vertical LRAS, so there's a recessionary gap. Firms need fewer workers, so unemployment rises above the natural rate.
Answer: AD decreases; the price level and real GDP fall; unemployment rises. Short-run equilibrium is at Y2 < YF, a recessionary gap.
- Example 2
Stagflation from an oil shock
World oil prices rise sharply. What happens to the price level, real GDP and unemployment in the short run, and what kind of inflation is this?
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- Step 1: Oil is an input for most firms, so production costs rise and SRAS shifts left (SRAS1 to SRAS2).
- Step 2: Along the unchanged AD curve, the new equilibrium is up and to the left: a higher price level and lower real GDP.
- Step 3: Lower output means fewer jobs, so unemployment rises.
- Step 4: Rising prices caused by higher costs is cost-push inflation. Together with falling output, that's stagflation.
Answer: The price level rises, real GDP falls, and unemployment rises: cost-push inflation and stagflation.
- Example 3
Demand up, supply down (classic trap)
At the same time, the government raises its spending and a drought raises food production costs. What happens to the price level and real GDP in the short run?
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- Step 1: More government spending shifts AD right. Alone, that raises the price level and output.
- Step 2: The drought raises costs, shifting SRAS left. Alone, that raises the price level and lowers output.
- Step 3: Price level: both push it up, so it rises for sure.
- Step 4: Real GDP: one shift raises it and the other lowers it. Without knowing the sizes, it's indeterminate.
- Step 5: The trap is to answer "output stays the same." Unless the question gives sizes, say it's indeterminate.
Answer: The price level rises; the change in real GDP is indeterminate.
Common mistakes
- Shifting AD for a supply shock like an oil price spike. Cost changes shift SRAS.
- Saying a negative supply shock lowers the price level. It raises the price level while lowering output.
- Shifting LRAS in a short-run question about a temporary shock. LRAS stays put.
- Giving a definite answer for both the price level and output when two curves shift.
On the exam
- Free-response questions describe a shock and ask for the short-run effect on the price level, real output and unemployment, usually with a graph. Make each answer match your graph.
- Know the vocabulary cold: demand-pull vs. cost-push inflation, and stagflation for a negative supply shock.
Connected topics
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Check yourself
4 questions on 3.6 Changes in the AD–AS Model in the Short Run. Pick an answer to see if you got it, and why.
An economy is in long-run equilibrium. Consumer spending increases sharply. In the short run, what happens to the price level, real output and unemployment?
A drought destroys much of a country's harvest and raises food and other input costs throughout the economy. In the short run, which of the following is most likely to occur?
A major new energy source sharply lowers energy costs for firms throughout the economy. In the short run, what happens to the price level and unemployment?
Which of the following is the best example of demand-pull inflation?
0 of 4 answered