Questions: Demand Shocks: Effects on Output and Inflation

Question 1

The government announces a large stimulus package. A commentator says 'This will permanently increase output by creating jobs.' What's wrong with this claim?

• A. Demand stimulus packages never raise output, even in the short run
• B. The output increase is temporary — once the labor market tightens and inflation rises, real output returns to potential
• C. Fiscal stimulus only works through monetary channels, not directly through spending
• D. Output gains from demand shocks are permanent as long as unemployment stays below NAIRU

Answer: (B)

The common misconception is that demand shocks produce permanent output gains. In the short run, sticky prices allow output to rise above potential. But as unemployment falls below NAIRU, the wage-price spiral pushes prices up, eroding real demand and returning output to its potential level. The permanent legacy is a higher price level (or sustained inflation), not higher real output. The commentator is confusing the short-run effect with the long-run equilibrium.

Question 2

Six months after a large positive demand shock, a central bank observes rising inflation but output still above potential. Why hasn't output returned to potential yet?

• A. The shock was too small to have a lasting effect on the labor market
• B. There is a 1-2 year lag between the initial shock and full price adjustment because the wage-price spiral takes time to work through contracts and bargaining
• C. Inflation always rises immediately with demand because prices are flexible
• D. Output above potential and rising inflation cannot coexist — the central bank's data is wrong

Answer: (B)

Price adjustment is slow: workers have nominal wage contracts, firms have menu costs, and bargaining takes time. First, unemployment falls below NAIRU; then workers gain bargaining power and push for wage increases; then firms pass through higher labor costs in higher prices. This full cycle typically takes 1-2 years after the initial shock. Rising inflation while output is still above potential is exactly the expected mid-adjustment picture.

Question 3

In the long run, a sustained positive demand shock that is not offset by monetary policy results in a permanently higher price level but output returning to its potential.

• T. True
• F. False

Answer: True

True. The long-run result is the classic AS-AD prediction: AD shifting right raises output temporarily (short run, sticky prices), but as prices fully adjust, the economy returns to potential output (long-run aggregate supply is vertical at potential). The cost is a permanently higher price level. For a persistent shock, the inflation rate itself may be permanently higher, not just the price level.

Question 4

A positive demand shock permanently reduces unemployment, because the increased output creates lasting new jobs.

• T. True
• F. False

Answer: False

False. The unemployment reduction is temporary. Once unemployment falls below NAIRU, inflation accelerates. Rising inflation erodes the real purchasing power of the original demand stimulus — higher prices reduce real government spending, household purchasing power, and net exports — pushing output back toward potential and unemployment back toward NAIRU. The shock buys temporary employment gains at the cost of lasting inflation, not permanent employment gains.

Question 5

Explain why a positive demand shock raises output in the short run but results only in higher inflation in the long run.

Model answer: In the short run, wages and prices are sticky — contracts and menu costs prevent immediate price increases, so firms respond to higher demand by increasing production. Output rises above potential. Over time, the tight labor market (unemployment below NAIRU) gives workers bargaining power to push wages up. Higher wages raise firms' costs, which they pass through as higher prices. As the price level rises, real demand falls back toward potential and output returns to its sustainable level. The lasting result is a higher price level, not higher real output.

The short-run/long-run distinction is about speed of price adjustment. In the short run, quantity adjusts to demand changes because prices are sticky. In the long run, prices fully adjust and quantity returns to potential. Understanding this is the foundation of AS-AD analysis and the Phillips curve.