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AP®︎/College Macroeconomics
Course: AP®︎/College Macroeconomics > Unit 3
Lesson 6: Changes in the AD-AS model in the short runLesson summary: Changes in the AD-AS model in the short run
In this lesson summary review and remind yourself of the key terms and graphs related to changes in the AD-AS model. Topics include AD shocks, such as changes in consumption, investment, government spending, or net exports, and supply shocks such as price surprises that impact SRAS, and how changes in either of these impact output, unemployment, and the price level.
Lesson Summary
We know from previous lessons that business cycles are deviations of GDP away from the long run trend. In other words, real GDP is increasing over time, but its a bumpy road along the way with lots of ups and downs.
But why do business cycles exist in the first place? This question continues to fascinate macroeconomists. In our last lesson, we learned how we can use the AD-AS model to describe what real GDP is today. Now, we will use the same model to describe why real GDP might change. Anything that shifts AD or SRAS will create a new macroeconomic equilibrium. We can use the AD-AS model to help explain the business cycle (in other words, the recessions and booms that we have seen in the real world).
When AD or SRAS curves shift, we call these “shocks”. Why a shock? Because the change come as a complete surprise! An unexpected change in the economy will shift either the aggregate demand (AD) or short-run aggregate supply (SRAS) curve. Negative shocks decrease output and increase unemployment. Positive shocks increase production and reduce unemployment. The effect on inflation, however, will depend on whether the shock was a supply shock or a demand shock.
Key Terms
| Key term | definition |
|---|---|
| shock | an unexpected change that will shift either the AD or SRAS curve; if a change is anticipated, that anticipation would already have been incorporated into the curve, so a change must be unexpected in order to cause a change. |
| demand shock | an unexpected change that shifts AD; a positive demand shock (such as an increase in consumer confidence) increases AD, but a negative demand shock decreases AD. |
| supply shock | an unexpected change that shifts SRAS; a positive supply shock increases SRAS, but a negative supply shock decreases SRAS. |
| stagflation | the combination of a stagnating (falling) aggregate output and a higher price level (inflation); stagflation occurs when SRAS decreases. |
Key takeaways
AD shocks have a short-run impact on the three macroeconomic variables
We can summarize the impact of an AD shock as described in the table below:
| Demand shock | impact on rGDP | impact on unemployment | impact on price level |
|---|---|---|---|
| ↑ AD | ↑ rGDP | ↓ UR | ↑ PL |
| ↓ AD | ↓ rGDP | ↑ UR | ↓ PL |
A change in any of the components of aggregate demand will cause AD to shift, creating a new short-run macroeconomic equilibrium. In other words, in our A, D, equals, C, plus, I, plus, G, plus, N, X equation, anything that increases C, I, G, or NX will shift AD to the right. Anything that decreases C, I, G, or NX will shift AD to the left.
For example, suppose an economy is initially in long-run equilibrium. If the economy experiences a positive AD shock, it would be in the expansion phase of the business cycle and have a positive output gap. Increases in AD are the most frequent cause of increases in aggregate output in the business cycle. Positive output gaps are frequently called inflationary gaps because increases in AD also cause an increase in the price level.
SRAS shocks have a short-run impact on our key macroeconomic variables
We can summarize the impact of a shock to SRAS as described in the table below:
| Supply shock | impact on rGDP | impact on unemployment | impact on price level |
|---|---|---|---|
| ↑SRAS | ↑rGDP | ↓ UR | ↓ PL |
| ↓SRAS | ↓rGDP | ↑ UR | ↑ PL |
Remember the mnemonic “SPITE” to summarize the things that can cause a shift in SRAS:
Subsidies for businesses
Productivity
Input prices
Taxes on businesses
Expectations about future inflation
For example, suppose an economy is initially in long-run equilibrium (current output is equal to full employment output). If the economy then experiences a positive SRAS shock, such as a decrease in Input prices. Now it would be in the expansion phase of the business cycle and experiences a positive output gap.
