Difficulty: Intermediate Prerequisites: Parts 1 and 2 of these notes (aggregate demand and aggregate supply curves, including the three theories of SRAS).
Source: Mankiw, Principles of Macroeconomics, 8th Edition, Chapter 20
Tags: AD-AS equilibrium, long-run equilibrium, short-run equilibrium, economic fluctuations, stagflation, demand shock, supply shock, Great Depression, Great Recession, oil shock, accommodating policy, fiscal policy, monetary policy, Keynesian economics
This is where the AD-AS model starts doing real work. Parts 1 and 2 built the curves; this section uses them to analyse what happens when the economy is hit by a shock, how it adjusts from short-run to long-run equilibrium, and what policymakers can (and cannot) do about it. The case studies (the Great Depression, the 1970s oil shocks, the 2008 recession) are recurring exam material and tie the theory to events you can remember. If you can walk through the four-step analysis for any given shock, you are well-prepared for this chapter.
In long-run equilibrium, the expected price level equals the actual price level, and output equals the natural rate. When AD or SRAS shifts, the economy moves to a new short-run equilibrium where output and the price level have changed. Over time, expectations adjust and the economy returns to the natural rate at a different price level. Policymakers face a trade-off: they can speed up the return to natural output or accept a different price-level outcome.
Long-run equilibrium
The state in which the expected price level equals the actual price level (P_E = P), output equals the natural rate (Y = Y_N), and unemployment is at its natural rate. All three curves (AD, SRAS, LRAS) intersect at the same point.
Short-run equilibrium
The intersection of AD and SRAS, where the quantity of goods demanded equals the quantity supplied in the short run. Output may be above or below the natural rate.
Stagflation
A period of falling output and rising prices occurring simultaneously. In simple terms, the economy gets worse in both directions at once: less output, higher prices. This happens when SRAS shifts to the left (e.g. from an oil price shock).
Demand shock
An event that shifts the aggregate demand curve. A negative demand shock (AD shifts left) causes lower output and a lower price level in the short run. A positive demand shock (AD shifts right) causes higher output and a higher price level.
Supply shock (cost-push shock)
An event that shifts the short-run aggregate supply curve. A negative supply shock (SRAS shifts left) raises the price level and lowers output, producing stagflation. A positive supply shock (SRAS shifts right) lowers the price level and raises output.
Accommodating policy
A policy response in which policymakers shift AD to offset the output effects of a supply shock. This restores output to the natural rate more quickly but accepts a permanently higher price level.
In long-run equilibrium, three conditions hold simultaneously:
P_E = P (expectations are correct)
Y = Y_N (output is at the natural rate)
Unemployment is at its natural rate
Graphically, AD, SRAS, and LRAS all intersect at one point.
This is the method the textbook uses for every scenario, and it is the structure you should follow on exam questions:
Step 1: Determine whether the event shifts AD or AS.
Step 2: Determine whether the curve shifts left or right.
Step 3: Use the AD-AS diagram to identify the new short-run equilibrium. Note what happens to P and Y.
Step 4: Use the AD-AS diagram to trace the transition from the new short-run equilibrium to the new long-run equilibrium.
Step 1: A stock market crash reduces household wealth, which affects consumption (C). This is an AD shift.
Step 2: C falls, so AD shifts left (from AD₁ to AD₂).
Step 3: Short-run equilibrium moves from point A to point B. Both P and Y fall. Unemployment rises. This is a recession.
Step 4: Over time, the lower output causes wages and prices to fall (P_E falls), which shifts SRAS to the right (from SRAS₁ to SRAS₂). The economy moves to point C: output returns to Y_N, but the price level is permanently lower than at point A.
Step 1: A boom in Canada increases demand for U.S. exports, which affects NX. This is an AD shift.
Step 2: NX rises, so AD shifts right.
Step 3: Short-run equilibrium: both P and Y rise. Unemployment falls below the natural rate.
Step 4: Over time, P_E rises (workers and firms expect higher prices), SRAS shifts left, output returns to Y_N, and the price level is permanently higher.
Step 1: An oil price increase raises production costs. This is an SRAS shift.
Step 2: Higher costs mean SRAS shifts left (from SRAS₁ to SRAS₂).
Step 3: Short-run equilibrium moves from A to B. P rises and Y falls. Unemployment rises. This is stagflation.
