Positive Demand Shock and Long-Run Self-Correction

Positive 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 meet on the LRAS curve. Real GDP is at full employment and the price level is stable.

2. 2

   Aggregate demand rises

   A shock such as a burst of optimism or a fiscal stimulus raises spending at every price level, so aggregate demand shifts right. Real GDP rises above full employment and the price level climbs, opening an inflationary gap.

3. 3

   Tight labor market lifts wages

   With output above full employment, the labor market is very tight and workers are scarce. Over time this shortage bids nominal wages and other input prices up, though the adjustment takes time, so the gap persists in the short run.

4. 4

   SRAS shifts left

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

5. 5

   Back to full employment

   AD and the new SRAS again intersect on LRAS, so real GDP returns to its full-employment level. The inflationary gap is closed, but the economy now sits at a permanently higher price level.

Where it ends up

In the long run real GDP returns to its full-employment level while the price level ends up higher 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

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