What happens when AD exceeds AS in the short run?

When Aggregate Demand (AD) exceeds Aggregate Supply (AS) in the short run, inflation occurs.

In the short run, if Aggregate Demand (AD) exceeds Aggregate Supply (AS), it creates an inflationary gap. This is because the total demand for goods and services in an economy surpasses the economy's capacity to produce those goods and services. This situation is often referred to as 'demand-pull inflation'.

When AD exceeds AS, firms respond by increasing their prices to balance the demand and supply. This leads to a general increase in the price level, causing inflation. The higher demand also encourages firms to increase their production, leading to an increase in real GDP. However, this increase in real GDP is often temporary as it is driven by higher demand rather than an increase in the economy's productive capacity.

In the labour market, the higher demand for goods and services leads to an increase in demand for labour as firms try to increase their production. This can lead to higher wages, further fuelling inflation. However, if the economy is already at full employment, the increase in demand for labour can lead to a shortage of skilled workers, causing wage inflation.

In the financial market, the higher demand can lead to an increase in interest rates as firms and consumers compete for available funds. This can lead to a decrease in investment and consumption, slowing down the economy.

In the foreign exchange market, the higher demand for goods and services can lead to an increase in imports, causing a deterioration in the balance of trade. If the increase in AD is driven by an increase in exports, it can lead to an appreciation of the domestic currency, making imports cheaper and exports more expensive.

In summary, when AD exceeds AS in the short run, it leads to inflation, an increase in real GDP, higher wages, higher interest rates, and changes in the balance of trade and exchange rates. However, these effects are often temporary and can lead to economic instability if not managed properly.