In: Economics
Explain with illustrations the impact of demand shocks on the real GDP and the price level?
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.