Expansionary Demand Shocks

We begin our analysis from a position where actual GDP is equal to potential GDP and price level is stable at the full employment level national income. Thus, our starting point as shown is full employment level of income Y_f (where actual and potential GDP are equal) and the price level is P0 corresponding to point E₀ where the aggregate demand curve AD₀ and the aggregate supply curve SRAS0 intersect each other.

Now, supposing this position of stability and equilibrium is disturbed by an expansionary aggregate demand shock caused by an increase in autonomous investment or government spending. The increase in autonomous spending shifts the aggregate demand curve (rightward) to AD₁. The new demand curve AD₁ intersect the aggregate supply curve (SRAS₀)at point E₁. This new equilibrium position corresponds to GDP level Y₁ and price level P₁, which are both higher than their earlier levels. Thus, an expansionary aggregate demand shock results in increase in both the price level as well as the GDP. This change is shown by a movement along the SRAS₀ curve from E0 to E₁.

But in the new equilibrium position, the actual GDP(Y1) exceeds the potential GDP(Y1) thus opening up the inflationary gap Y1- Yf. This inflationary gap shows that economy is producing beyond its normal capacity thereby creating usually excess demand for labor and other inputs. The resulting rise in wages above the productivity levels of labor as well as increase in price of other inputs will cause the SRAS curve shift upward(leftward). This will cause a decline in production level and further increase in price level. This process will continue till the inflationary gap is removed and the actual output become equal to potential output. As shown the initial rise in price from P0 to P1 caused by upward shift in AD from AD0 to AD1 further results in upward shift of AS curve from SRAS0 to SRAS1 resulting in decline in output and still further rise in price. The equilibrium is achieved at pointy E2 where output level is back to the potential GDP level Yf and price goes up to P2. This movement from E1 to E2 involves upward movement along with AD1 curve where decrease in output from Y0 to Yf is accompanied by increase in price level from P1 to P2. Since, now the inflationary gap is fully closed, the new position will be stable with the same old output level (Yf) but higher price level P2 caused by the economy’s endeavor to produce more than its normal capacity thus opening up inflationary output gap.

This impact and sequence of expansionary demand shock can be summarized as follows:

• Starting from the position of full employment (actual GDP equal to potential GDP) and stable price level, an increase in aggregate demand shifts the AD curve upwards and causes increase in GDP as well as price level.
• The new GDP level being beyond the normal production capacity of the economy creates excessive demand for labor and other inputs resulting in rise in their price (and wages). This rises per unit cost and shifts the aggregate supply curve upwards (rightwards) thus leading to a fall in GDP and rise in price level.
• The process of upward shift in SRAS curve continues till the inflationary gap is fully closed and actual GDP and potential GDP becomes equal. The net result of inflationary gap is that output remains the same while price level rises further.