Step 4 (No policy response): Low employment eventually causes wages to fall, SRAS shifts back to the right, and the economy returns to the original equilibrium at point A.
Step 4 (Accommodating policy): Policymakers increase AD (using fiscal or monetary policy) to shift AD right. This brings Y back to Y_N more quickly, but the price level ends up permanently higher (point C rather than point A).
If policymakers do nothing: the economy eventually self-corrects, but the adjustment can be slow and painful (prolonged unemployment).
If policymakers accommodate: output recovers faster, but they accept permanently higher prices (inflation becomes embedded).
There is no costless option. This trade-off is central to macroeconomic policy debates.
1973-75: Real oil prices rose 138%. CPI rose 21%. Real GDP fell 0.7%. Unemployment rose by 3.5 million.
1978-80: Real oil prices rose 99%. CPI rose 26%. Real GDP rose 2.9% (the second shock was partly accommodated). Unemployment rose by 1.4 million.
Both episodes produced stagflation, which the AD-AS model explains as a leftward shift of SRAS.
A massive negative AD shock: money supply fell 28% due to banking failures, stock prices fell 90%.
Both C and I collapsed.
Real GDP fell 27%. The price level fell 22%. Unemployment rose from 3% to 25%.
This is the textbook example of a large leftward shift in AD.
A massive positive AD shock: government spending (G) rose from $9.1 billion to $91.3 billion.
Real GDP rose 90%. The price level rose 20%. Unemployment fell from 17% to 1%.
This is the textbook example of a large rightward shift in AD driven by government spending.
Background: House prices rose sharply from 2002 to 2006, fuelled by low interest rates, easier credit for sub-prime borrowers, government policies promoting homeownership, and securitisation of mortgages.
The crash: House prices peaked around 2006 and then fell sharply. Millions of homeowners went "underwater" (owed more than their homes were worth). Mortgage defaults and foreclosures surged. Mortgage-backed securities became "toxic," causing heavy losses for banks and financial institutions.
The macro effects: Real GDP fell 4.2% from Q4 2007 to Q2 2009. Unemployment rose from 4.4% to 10.0%. This was a large contractionary shift in AD, driven by falling C (wealth destruction) and falling I (credit freeze).
The policy response:
The Federal Reserve cut the Fed Funds rate to near zero.
The Fed purchased mortgage-backed securities and other private loans (quantitative easing).
The U.S. Treasury injected capital into banks to prevent a credit crunch.
Fiscal policymakers increased government spending and cut taxes by roughly $800 billion (the stimulus package).
Keynes argued in The General Theory (1936) that recessions can result from inadequate aggregate demand and that policymakers should actively shift AD.
His famous critique of classical theory: "In the long run, we are all dead." The point being that waiting for the economy to self-correct may take too long and cause too much hardship.
Keynesian economics underpins the argument for fiscal and monetary stimulus during recessions.
Four-step analysis template (for any shock):
Which curve shifts? (AD or SRAS)
Which direction? (left or right)
New short-run equilibrium: what happens to P and Y?
Transition to long-run equilibrium: how does P_E adjust, and what is the final outcome?
Stagflation in the AD-AS diagram: SRAS shifts left while AD stays put. The economy moves up and to the left along AD: higher P, lower Y.
Accommodation in the AD-AS diagram: After SRAS shifts left, policymakers shift AD right. The economy ends up at Y_N but with a higher price level than before the shock.
The 2008 Great Recession is a vivid example of how a collapse in one market (housing) can cascade through the financial system and produce a large contractionary shift in AD. The policy response (rate cuts, quantitative easing, fiscal stimulus) is a direct application of the accommodating-policy logic from this chapter. The 1970s oil shocks illustrate the stagflation dilemma that supply shocks create for policymakers: there is no way to fix both the output problem and the inflation problem at the same time.
Students often think the economy cannot have rising prices and falling output at the same time. It can, and it is called stagflation. It results from a negative supply shock (SRAS shifts left), not a demand shock.
Students sometimes believe that the economy stays permanently at a short-run equilibrium after a shock. It does not. Over time, P_E adjusts, SRAS shifts, and the economy returns to Y_N. The self-correction may be slow, but it does happen.
Students confuse the direction of the SRAS shift during the adjustment process. After a negative AD shock (recession), P_E eventually falls, which shifts SRAS to the right (not left), helping the economy recover.
