Distinguish demand and supply shocks on a graph

Distinguish demand and supply shocks on a graph

Question and evidence

Can falling output come with either rising or falling prices?

A fictional short-run economy has aggregate demand P=200−Y and short-run aggregate supply P=40+Y, where P is a price index and Y is an output index. Initial potential output is 80. These are illustrative lines, not estimated national equations.

This packet uses fictional data to isolate a mechanism. It is not an empirical estimate.

Mechanism and worked example

Aggregate demand and supply compare the overall price level with real output. A demand contraction can lower both short-run output and prices; an adverse supply shock can lower output while raising prices. Potential output is a separate benchmark. Long-run adjustment, expectations and policy can alter subsequent paths.

Initially 200−Y=40+Y gives Y=80, P=120. Case D gives Y=70, P=110. Case S gives Y=70, P=130. Equal output declines have opposite price changes.

Complication

Case D reduces demand to P=180−Y. Case S instead raises supply costs to P=60+Y. A headline says every fall in output causes falling prices; it ignores which curve shifted.

Your investigation

Plot both shock cases on separate axes with identical scales. Mark potential output and explain the curve shift before describing the result.

Revise your answer to “Can falling output come with either rising or falling prices?” using both source IDs. Separate the checked calculation from a judgment, and identify evidence that could reverse your judgment.

Vocabulary

Stagflation: A combination of weak economic activity and rising prices; mechanisms require separate analysis.

Assumption: A condition accepted for a model or argument; it needs justification before applying the result elsewhere.

Independent extension

Independently extend the investigation “Distinguish demand and supply shocks on a graph” with a documented real dataset or scholarly source. Preserve definitions, recreate one calculation or evidence table, compare a rival explanation and report why the teaching example cannot establish the real-world conclusion.

Inspect the worked graph

Lines follow the specified linear teaching equations. Axes start at zero. The table identifies every series without relying on color.

Series	Output index Y	Price index P
Initial demand	0	200
Initial demand	80	120
Initial demand	100	100
Initial supply	0	40
Initial supply	80	120
Initial supply	100	140
Demand contraction	0	180
Demand contraction	70	110
Demand contraction	100	80
Supply cost shock	0	60
Supply cost shock	70	130
Supply cost shock	100	160

Explain the curves before manipulating them

Aggregate demand concerns planned domestic output purchases by households, businesses, government and foreign customers, net of imports. In a separate fixed-price ledger, C=60, I=20, G=25 and net exports=−5 sum to 100. If autonomous investment rises five with other entries held fixed, planned spending at that price becomes 105. That changes the schedule. A change in the economy-wide price level with the underlying determinants held fixed instead moves along a schedule. This ledger is not an estimate of the workbench’s intercept change or a final multiplier outcome.

Three conditional channels help explain downward-sloping AD:

• Real purchasing power: a fixed nominal balance of 120 buys twelve baskets at price ten but ten baskets at price twelve. Lower real balances can reduce consumption. Household debt, wealth distribution and responses matter; not every person’s consumption moves identically.
• Interest rates: with a fixed nominal money supply, higher prices raise money needed for transactions relative to available balances. In the textbook money-market account, higher interest rates reduce interest-sensitive spending. A different monetary-policy response can alter this channel.
• Exchange rates: higher domestic interest rates can attract financial inflows and appreciate the currency, reducing net exports under the stated exchange-rate and demand assumptions. Foreign conditions, risk and policy are held fixed in this account.

These are economy-wide conditional chains. Replacing one now-expensive product with another is not, by itself, an explanation of aggregate demand for all domestic output. For each channel, name an assumption that could fail before applying it to an observed episode.

Why nominal contracts matter for short-run supply

A separate producer pays a fixed nominal wage of eight credits for the labor required per unit, with no other cost in this illustration. Its output price rises from ten to twelve while that wage is unchanged. Calculate the wage in units of output and the margin per unit before claiming that production incentives changed. A production response still requires available inputs and a technology; the price arithmetic alone does not specify a quantity.

Check the fixed-wage mechanism

The real wage falls from 8/10=0.8 to 8/12≈0.667 units of output per labor unit. Nominal margin rises from two to four credits. This illustrates why a higher output price with some input prices sticky can encourage greater supply. If the wage also rises proportionally to 9.6, its real value is again 0.8. The real margin per unit returns to 0.2, even though the nominal margin is 2.4. Nominal and real comparisons answer different questions.

The short run names the period in which relevant contracts or prices have not fully adjusted; it is not a fixed number of months. An input-price or expected-wage change shifts SRAS; a change in output price with the contract fixed is a movement along it. The aggregate straight line below is a teaching assumption, not a derivation from this single producer.

