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AP® Macroeconomics · Unit 3 · Topic 3.6

Changes in the AD–AS Model in the Short Run: Study Guide (Macroeconomics 3.6)

Learn how demand shocks and supply shocks shift the AD and SRAS curves, what happens to output, employment and the price level in the short run, and how demand-pull and cost-push inflation differ.

What a shock is

In Topic 3.5 the economy sat in equilibrium where AD crossed SRAS. Now something changes. A shock is an event that shifts the AD curve or the SRAS curve.

  • A positive shock shifts a curve to the right (an increase in AD or in SRAS).
  • A negative shock shifts a curve to the left (a decrease in AD or in SRAS).

This topic is about the short run: nominal wages and some other input prices are still sticky, and the LRAS curve does not move. You compare the old equilibrium (E₁) with the new one (E₂) and say what happened to three things: the price level, real output and employment (and so unemployment).

One rule makes every question easier. Identify which curve shifts and in which direction before you draw anything. A change in spending by households, firms, the government or foreigners shifts AD (Topic 3.1). A change in production costs shifts SRAS (Topic 3.3).

Demand shocks: shifts of AD

When AD increases, buyers want more real output at every price level. At the old price level there is now a shortage: inventories run down, so firms raise prices. As the price level rises, sticky wages make it profitable to produce more, so firms move up the SRAS curve, hire more workers and raise output.

A positive AD shock raises the price level, real output and employment in the short run. Unemployment falls.

A negative AD shock works the other way. At the old price level there is a surplus, so the price level falls; firms move down SRAS, produce less and lay off workers.

A negative AD shock lowers the price level, real output and employment in the short run. Unemployment rises.

Inflation caused by an increase in AD is called demand-pull inflation: spending “pulls” the price level up.

Our fictional economy: Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). The starting point is the long-run equilibrium from Topic 3.5: price level 104, real GDP VD 840 billion = Yf, unemployment 5.0% (the natural rate) with a labour force of 25.0 million. All data are fictional.

Price level (index) 96 100 104 108 112
AD₁ (VD billion) 880 860 840 820 800
SRAS₁ (VD billion) 760 800 840 880 920

As before, assume every VD 40 billion of real output needs 0.25 million workers, so each VD 40 billion change in output moves the unemployment rate by 1.0 percentage point.

Worked example 1: a positive demand shock

Question. Valdorian firms become more optimistic and raise planned investment by VD 15 billion at every price level. The marginal propensity to consume (MPC) is 0.75. (a) By how much does AD shift? (b) Find the new short-run equilibrium. (c) Calculate the inflation rate and the changes in real output, employment and the unemployment rate. (d) Why does real output rise by less than the shift in AD? (e) Name the type of inflation and the output gap.

(a) Spending multiplier = 1 ÷ (1 − MPC) = 1 ÷ 0.25 = 4. AD shifts right by 4 × 15 = VD 60 billion at every price level (Topic 3.2).

Price level 96 100 104 108 112
AD₂ (VD billion) 940 920 900 880 860
SRAS₁ (VD billion) 760 800 840 880 920

(b) AD₂ = SRAS₁ = VD 880 billion at a price level of 108. E₂ is at PL₂ = 108, Y₂ = VD 880 billion.

(c) Inflation rate = (108 − 104) ÷ 104 × 100 = 3.85%. Real output rises by 880 − 840 = VD 40 billion (40 ÷ 840 × 100 = 4.76%). Employment rises by 0.25 million, from 23.75 to 24.00 million, so the unemployment rate falls from 5.0% to 4.0%.

(d) At the old price level (104), buyers now want VD 900 billion, a shortage of 900 − 840 = VD 60 billion. But the shortage pushes the price level up, and a higher price level reduces the quantity of real output demanded along AD₂ (through the wealth, interest-rate and exchange-rate effects from Topic 3.1). From 104 to 108, the quantity demanded on AD₂ falls from VD 900 billion to VD 880 billion. So output rises by VD 40 billion, not the full VD 60 billion. The rest of the extra spending is absorbed by higher prices.