On the other hand, if the economy starts in long-run equilibrium and then experiences a negative SRAS shock, it would be in the recession phase of the business cycle and experience a negative output gap. The combination of low output and high inflation that is caused by a decrease in SRAS is so unusual that it gets its a special name: stagflation. This word is a mashup of “stagnation” and “inflation.”
Shifts in SRAS represent the best and the worst outcomes for an economy. If SRAS increases, we end up with lower prices, less unemployment, and more output! On the other hand, decreases in SRAS give us more of what we like the least: less stuff, more unemployment, and higher prices.
Key graphs
Positive demand shocks
This economy was initially at long-run equilibrium, so its current output (Y, start subscript, 1, end subscript) was equal to its full employment output (Y, start subscript, f, end subscript). As the result of an increase in one of the components of AD, the entire curve will increase (shift to the right). At the old price level, AD would exceed SRAS. This excess demand puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (P, L, start subscript, 2, end subscript) and higher output (Y, start subscript, 2, end subscript). Because output has increased, the unemployment rate has decreased.
Positive supply shocks
This economy was initially at long-run equilibrium, and its current output (Y, start subscript, 1, end subscript) was equal to its full employment output (Y, start subscript, f, end subscript). Something has changed in the economy making output cheaper for producers, such as a decrease in the cost of labor. At the old price level, SRAS would exceed AD. This surplus output puts downward pressure on the price level until the economy assumes a new short-run equilibrium at a lower price level (P, L, start subscript, 2, end subscript) and higher output (Y, start subscript, 2, end subscript). Because output has increased, the unemployment rate has decreased.
Shifts in SRAS are caused by things that impact the ability to produce goods and services in the short run. The most common factor that affects SRAS is an economy-wide change in factor prices. Some things that impact an economy’s ability to produce are so profound that they have not just a short-run impact, but a long-run impact, which means both the SRAS and LRAS will shift. For example, if more resources become available (like an entirely new form of energy is discovered), then this would shift the LRAS curve to the right. We will develop this idea more in a future lesson, however. For now, focus on the immediate impact a change in the cost of production has on SRAS alone.
Negative demand shocks
This economy was initially at long-run equilibrium, and its current output (Y, start subscript, 1, end subscript) was equal to its full employment output (Y, start subscript, f, end subscript). As the result of a decrease in one of the categories of AD, the entire AD curve has decreased (shifted to the left). At the old price level, SRAS would exceed AD. This puts downward pressure on the price level until the economy assumes a new short-run equilibrium at a lower price level (P, L, start subscript, 2, end subscript) and lower output (Y, start subscript, 2, end subscript). Because output has decreased, the unemployment rate has increased.
Negative supply shocks
This economy was initially at long-run equilibrium, and its current output (Y, start subscript, 1, end subscript) was equal to its full employment output (Y, start subscript, f, end subscript). Something has changed in the economy making output more costly for producers, such as increased regulation. At the old price level, AD would exceed SRAS. This puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (P, L, start subscript, 2, end subscript) and lower output (Y, start subscript, 2, end subscript). Because output has decrease, the unemployment rate has increased.
Common misperceptions
-Some people get confused about changes in the price level versus changes in expectations in the price level. A change in the price level leads to movement along the SRAS or AD curve, but changes in expectations shift the entire curve itself. If something happens that makes firms believe that inflation is coming, they will adjust their plans accordingly.
For example, if firms expect they will have to pay higher wages in the future because of inflation, they start cutting back production today in anticipation of that inflation. As a result, the SRAS curve will decrease, even before any inflation has occurred. Expectations of inflation are, in effect, self-fulfilling prophecies!
Discussion questions
- The economy of Petmeckistan is initially in long-run macroeconomic equilibrium. Then, the stunning defeat of the Petmeckistan synchronized skating team at the Winter Olympics by their arch rival, Lizania, causes widespread pessimism among consumers.