Students forget that accommodating a supply shock eliminates the output loss but locks in a higher price level. There is a trade-off, not a free fix.
⚠️ The four-step analysis is almost guaranteed to appear on the exam. Practise it with multiple scenarios until you can do it quickly and accurately.
⚠️ Be able to explain stagflation using the AD-AS model: which curve shifts, in which direction, and why both P rises and Y falls.
⚠️ Know the key facts from each case study: the Great Depression (money supply fell 28%, GDP fell 27%), the WWII boom (G surged, GDP rose 90%), and the Great Recession (housing crash, GDP fell 4.2%, unemployment hit 10%).
⚠️ Understand the trade-off policymakers face when responding to a supply shock: accommodate (faster recovery, higher prices) or do nothing (slower recovery, prices eventually return).
⚠️ Keynes's "In the long run, we are all dead" quotation comes up frequently. Know the argument it supports: waiting for self-correction is costly, so active policy is justified.
True or False: In long-run equilibrium, P_E = P and Y = Y_N.
Fill in the blank: A period of falling output and rising prices at the same time is called ________.
True or False: After a negative AD shock, the economy self-corrects because P_E eventually rises, shifting SRAS left.
Fill in the blank: If policymakers accommodate a negative supply shock, output returns to Y_N but the price level is permanently ________.
True or False: During the Great Recession, the Federal Reserve raised interest rates to combat inflation.
Answers: 1. True. 2. Stagflation. 3. False (P_E eventually falls, shifting SRAS right). 4. Higher. 5. False (the Fed cut rates to near zero).
Q: Using the four-step method, analyse the short-run and long-run effects of a stock market crash.
A: Step 1: A stock market crash reduces household wealth, affecting C, so it shifts the AD curve. Step 2: C falls, so AD shifts left. Step 3: In the new short-run equilibrium, both P and Y are lower, and unemployment is higher. Step 4: Over time, the lower price level causes P_E to fall, which shifts SRAS to the right. The economy returns to the natural rate of output at a lower price level.
Q: Explain why an oil price increase can cause stagflation.
A: An oil price increase raises firms' production costs, shifting SRAS to the left. At the new short-run equilibrium, the price level is higher (because supply has contracted) and output is lower (because production is more expensive). This combination of rising prices and falling output is stagflation.
Q: What are the two options policymakers face after a negative supply shock, and what is the trade-off?
A: Option 1: Do nothing and let the economy self-correct. Low output and high unemployment eventually push wages and costs down, shifting SRAS back to the right. Output returns to Y_N at the original price level, but the adjustment is slow and painful. Option 2: Accommodate the shock by using fiscal or monetary policy to shift AD to the right. Output returns to Y_N more quickly, but the price level ends up permanently higher. The trade-off is speed of recovery vs. permanently higher inflation.
Q: What caused the Great Recession of 2008-2009, and how did policymakers respond?
A: The Great Recession was triggered by a collapse in the U.S. housing market. House prices had risen sharply due to low interest rates, sub-prime lending, and mortgage securitisation. When prices fell, millions of homeowners went underwater, mortgage-backed securities lost value, and banks suffered heavy losses. The result was a large contractionary shift in AD: C fell (wealth destruction) and I fell (credit freeze). Policymakers responded by cutting the Fed Funds rate to near zero, purchasing mortgage-backed securities, injecting capital into banks, and increasing government spending while cutting taxes by about $800 billion.
Q: What does Keynes's quote "In the long run, we are all dead" mean in the context of the AD-AS model?
A: Keynes was criticising classical economists who argued the economy would self-correct in the long run and therefore no policy intervention was needed. His point was that the self-correction process can take years, during which real people suffer from unemployment and lost income. Waiting for SRAS to shift on its own may be theoretically sound but practically inadequate, so active fiscal and monetary policy to shift AD is justified.
This material connects directly to fiscal policy (Chapter 21) and monetary policy (Chapter 22), which are the tools policymakers use to shift AD. The discussion of stagflation links to the Phillips curve (Chapter 22), which formalises the short-run trade-off between inflation and unemployment. The Great Recession case study connects to banking and the financial system (Chapter 18), since the crisis originated in the housing and mortgage markets. Keynes's ideas set the stage for the multiplier effect and the debate over government intervention that runs through the rest of the macroeconomics course.
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