(e) Demand-pull inflation. Output (VD 880 billion) is now above Yf (VD 840 billion): a positive (inflationary) output gap of VD 40 billion.

Check. The price level, output and employment all rose together. That is the signature of an AD shock.

A positive demand shock in Valdoria: AD shifts right A graph with real GDP in billions of valdas on the horizontal axis, from 740 to 1000, and the price level on the vertical axis, from 92 to 116. LRAS is vertical at 840, marked Yf. SRAS1 slopes upward. AD1 slopes downward and crosses SRAS1 and LRAS at E1, price level 104 and real GDP 840. AD2 is parallel to AD1 and 60 billion to its right, shown by a horizontal arrow labelled shift of 60. AD2 crosses SRAS1 at E2, price level 108 and real GDP 880, to the right of LRAS. 9296100104108112 740800880920960 Yf = 840 Real GDP (VD billion) Price level (index) LRAS SRAS₁ AD₁ AD₂ shift = 60 E₁ E₂
Figure 1. Positive demand shock (fictional data). Both axes start above zero. AD shifts right by VD 60 billion (dashed AD₂). The economy moves from E₁ (circle: PL 104, VD 840 billion) to E₂ (square: PL 108, VD 880 billion). Output rises by only VD 40 billion because the higher price level reduces the quantity demanded along AD₂.

Supply shocks: shifts of SRAS

A supply shock changes production costs across the economy, so it shifts SRAS (Topic 3.3).

A negative supply shock (higher energy or raw-material prices, a drought, a rise in nominal wages, higher expected inflation) makes each level of output more expensive to produce. SRAS shifts left. At the old price level firms now supply less than buyers want, so the price level rises; buyers move up along AD and buy less. Firms produce less and need fewer workers.

A negative SRAS shock raises the price level but lowers real output and employment in the short run. Unemployment rises.

This combination, a rising price level with falling output and rising unemployment, is called stagflation. Inflation caused by a decrease in SRAS is cost-push inflation: higher costs “push” the price level up.

A positive supply shock (cheaper energy, a bumper harvest, higher productivity) shifts SRAS right.

A positive SRAS shock lowers the price level but raises real output and employment in the short run. Unemployment falls.

So for SRAS shocks, the price level and output move in opposite directions. For AD shocks they move in the same direction.

Worked example 2: a negative supply shock

Question. World energy prices rise sharply. Valdorian firms’ costs rise so that they supply VD 60 billion less at every price level. AD does not change. (a) Write the new SRAS schedule and find the new short-run equilibrium. (b) Calculate the inflation rate and the changes in real output, employment and unemployment. (c) Name the type of inflation and the output gap. (d) Compare the result with Worked example 1.

(a) Subtract 60 from each SRAS₁ value.

Price level 96 100 104 108 112
AD₁ (VD billion) 880 860 840 820 800
SRAS₂ (VD billion) 700 740 780 820 860

AD₁ = SRAS₂ = VD 820 billion at a price level of 108. E₂ is at PL₂ = 108, Y₂ = VD 820 billion.

(b) Inflation rate = (108 − 104) ÷ 104 × 100 = 3.85%. Real output falls by 840 − 820 = VD 20 billion (−2.38%). VD 20 billion of output is 0.125 million jobs, so employment falls from 23.75 to 23.625 million. Unemployed = 25.0 − 23.625 = 1.375 million, so the unemployment rate rises from 5.0% to 5.50%.

(c) Cost-push inflation, with stagflation: the price level rose while output fell and unemployment rose. Output is VD 20 billion below Yf: a negative (recessionary) output gap.

(d) Both shocks raised the price level from 104 to 108, so the inflation rate alone cannot tell you which shock happened. Output tells you: it rose to VD 880 billion after the AD shock but fell to VD 820 billion after the SRAS shock. Unemployment fell to 4.0% in one case and rose to 5.50% in the other.

Check. At the old price level (104), SRAS₂ gives only VD 780 billion while AD₁ is still VD 840 billion: a shortage of VD 60 billion, which is why the price level has to rise.

