Topic 3.6 Notes – Changes in the AD–AS Model in the Short Run

1. Short-Run Equilibrium in the AD-AS Model

Here’s the basic picture you need in your head. The graph below shows a leftward shift of short-run aggregate supply caused by higher health insurance premiums paid by firms.

Leftward shift of SRAS in the AD-AS model

Aggregate Demand (AD)

AD shows total spending in the economy:

$$AD = C + I + G + (X - M)$$

• C consumer spending
• I investment spending
• G government spending
• X − M net exports

It slopes downward because:

• Wealth effect higher prices reduce purchasing power
• Interest rate effect higher prices → higher interest rates → less investment
• Exchange rate effect higher prices → exports fall

Short-Run Aggregate Supply (SRAS)

SRAS slopes upward because input prices, especially wages, are sticky in the short run.

When the price level rises:

• Output prices rise
• Wages don’t adjust immediately
• Profits increase
• Firms produce more

Short-Run Equilibrium

On the graph, equilibrium occurs where AD intersects SRAS. In the initial equilibrium at SRAS₁, the economy produces Y₁ at price level P₁. When SRAS shifts left to SRAS₂, real GDP falls to Y₂ and the price level rises to P₂.

• Real GDP
• Price level
• Employment (because labor demand is derived from output)

If output rises, unemployment falls. If output falls, unemployment rises.

Now let’s see what happens when one of these curves shifts.

2. Aggregate Demand Shocks

Anything that changes C, I, G, or (X − M) shifts AD.

Positive AD Shock (AD →)

Examples:

• Tax cuts increase disposable income
• Government deficit spending (fiscal stimulus)
• Exports increase
• Strong consumer or business confidence

Historical anchors:

• 1960s expansionary fiscal policy → higher inflation
• COVID stimulus (2020-2021) → strong demand and rising prices

Short-run effects:

• Real GDP ↑
• Employment ↑ (unemployment ↓)
• Price level ↑

When output and price level rise together, that’s your clue it’s an AD shift.

Inflation from rising demand is demand-pull inflation.

Negative AD Shock (AD ←)

Examples:

• Tax increases
• Decrease in government spending
• Recession in trading partners (exports fall)
• Collapse in investment (like the 2008 financial crisis)

Short-run effects:

• Real GDP ↓
• Employment ↓ (unemployment ↑)
• Price level ↓

Output and price level fall together.

If a question says “consumer income decreases because taxes increase,” think:
Taxes ↑ → disposable income ↓ → C ↓ → AD shifts left.

3. Short-Run Aggregate Supply Shocks

SRAS shifts when production costs or productivity change.

Determinants:

• Resource prices (wages, oil)
• Productivity/technology
• Business taxes or subsidies
• Regulation

Negative Supply Shock (SRAS ←)

Definition: Unexpected rise in input costs or drop in productivity.

Examples:

• 1973 and 1979 OPEC oil embargoes
• Tariffs on imported inputs
• Natural disasters

Oil shocks raised energy costs across the economy, shifting SRAS left.

Short-run effects:

• Real GDP ↓
• Employment ↓
• Price level ↑

Higher inflation + higher unemployment = stagflation.
Inflation from higher production costs is cost-push inflation.

Key pattern:

• AD shock → output and price level move in the same direction
• SRAS shock → output and price level move in opposite directions

Positive Supply Shock (SRAS →)

Definition: Unexpected fall in costs or rise in productivity.

Examples:

• Internet and tech boom (1995-2000)
• Decrease in oil prices
• Corporate tax cuts lowering production costs

If corporate taxes fall:

• Production costs ↓
• SRAS shifts right

Short-run effects:

• Real GDP ↑
• Employment ↑
• Price level ↓

Growth with falling prices is the ideal scenario.

4. Demand-Pull vs Cost-Push Inflation

When both output and price level rise, think demand.
When price rises but output falls, think supply.

On tests, always say:

1. Which curve shifts
2. Which direction
3. What happens to real GDP, unemployment, and price level

That sequence earns points consistently.