An oil price spike shifts SRAS leftward. What happens to output and price level in the short run?
AOutput rises, price level falls
BOutput falls, price level rises
COutput falls, price level falls
DOutput rises, price level rises
An adverse supply shock raises production costs, shifting SRAS left. The new intersection of AD and SRAS is at lower real GDP and a higher price level — stagflation. This is distinct from a demand shock, which moves output and price level in the same direction.
Question 2 True / False
A positive demand shock (AD shifts right) permanently raises real GDP above its long-run potential level.
TTrue
FFalse
Answer: False
LRAS is vertical at potential output — it is determined by the productive capacity of the economy (labor, capital, technology), not by the price level. A demand shock raises output in the short run, but as wages and input prices adjust upward, SRAS shifts left until output returns to potential at a higher price level. Real GDP reverts; only the price level is permanently higher.
Question 3 Short Answer
After a negative demand shock, how does the economy self-correct without policy intervention, and what happens to the price level during this process?
Think about your answer, then reveal below.
Model answer: Below-potential output means unemployment rises and workers accept lower wages. Lower labor costs shift SRAS rightward over time. The economy moves back toward potential output, but at a lower price level than before the shock. Self-correction is slow — wages are sticky downward — which is why many economists argue for active stabilization policy.
The self-correction mechanism operates through the labor market: a recession creates slack, reducing wage pressure, which lowers firms' costs and induces more production. This takes time because nominal wages are slow to fall. Recognizing this dynamic is why the short-run vs. long-run distinction in the AS-AD model matters for policy.