What a recession looks like on the AD-AS graph
The test says: "Show a recession on the AD-AS graph." A student draws three curves, moves the price level down, writes "GDP falls" and loses the marks. A lower price level does not cause a recession; it is one of its results. A recession is a shift, and the first question is always which curve shifted.
The three curves in one picture
Across the bottom, real GDP: everything the country makes in a year, in $ million. Up the side, the price level: an index of all prices, set to 100 today. Three curves live on it.
- AD, aggregate demand: all the spending on the country's goods and services (consumption, investment, government and net exports) at each price level. It slopes down: at a lower price level savings buy more, loans get cheaper and exports get cheaper than foreign goods. On Coralia, 90 instead of 100 makes buyers want $40M more.
- SRAS, short-run aggregate supply: what firms make at each price level while wages are fixed by contracts. It slopes up: if selling prices rise and wages do not, each sale earns more, so firms make more. At 110, Coralia's firms make $40M more.
- LRAS, long-run aggregate supply: a vertical line at potential output, what the country makes at full employment, once wages have caught up with prices. It depends on workers, machines and know-how, not on the price level: $1,000M on Coralia.
Where AD crosses SRAS is where the economy is now. Today, on Coralia, all three curves meet at a price level of 100 and $1,000M: full employment, no gap. Then the tourists stop coming.
Tourists stop coming: AD shifts left
Tourists spend their money in hotels and dive schools. The hotels' lost sales are lost income for their workers, who buy less bread and fewer boats, so the bakery and the boatyard sell less too. One shock spreads from firm to firm: at every price level, the island's buyers now spend $80M less. That is a shift of the whole AD curve, not a move along it.
Two things to read off the new crossing. First, real GDP fell by $40M, not $80M: the price level dropped to 90, and lower prices softened the blow, because at 90 buyers want more along the new AD and firms make less along SRAS. On Coralia's curves, every $80M taken from spending costs $40M of output and 10 points of price level. Second, the gap is measured on the horizontal axis, from the new real GDP to the LRAS line: $40M. Firms making $40M less need fewer workers, so hotels, bakery and boatyard cut jobs at once. Unemployment rises above its natural rate (the normal rate at full employment); the extra part is cyclical unemployment, and it is what a recession means for people.
Slide right instead, past zero: $80M more spending moves the crossing to $1,040M at a price level of 110, above potential. That is an inflationary gap, the mirror image, where firms compete for scarce workers and wages start to rise.
The other recession: when prices go up
Not every recession comes from the demand side. In Coralia's second shock the world price of fuel jumps: ferries, fishing boats and ovens all cost more to run, so firms make $80M less at every price level. Now it is SRAS that shifts left, and the crossing slides up the AD curve instead of down the SRAS curve.
| Shock | Curve | Price level · real GDP | Result |
|---|---|---|---|
| Tourists spend $80M less | AD left | 90 · $960M | Recessionary gap $40M |
| Tourists spend $80M more | AD right | 110 · $1,040M | Inflationary gap $40M |
| Fuel costs $80M more | SRAS left | 110 · $960M | Stagflation |
Same output, $960M, opposite price level. That gives you the rule for any test question: a shift of AD moves prices and output the same way; a shift of SRAS moves them opposite ways. Output down and prices up is stagflation, stagnation plus inflation, and it is the hard case, because more spending would push prices higher still and less spending would cut output further. The real one: in 1973–74 the world price of oil roughly quadrupled; in the United States prices rose by about 11% in 1974 while real GDP fell and unemployment climbed to about 9% in 1975.
Does it end on its own?
Back to the tourism shock, at $960M and 90. With many people out of work, new wage contracts are signed at lower pay. Lower wages mean lower costs, and lower costs let firms make more at every price level: SRAS shifts right. Slide to watch it.
At the end, output is back at potential and the price level has fallen from 100 to 80. This is self-correction: in the long run wages adjust and the gap closes by itself. The catch is the word "long". Economists disagree on how long it takes, months or many years, and every month in between means lost jobs. That is why governments often do not wait: they spend more or cut taxes to push AD back to the right, which is fiscal policy, the next lesson. Whether waiting or acting is better is a debate, not a formula; the graph only tells you what each choice does to prices and output.
The trap on tests
- A recession is a shift, not a slide. Moving the price level down along AD changes nothing. Something in C, I, G or NX changed at every price level, so the whole AD curve moved left.
- Mark the gap on the horizontal axis. The recessionary gap is the distance from the new real GDP to LRAS ($40M on Coralia), not the size of the shift ($80M). Prices absorbed the rest.
- Prices tell you which curve moved. Output down and prices down: AD shifted left. Output down and prices up: SRAS shifted left, stagflation.
- LRAS stays put. Potential output depends on workers, machines and know-how. A recession leaves them in place; it leaves some of them idle.
- Unemployment above the natural rate. A recessionary gap means cyclical unemployment on top of the frictional and structural kinds that exist in any year.
Quick check
1. Coralia's government cancels a road project: $40M less spending at every price level. New real GDP, new price level, and the gap?
AD shifts left by $40M, half the tourists' $80M, so half the result: output falls by $20M instead of $40M, and the price level by 5 points instead of 10. Real GDP = 1,000 − 20 = $980M, price level = 100 − 5 = 95. The recessionary gap is 1,000 − 980 = $20M, half the shift, as with the tourists.
2. Real GDP fell from $1,000M to $960M and the price level rose from 100 to 110. Which curve shifted, and which way?
SRAS shifted left. A fall in AD would have pulled the price level down with output; prices up and output down means higher costs for firms, a supply shock. The result is stagflation, like the fuel shock and the oil shock of 1973–74.
3. After the tourism shock, wages have fallen enough to shift SRAS right by $40M, half the way. Where is the economy now?
Start from the recession, $960M and 90. Each $20M of lower costs moves the crossing down the AD line by $10M of output and 2.5 points of price level, so $40M moves it twice that: real GDP = 960 + 20 = $980M, price level = 90 − 5 = 85. Still a $20M recessionary gap: self-correction is halfway, and the price level keeps falling until the crossing reaches LRAS at 80.