Worked example 1
An economy is initially in long-run equilibrium at Yf = $800bn and P = 100. Consumer confidence rises and AD increases by $40bn at every price level.
(a) On an AD–AS diagram, describe the shift. (b) Predict the new equilibrium P and Y in the short run (assume SRAS is upward sloping). (c) What happens in the long run if AD stays at the higher level?
Show solution outline
(a) Diagram Draw AD₁ and AD₂ with AD₂ to the right of AD₁ (parallel shift right by $40bn). Mark initial equilibrium E₁ at AD₁ ∩ SRAS. New short-run equilibrium E₂ at AD₂ ∩ SRAS.
(b) Short-run effect Both P rises (e.g. from 100 to ~105) and Y rises (e.g. from 830bn). The economy moves into an inflationary gap (Y > Yf).
(c) Long-run adjustment If AD remains high, wages and costs adjust upward. SRAS shifts left until Y returns to Yf but at a higher price level — demand-pull inflation without permanent output gain.