A negative supply shock in Valdoria: SRAS shifts left A graph with real GDP in billions of valdas on the horizontal axis, from 740 to 1000, and the price level on the vertical axis, from 92 to 116. LRAS is vertical at 840, marked Yf. AD1 slopes downward. SRAS1 crosses AD1 and LRAS at E1, price level 104 and real GDP 840. SRAS2 is parallel to SRAS1 and 60 billion to its left, shown by a horizontal arrow pointing left labelled shift of 60. SRAS2 crosses AD1 at E2, price level 108 and real GDP 820, to the left of LRAS. 9296100104108112 740800880920960 Yf = 840 820 Real GDP (VD billion) Price level (index) LRAS SRAS₁ SRAS₂ AD₁ shift = 60 E₁ E₂
Figure 2. Negative supply shock (fictional data). Both axes start above zero. SRAS shifts left by VD 60 billion (dashed SRAS₂). The economy moves from E₁ (circle: PL 104, VD 840 billion) to E₂ (square: PL 108, VD 820 billion): a higher price level with lower output, which is stagflation.

All four shocks from the same starting point

Starting from Valdoria’s long-run equilibrium (PL 104, VD 840 billion, 5.0% unemployment), here is each shock with a shift of VD 60 billion.

Shock Example cause New PL New real GDP (VD billion) Unemployment Output gap
AD increases More business optimism, higher government spending 108 ↑ 880 ↑ 4.0% ↓ Positive
AD decreases Falling consumer confidence, a recession abroad cutting exports 100 ↓ 800 ↓ 6.0% ↑ Negative
SRAS decreases Higher energy prices, higher expected inflation 108 ↑ 820 ↓ 5.50% ↑ Negative
SRAS increases Cheaper raw materials, higher productivity 100 ↓ 860 ↑ 4.50% ↓ Positive

The pattern to remember:

  • Same direction for the price level and output → an AD shock.
  • Opposite directions → an SRAS shock.
  • Demand-pull inflation comes from AD shifting right; cost-push inflation comes from SRAS shifting left.

Common misconceptions

  • “A rise in the price level shifts SRAS right” (or “shifts AD left”). A price-level change is a movement along the curves. Only the determinants shift them.
  • “Higher energy prices shift AD left, because people spend less.” Energy is an input for almost every firm, so the main effect is on costs: SRAS shifts left.
  • “All inflation is demand-pull.” Inflation can also come from rising costs (cost-push). Check whether output rose or fell.
  • “After an AD shock, output rises by the full shift.” With an upward-sloping SRAS, part of the shift shows up as a higher price level, so output rises by less than the horizontal shift.
  • “A negative supply shock lowers the price level, because output falls.” It raises the price level while output falls: stagflation.
  • “Unemployment and the price level always move in opposite directions.” True for AD shocks, but not for SRAS shocks: after a negative SRAS shock both rise together, and after a positive one both fall.
  • Shifting LRAS for a temporary cost shock. A short-lived rise in input prices shifts SRAS only.
  • Showing only the final position. Graphs need both curves (old and new), both equilibria and the new price level and output labelled.

Where this leads

Topic 3.7 asks what happens next if no policy is used: flexible wages and prices move the economy back to full-employment output in the long run. Continue with the long-run self-adjustment study guide. Topic 3.8 then shows how fiscal policy can shift AD to close a gap, and Topic 3.9 how automatic stabilizers soften the effect of shocks. If equilibrium and output gaps are not yet secure, go back to Topic 3.5.

Now try the practice questions, then use the revision notes and the checklist to consolidate.

Quick questions

Does a change in the price level shift AD or SRAS?

No. A change in the price level is a movement along both curves. Only a change in one of the determinants, such as consumer confidence or input prices, shifts a curve.

Does LRAS shift in this topic?

Not for the short-run shocks here. A temporary change in spending or in input prices does not change the economy's resources or technology, so LRAS stays where it is. Shifts of LRAS come in Topic 3.7 and Unit 5.

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