Macroeconomic equilibrium, output gaps, demand-pull and cost-push inflation and supply-side growth, with AD and AS together.
As lockdowns ended in 2021, spending rebounded, helped by savings built up in lockdown. But supply could not keep up: there were shortages of shipping containers, computer chips and lorry drivers, and petrol stations ran dry for a time in the autumn. Prices began to rise quickly, and in 2022 the energy shock added to them.
To see what happens to prices and output, we need demand and supply together.
Macroeconomic equilibrium is where aggregate demand equals aggregate supply: it sets the price level and the level of real GDP.
An output gap is the difference between actual GDP and potential GDP (productive capacity, LRAS). A positive gap means the economy is producing above its sustainable capacity; a negative gap means spare capacity and unemployment.
Demand-pull inflation comes from AD rising faster than supply. Cost-push inflation comes from rising costs shifting SRAS left. Ceteris paribus: one curve moves at a time.
Households suddenly spend much more, but firms are already near full capacity.
What is most likely to happen?
When firms cannot easily produce more, extra spending mainly pushes up prices: demand-pull inflation. In 2021, as lockdowns ended, spending bounced back faster than supply chains could cope, and prices started rising quickly.
The economy settles where AD1 meets SRAS1: price level P1 and real GDP Y1. Here it is also on LRAS: producing at capacity, with no output gap.
AD rises to AD2. Firms respond by producing more, so real GDP rises to Y2, and the extra demand pulls up the price level to P2: demand-pull inflation. Y2 is beyond LRAS: a positive output gap, which cannot last, as workers and resources are stretched.
Check: AD increases to AD2. What happens to the price level and real GDP?
At the old price level there is excess demand, so prices rise and firms produce more along SRAS.
Now a supply shock instead. Costs rise and SRAS shifts left to SRAS2. The price level rises, but real GDP falls: cost-push inflation with falling output. Rising prices and stagnating output together is called stagflation, as in 2022.
The best outcome comes from the supply side. If productive capacity grows, LRAS and SRAS shift right: real GDP rises and the price level falls. That is why governments care so much about productivity.
Check: Which change gives higher real GDP with a lower price level?
More supply at every price level: output up, prices down.
The AD/AS model is the toolkit for every macro question: shift the right curve, find the new equilibrium, then explain the chain.
When AD rises, the price level and real GDP both rise: firms extend output along SRAS. Higher prices with lower output comes from a fall in SRAS, not a rise in AD.
Using an AD/AS diagram, explain the difference between demand-pull and cost-push inflation.
Demand-pull inflation is caused by aggregate demand rising faster than aggregate supply. For example, if households spend savings built up during lockdowns, AD shifts right from AD1 to AD2. At the original price level there is excess demand, so the price level rises and firms extend output along SRAS: both the price level and real GDP rise.
[Diagram 1: AD1 and AD2 with SRAS; equilibrium moves up and to the right.]
Cost-push inflation is caused by rising costs of production. For example, a sharp rise in energy prices shifts SRAS left from SRAS1 to SRAS2. The price level rises, but real GDP falls, because firms produce less at every price level.
[Diagram 2: SRAS1 and SRAS2 with AD; equilibrium moves up and to the left.]
The key difference is the effect on output: demand-pull raises prices and output together, while cost-push raises prices and lowers output, which makes it harder for policy to fix without deepening the fall in output.
Supply shortages in 2021: widely reported in the UK. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed. Your answers are saved only on this device.