Office Hours: Multiple Shocks with the AD-AS Model

Today, we'll walk through three examples of what happens to an economy in the short run when it experiences multiple shocks. We'll track more than one shock at a time because that's what happens in the real world.

First, suppose our nation's scientists invent many new Internet tools, raising productivity and making consumers and investors optimistic about future inventions as well. Let's take it one shock at a time.

So the fact that scientists created a new invention -- that's great news for the economy. This marks a change to the fundamental factors of production, a positive technological shock which will cause the "LRAS" curve -- our North Star -- to shift to the right. This will increase real GDP growth rate and lower the inflation rate. But that's not the only change occurring in the economy.

What if seeing these new inventions boosts consumer confidence and convinces them that even more inventions are coming? Consumers may then decide to spend more -- in a way spending their new wealth even before it actually has been produced, and shifting the "AD" curve out and to the right. It's boom time.

Both shocks increase real GDP growth. But what happened to inflation in this instance? Well, that's ambiguous. Even though we've drawn our shifts such that inflation increased -- we could have easily drawn it differently to show a decrease in inflation. The two events affect inflation in opposite directions so the relative size and magnitude will ultimately determine whether the inflation increases or decreases, or stays the same as the original equilibrium point.

So let's try another example: the economy experiences a year of excellent weather for growing crops, and the government cuts back on spending. So let's reset the graph. If the economy experienced good weather for crops, fundamental factors changed and will shift the LRAS curve to the right. But we don't stop there. When the government cuts spending, velocity growth decreases, and this shifts the AD curve to the left. The net effect of both shocks is lower inflation, but it's unclear if real GDP is higher or lower. Cutting spending reduces real GDP growth, and good weather increases it.

And, finally, let's try one more scenario. Suppose there is a war in the Middle East which reduces the supply of oil, and for reasons that we'll get into, we'll also suppose that the Central Bank then reduces the growth rate of the money supply. Resetting the graph one last time. Oil is an important input into the production of many goods and services in an economy. So when the supply decreases, prices go up rapidly -- the LRAS curve will shift back, lowering real GDP growth and increasing inflation. But if the Central Bank sees higher inflation and decides to reduce the inflation rate by slowing the rate of money growth -- this leads to an inward shift in the AD curve, causing a fall in inflation and real GDP growth. So both shocks cause GDP to fall, but the change in inflation is ambiguous. An oil shock pushed up inflation while a decrease in money growth pushed it down.

What these exercises show us is that we don't always know the short run results of inflation and GDP from multiple shocks to the economy until we know which shock was larger. Now it's important to remember that these exercises are tracking what's happening to an economy in the short run. But what about the long run?

Well, if you'd like some additional challenges, you'll have to check out our practice problems at the end of this video. Or you can continue to master more macroeconomics concepts.