In a correctly labeled graph of the long-run aggregate supply, short-run aggregate supply, and aggregate demand, show each of the following:
- Initial equilibrium output and price level, labeled as Y, start subscript, 1, end subscript and P, L, start subscript, 1, end subscript
- The new equilibrium output and price level, labeled as Y2 and P, L, start subscript, 2, end subscript
- Full employment output, labeled as Y, start subscript, f, end subscript
- In a previous lesson it was stated that there is a negative relationship between unemployment and inflation in the short run. A shock to one of our curves is consistent with this idea, but a shock to the other curve is not actually consistent with a negative relationship between unemployment and inflation. What kind of shift is consistent with this relationship, and which is not?
- During the 1970s, the United States was hit with an oil embargo which dramatically increased the price of energy. Explain how this would impact output, inflation, and the unemployment rate.
Want to join the conversation?
Q: During the 1970s, the United States was hit with an oil embargo which dramatically increased the price of energy. Explain how this would impact output, inflation, and the unemployment rate.
A: The oil embargo would be an example of a negative supply shock. This decreases real GDP (which means that output decreased), increases unemployment, and increases the aggregate price level (resulting in inflation). Graphically, the short run supply curve will shift to the left, meaning that less output will be produced at every price level.(13 votes)
I'm having trouble with the GDP Deflator question on the quiz. If the GDP Deflator increases, it means inflation is higher, SRAS moves left, prices go up, output goes down.
That, I believe, is the only answer provided which fits.
I keep reading the question and coming up with aggregate demand increases, decreasing unemployment and increasing inflation. I'm having trouble fully internalizing the SRAS explanation and don't entirely understand it.(4 votes)
I was having trouble with that question too, the correct answer was that short-run supply decreases because it is associated with increasing inflation, but the real gdp decreases because decreasing short run supply indicates reduced output(1 vote)
About the SRAS, the textbook which was written by Hubbard and O'Brien shows a different theory.(3 votes)- how come that when inflation is expected will cause -ve supply shock, while in the last session we agreed that when there is expected inflation suppliers will supply more to use sticky costs at this time like sticky wages(3 votes)
- The previous lesson didn't say anything about expectations about inflation. What sal said was when actual price level increases in short run (atleast 1 price is fixed ), producers will take advantage of that 1 sticky price, let's say price of labour and produce more, whereas in case of expectations, when producers will expect inflation in future, they will hesitate in renewing employee contracts to raise their wages and maybe lay off some workers to mitigate cost. They also might stockpile raw materials and inventories as future prices will increase, increasing the cost of inputs and prices of their own goods as well.All of this will reduce their supply in the short run.(1 vote)
Why will increase in the investment spending of firms increase AD instead of SRAS?(2 votes)
Because expenditure equals income, so the firms will pay money to other firms, which goes to wages or more spending by that firm, and so on. I suppose investment spending might increase LRAS because firms can produce more per worker. In other words, since expenditure equals income, that money goes to consumption and other uses. It might affect SRAS a little bit, but the main effect is that on AD.(2 votes)
- {For example, if firms expect they will have to pay higher wages in the future because of inflation, they start cutting back production today in anticipation of that inflation. As a result, the SRAS curve will decrease, even before any inflation has occurred. Expectations of inflation are, in effect, self-fulfilling prophecies!}，
how to explain this? there are 2 factors now (expect future and input cost would increase) it's a little bit puzzling.(2 votes)- lets take an example, I produce burgers and I have 10 employees. I expect the price level to go up in the future. For that I will have to renew the salaries of the employees as they will face higher prices (according to expectations), i also have to keep in mind that the cost of inputs like bread buns, cheese and ketchup may increase. Now lets say that my burger's prices are sticy, as it happens in the short run. But the overall wage rate in the market has increased (everyone expects the prices to go up) , my employees demand equalant wages, I will have to lay some of them off, in order to keep cost low. That will reduce production. Also, I will hoard some of my inputs due to expected higher cost of inputs in the future (remember that my prices are sticky, that will cause me to think that hey, maybe the prices of my burgers will not change in long run either and in order to continue production i have to hoard now). This will furthur reduce my production in short term.
Hope this helps(1 vote)