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In the short run with sticky prices, output is demand-determined: firms set prices and supply whatever quantity customers demand. Quantity adjustments absorb demand shocks; price changes lag far behind.
Draw AS-AD diagram with vertical short-run AS (sticky prices) and upward-sloping medium-run AS. Show positive demand shock raises output and price level. Explain firms can't adjust instantly due to menu costs.
From the AS-AD model, you have the framework: aggregate demand (AD) slopes downward because higher price levels reduce real money balances and thus spending, while the aggregate supply (AS) curve describes how firms respond to changes in the overall price level. From nominal rigidities and sticky prices, you understand why firms do not instantly reprice: menu costs, long-term contracts, customer relationships, and the coordination problem all make rapid price adjustment costly or impractical. Short-run sticky-price equilibrium puts these together into a coherent model of how the economy absorbs demand shocks in the short run.
The key claim is that when prices are sticky, output is demand-determined: firms are on their supply curve only in the long run. In the short run, they commit to a price (often set in advance) and then meet whatever demand arrives at that price. Think of a restaurant with a printed menu: when lunch demand unexpectedly surges, the restaurant does not raise its prices mid-service — it runs out of some items, seats more customers, and serves more meals. Output adjusts; the price remains fixed. This is quantity adjustment rather than price adjustment, and it is the defining feature of short-run equilibrium with sticky prices.
In the AS-AD diagram, this corresponds to a flat short-run AS curve (or nearly flat): at the prevailing price level, firms supply whatever quantity is demanded. When aggregate demand shifts rightward — say, because government spending increases or consumer confidence improves — the new equilibrium moves along the flat SRAS curve: output rises, but the price level barely moves. This is precisely why fiscal and monetary policy can affect real output in the short run but not the long run. In the long run, prices eventually adjust to reflect the new demand level, the economy returns to its potential output, and the only lasting effect is a higher price level. The short run is the window during which that adjustment has not yet occurred.
The "short run" here is not a calendar period — it is the window during which prices remain predetermined. For some prices (airline seats, financial assets, commodity spot prices), the adjustment is nearly instantaneous and the short run is measured in minutes. For others (wage contracts, lease agreements, administered prices in utilities), the short run can be a year or more. What makes the economy as a whole exhibit short-run stickiness is that enough prices — particularly wages, which are the largest cost for most firms — adjust slowly. When wages are sticky, firms cannot easily cut costs in response to falling demand, so they reduce output and employment instead. This is why demand contractions cause recessions: firms cannot quickly lower wages to maintain production at lower prices, so they lay off workers instead, propagating the demand shortfall through the economy.