Negative Demand Shock and Long-Run Self-Correction

Negative Demand Shock and Long-Run Self-Correction, step by step

1. 1

   Long-run equilibrium

   The economy begins in long-run equilibrium, where AD and SRAS intersect exactly on the LRAS curve. Real GDP is at its full-employment level and the price level is stable.

2. 2

   Aggregate demand falls

   A shock such as a collapse in consumer and business confidence reduces spending at every price level, so aggregate demand shifts left. Real GDP falls below full employment and the price level drops, opening a recessionary gap.

3. 3

   Slack pushes wages down

   With output below full employment, unemployment is high and there is a surplus of labor. Over time this slack pushes nominal wages and other input prices down, but the adjustment is slow, which is why the gap persists in the short run.

4. 4

   SRAS shifts right

   As nominal wages fall, production becomes cheaper at every price level, so short-run aggregate supply shifts right. Output rises back toward full employment and the price level falls further.

5. 5

   Back to full employment

   AD and the new SRAS now intersect on LRAS again, so real GDP is back at its full-employment level. The recessionary gap is closed, but the economy has settled at a lower price level than before the shock.

Where it ends up

In the long run real GDP returns to its full-employment level while the price level ends up lower than where it started.

Now draw it yourself

Same graph, graded on whether you move the right curve and leave the rest alone.

• Expansionary Fiscal Policy →
• Consumer Confidence Shock →
• Oil Price Shock →

More AD-AS Model walkthroughs

• Positive Demand Shock and Long-Run Self-Correction →
• Adverse Supply Shock and the Stagflation Dilemma →