University of Sydney · S1 2026 · FACULTY OF BUSINESS & ECONOMICS

ECON1002 · Introductory Macroeconomics

Q: How is the AD-AS model examined in ECON1002?

It is the heart of Section B and of the Weeks 8-13 focus. Expect a labelled-diagram question: shift AD (e.g. higher G or a changed inflation target) or AS (a supply shock), show the short-run point and the self-correction back to potential, and explain the inflation outcome. The 2025 final used exactly this with a COVID-era shock and a disinflation scenario.

Q: Why does aggregate demand slope downward in inflation-output space?

Through the central bank's policy reaction function. When inflation is higher, the RBA sets a higher real interest rate, which reduces consumption and investment and therefore planned aggregate expenditure and output. So higher inflation is associated with lower output — a downward-sloping AD curve in (π, Y) space, even though prices are not the direct cause.

Q: What is the difference between demand-pull and supply-shock inflation?

Demand-pull inflation comes from excess spending: AD shifts right, output rises above potential, and SRAS then drifts up until output returns to Y* at a higher inflation rate. A supply shock shifts SRAS up directly, raising inflation while lowering output below potential at the same time — the stagflation dilemma — which is harder for policy because fixing one worsens the other.

Q: How does the economy self-correct after a demand shock?

Via the output gap. When a positive demand shock pushes output above potential, the expansionary gap raises expected and actual inflation, shifting SRAS up. As SRAS drifts up, output falls back toward Y* and the gap closes. In the long run output is pinned at the vertical LRAS, so a demand shift changes only inflation, not output — that is the self-correction the diagram must show.

- one subject, every graph, every model, every mark

50% final exam · hurdle14 Chapters8-page Bible

Our own words - no uploaded lecturer files

Built to mirror S1 2026 · updated this semester

Chapter 9 of 12 · ECON1002

AD-AS Model & Inflation

The AD-AS model ties the short-run model to inflation. Aggregate demand slopes down in (π, Y) space because, through the policy reaction function, higher inflation prompts a higher real rate, lower spending and lower output. Aggregate supply reflects inflation inertia (πₜ depends on πₜ₋₁ plus the output gap and shocks), with a vertical LRAS at Y*. The output gap drives the change in inflation, and the model classifies the two sources of inflation — excess spending and adverse supply shocks.

It is examined as a Section-B diagram question: shift AD or AS, trace the adjustment back to Y*, and explain disinflation under credible inflation targeting.

In this chapter

What this chapter covers

011. Deriving AD: higher π ⇒ (via the policy reaction function) higher r ⇒ lower PAE ⇒ lower Y (AD slopes down)
022. What shifts AD: higher exogenous spending (G) right; a higher inflation target (dove) right, lower (hawk) left
033. Aggregate supply & inflation inertia: πₜ = πₜ₋₁ + (output-gap effect) + shock
044. SRAS vs LRAS (vertical at potential output Y*)
055. Output gap drives Δπ: expansionary gap ⇒ inflation rises; contractionary ⇒ falls; no gap ⇒ unchanged
066. Source 1 of inflation: excessive spending (AD right, Y > Y*, SRAS drifts up until Y = Y* at higher π)
077. Source 2 of inflation: adverse supply shock (SRAS up, Y < Y* AND π up — stagflation dilemma)
088. Self-correction & disinflation: economy returns to Y*; credible inflation targeting anchors expectations

Worked example · free

Excess-spending inflation and the return to potential

Q [6 marks]. Starting from long-run equilibrium at potential output Y*, the government sharply increases spending G. Using the AD-AS model, trace what happens to output and inflation (a) in the short run and (b) as the economy self-corrects in the long run, and state the long-run effect on output and inflation.

2 marks(a) Higher G shifts aggregate demand to the right. Along the upward short-run aggregate supply, output rises above potential (Y > Y*) and inflation rises — an expansionary output gap opens.
2 marksBecause Y > Y*, the positive output gap puts upward pressure on inflation: through inflation inertia, expected and actual inflation drift up, so short-run aggregate supply shifts up over time.
1 mark(b) As SRAS drifts up, output falls back toward potential and inflation keeps rising until the gap closes at Y = Y*. The economy self-corrects to potential output but at a permanently higher inflation rate.
1 markLong-run effect: output returns to Y* (no permanent output gain), while inflation is permanently higher — the classic excess-spending inflation result.

Short run: Y rises above Y* and inflation rises (expansionary gap). Long run: SRAS drifts up, output returns to Y*, and inflation is permanently higher — demand stimulus buys higher inflation, not lasting output.

