Demand Shocks in the Short Run

Aggregate demand shifts whenever households, firms, or governments suddenly change how much they plan to spend, even though the economy's productive capacity hasn't changed at all. A wave of pessimism makes consumers save more and buy less; that drop in spending is the shock itself. Nothing physical happened to factories or workers, but the AD curve shifts left, and the economy slides down the short-run aggregate supply curve to a lower output and price level.

Trace a negative shock step by step. Autonomous spending falls, the AD curve shifts left, and the new intersection with short-run aggregate supply sits at lower real GDP and a lower price level. Lower output means firms need fewer workers, so unemployment rises above its natural rate. This combination, falling output and rising unemployment with only a mild dip in prices, is the signature of a recessionary gap. A positive shock at full employment runs the same logic in reverse: AD shifts right, pushing the economy past potential output into an inflationary gap, with unemployment below natural and prices rising faster, since prices are far more flexible upward than downward.

This is the short-run half of the story unit 3 builds toward. Left alone, these gaps are temporary: in the long run wages and expectations adjust, shifting short-run aggregate supply until the economy returns to potential output at a new price level. Fiscal policy enters here as a deliberate attempt to speed that return, pushing AD back toward potential rather than waiting on slow wage adjustment.