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In: Economics

Explain with illustrations the impact of demand shocks on the real GDP and the price level?

Explain with illustrations the impact of demand shocks on the real GDP and the price level?

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Expert Solution

The demand shock refers to an unexpected change in the economy that causes a shift in the aggregate demand (AD). Demand shocks will lead to change in P and Y in the similar direction; i.e. both fall with a decline in demand or both rise with a rise in demand. The demand shocks have a short-run effect on three macroeconomic variables":

-- Increase in AD shock causes an increase in real GDP and price level; and a decrease in unemployment

-- Decrease in AD shock causes decrease in real GDP and price level; and an increase in unemployment

For example, we are assuming that initially the economy is in long-run equilibrium. If the positive AD shock is experienced in an economy, it would cause an expansion phase of the business cycle and leads to a positive output gap. A rise in AD is the most frequent cause for a rise in the aggregate output in the business cycle. Also the positive output gaps leads to the inflationary gaps because a rise in AD would lead to a rise in the price level.

Rahul Sunny answered 1 month ago
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