Follow a shock, then test the adjustment assumption

Original fictional index model. AD is P = a − Y; SRAS is P = b + Y. P is the price-level index, Y the real-output index, a the demand intercept and b the supply intercept. Potential output is a separate stipulated benchmark. Predict the changed curve and gap before selecting a stage.

Aggregate scenarioDemand contractionDemand expansionTemporary input-cost increaseTemporary input-cost decreaseLasting productivity improvement Stage to inspectInitial equilibriumAfter shockConditional long run

Households reduce autonomous consumption at each price level; other demand components and productive capacity stay fixed.

Solid line: AD. Dashed line: SRAS. Dotted vertical line: LRAS at the selected stage's potential output. Filled circle: selected equilibrium. Outlined square: original equilibrium; they overlap initially. All equations and points have equivalent values below.

Selected equations: P = 180 − Y and P = 40 + Y. Equating them gives Y = (180 − 40) ÷ 2 = 70; substituting gives P = 110.

Compare stages of the same scenario, not a forecast timetable

Stage	Output	Price level	Potential	Output gap	Gap / potential
Initial	80	120	80	0	0.00%
After shock	70	110	80	-10	-12.50%
Conditional long run	80	100	80	0	0.00%

After shock: output 70, price level 110, gap -10 index points. Output is below potential.

Conditional long run holds the selected AD and productive capacity fixed. For demand shocks, wage/price adjustment moves SRAS toward the stipulated full-employment intersection. Temporary cost shocks are assumed to unwind. The productivity case retains its new capacity. These are different mechanisms, not a universal automatic recovery rule; no adjustment speed, hardship or policy response is estimated.

Potential is sustainable output, not an absolute physical ceiling. Under fixed labor-force and productivity assumptions, greater short-run output generally requires more employment; the graph does not calculate an unemployment rate. A changed price-level index is not by itself a continuing inflation rate.

Restore aggregate comparison

Save the changed curve, stage values and assumptions in the source notebook. Controls are temporary and reset on reload. The model supplies practice evidence, not a policy forecast or mastery score.

Compare the adjustment paths

For each demand shock, record the initial, shocked and conditional long-run intersections. Explain why SRAS moves in a different direction after a positive versus negative output gap. Keep AD fixed during the adjustment stage. Then compare the temporary cost decrease with the lasting productivity improvement: they initially have the same output and price, but different potential-output benchmarks.

Check demand adjustment and lasting capacity

After demand contraction, output 70 and price 110 leave a gap of −10 relative to potential 80. Under the specified adjustment, SRAS becomes P=20+Y; unchanged AD P=180−Y meets it at output 80 and price 100. After demand expansion, output 90 and price 130 leave a +10 gap. Conditional wage/cost adjustment raises SRAS to P=60+Y; AD P=220−Y meets it at output 80 and price 140.

The temporary cost decrease initially produces output 90 and price 110 with potential still 80; the specified unwind returns it to 80/120. The lasting productivity improvement gives output 90 and price 110 with potential now 90, and retains that new equilibrium. A higher sustainable capacity corresponds to an outward production-frontier shift; producing temporarily above unchanged potential is a different claim.

These conclusions assume the supplied adjustments and no further shocks or policy. Persistent damage, wage rigidities, changed expectations or hysteresis could invalidate a return to the old benchmark. The workbench does not measure those effects.

Transfer: a new gap and a misleading inflation claim

An unfamiliar economy has AD P=240−Y, SRAS P=60+Y and potential output 100. Solve the short-run equilibrium and its signed gap. Holding AD and potential fixed, find the SRAS intercept required for the conditional full-employment equilibrium. Draw both stages and explain the direction of the required cost adjustment.

Separately, a price index is 120 in one year, 132 in the next and remains 132 in the third. Calculate each annual inflation rate and critique “the index remains high, so inflation is still ten percent.”

Check the unfamiliar adjustment and price sequence

Short-run output is (240−60)/2=90 and price is 150, leaving a gap of −10, or −10% of potential. At output 100, unchanged AD requires price 140. SRAS therefore needs intercept 40: P=40+Y. The lower intercept represents the assumed cost adjustment; the graph alone does not establish that this adjustment will occur.

The price index rises 10% from 120 to 132, then 0% from 132 to 132. A high price level can persist with zero inflation. Neither these two growth rates nor the workbench’s index levels identify an inflation cause without further evidence.

Keep your independently drawn stages, gap calculations and explanation of assumptions in the notebook. Guided feedback supports practice; a reviewer must still assess an unfamiliar graph and causal explanation. Introductory-college work should additionally compare a documented episode with the model’s assumptions and distinguish identification from a visual resemblance.