Sia tip — Always finish at the vertical LRAS: in the long run output is pinned at Y*, so a demand-side shift changes only inflation, not output. The trap is stopping at the short-run point and claiming a permanent output gain — name the self-correction (SRAS drifts to close the gap) for the explanation marks.

Glossary

Key terms

Aggregate demand (AD): The downward-sloping relationship between inflation and output in (π, Y) space. It slopes down because higher inflation triggers (via the policy reaction function) a higher real interest rate, which lowers planned spending and output. It shifts with exogenous spending and the inflation target.
Inflation inertia: The tendency of inflation to change only slowly, because expectations and contracts anchor it: πₜ = πₜ₋₁ + (output-gap effect) + shock. This stickiness is why short-run aggregate supply adjusts gradually rather than jumping.
SRAS vs LRAS: Short-run aggregate supply reflects sticky/expected inflation and shifts with shocks and expected inflation; long-run aggregate supply (LRAS) is vertical at potential output Y*, because in the long run output is determined by supply-side fundamentals, not inflation.
Output gap and Δinflation: The output gap drives the change in inflation: a positive (expansionary) gap pushes inflation up, a negative (recessionary) gap pulls it down, and a zero gap leaves inflation unchanged. This is the engine of self-correction in the model.
Demand-pull vs supply-shock inflation: Demand-pull (excess spending): AD shifts right, output rises above Y* and SRAS then drifts up until output returns to Y* at higher inflation. Supply shock: SRAS shifts up, producing the stagflation dilemma of lower output (Y < Y*) and higher inflation at once.
Disinflation & inflation targeting: Disinflation is a sustained fall in the inflation rate. A credible inflation target anchors expectations, so the central bank can lower inflation with a smaller and shorter output cost; mis-reading the LRAS (the Great Inflation) led to costly policy mistakes.

FAQ

AD-AS Model & Inflation FAQ

How is the AD-AS model examined in ECON1002?

It is the heart of Section B and of the Weeks 8-13 focus. Expect a labelled-diagram question: shift AD (e.g. higher G or a changed inflation target) or AS (a supply shock), show the short-run point and the self-correction back to potential, and explain the inflation outcome. The 2025 final used exactly this with a COVID-era shock and a disinflation scenario.

Why does aggregate demand slope downward in inflation-output space?

Through the central bank's policy reaction function. When inflation is higher, the RBA sets a higher real interest rate, which reduces consumption and investment and therefore planned aggregate expenditure and output. So higher inflation is associated with lower output — a downward-sloping AD curve in (π, Y) space, even though prices are not the direct cause.

What is the difference between demand-pull and supply-shock inflation?

Demand-pull inflation comes from excess spending: AD shifts right, output rises above potential, and SRAS then drifts up until output returns to Y* at a higher inflation rate. A supply shock shifts SRAS up directly, raising inflation while lowering output below potential at the same time — the stagflation dilemma — which is harder for policy because fixing one worsens the other.

How does the economy self-correct after a demand shock?

Via the output gap. When a positive demand shock pushes output above potential, the expansionary gap raises expected and actual inflation, shifting SRAS up. As SRAS drifts up, output falls back toward Y* and the gap closes. In the long run output is pinned at the vertical LRAS, so a demand shift changes only inflation, not output — that is the self-correction the diagram must show.

Study strategy

Exam move

Treat AD-AS as a drawing-and-narrating skill, because Section B rewards a clear, labelled diagram plus the mechanism in words. Rehearse the four standard moves until automatic: a demand shift (G or inflation target), a supply shock, the self-correction back to Y*, and disinflation. For each, narrate the chain — what shifts, the short-run output and inflation effect, why the output gap then moves SRAS, and where it ends on the vertical LRAS. Memorise the two anchors: AD slopes down because of the policy reaction function, and LRAS is vertical at Y*, so demand shocks leave long-run output unchanged. Always close at potential output and state the permanent effect (inflation, not output) — the explanation marks live in naming the self-correction.

Keep going — explore the course

A+Everything unlocked

Unlocks this Bible + all 191 of your University of Sydney subjects - and 1,000+ Bibles across every Australian university.

Sia - your ECON1002 tutor, unlimited, worked the way the exam marks it

The full 8-page Bible + practice bank with worked solutions

Chrome extension - sync your LMS so Sia knows your deadlines

Bilingual EN / Chinese on every Bible and every Sia answer

$25/ month

30-day money-back · cancel in one tap · how it works