Starting from Equilibrium and Output Gaps, any event that shifts a curve moves the economy to a new short-run equilibrium. The direction of the change depends on which curve moved.
Key idea
A demand shock (AD shifts) moves the price level and real GDP in the same direction. A supply shock (SRAS shifts) moves them in opposite directions. A negative supply shock brings stagflation: a higher price level with falling output and rising unemployment.
Why it works
AD slopes down and SRAS slopes up. If AD shifts right, the economy slides up along SRAS: more output, higher prices. If SRAS shifts left, the economy slides up along AD: higher prices, but less output. So the pattern of the change tells you which kind of shock hit. In the 1970s, oil price jumps raised prices while output fell, a clear supply shock.
| Shock | Price level | Real GDP | Unemployment |
|---|---|---|---|
| AD right | up | up | down |
| AD left | down | down | up |
| SRAS left (negative supply shock) | up | down | up |
| SRAS right (positive supply shock) | down | up | down |
Worked examples
Worked example: Which way?
Starting at long-run equilibrium, a drought raises food and input costs. What happens in the short run?
- Higher input costs: SRAS shifts left.
- Along AD, the price level rises and real GDP falls: stagflation.
Answer: Price level up, real GDP down
Worked example: With equations
AD: $P = 180 - 5Y$ and SRAS: $P = 60 + 5Y$, so $Y = 12$, $P = 120$. Consumer confidence rises and AD becomes $P = 200 - 5Y$. Find the new equilibrium.
- $200 - 5Y = 60 + 5Y$, so $140 = 10Y$ and $Y = 14$.
- $P = 200 - 5(14) = 130$.
- Both rose: a demand shock moves them the same way.
Answer: $Y = 14$, $P = 130$
Common mistake
Expecting every shock to raise prices and output together, and missing stagflation, where a negative supply shock raises prices while output falls. Check: first ask which curve shifted. Demand: same direction. Supply: opposite directions.