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A positive demand shock increases output in the short run (sticky prices); firms respond by increasing production. If sustained, it tightens the labor market, pushing unemployment below NAIRU and triggering wage-price increases. In the long run, inflation rises while output returns to potential.
Trace demand shock through AS-AD diagram and Phillips curve. Positive shock shifts AD right, raising output and lowering unemployment below NAIRU. This creates inflation pressure. Show policy trade-off.
A demand shock is anything that shifts the aggregate demand for goods and services in the economy — a burst of consumer confidence, a fiscal stimulus package, a surge in export demand, or a sharp rise in business investment. From your study of aggregate demand and the expenditure approach, you know that AD is the sum of consumption, investment, government spending, and net exports. When any of these components rises unexpectedly and persistently, the economy faces a rightward shift in the AD curve. The question is what happens to output and inflation in response — and the answer depends critically on whether we are looking at the short run or the long run.
In the short run, wages and prices are sticky: workers have nominal wage contracts, firms have menu costs, and adjustment takes time. When demand rises, firms cannot immediately raise prices to clear the market, so they respond by increasing production. Output rises above its potential level — the level consistent with normal capacity utilization and the NAIRU (the unemployment rate at which inflation is stable). Okun's Law, which you have already studied, tells you what this output gap implies: output above potential means unemployment falls below NAIRU. Firms are hiring more workers than their "natural" level, and the economy is running hot.
The labor market tightening then triggers the inflation dynamic. When unemployment falls below NAIRU, workers gain bargaining power and push for higher wages. Firms facing higher labor costs pass them through in higher output prices. This is the wage-price spiral — wages chase prices, prices chase wages — and it is the channel through which a demand shock that initially only raised output eventually raises inflation as well. The Phillips curve (which you are building toward) formalizes this relationship: inflation rises when unemployment falls below NAIRU by an amount proportional to the gap. Crucially, this process takes time — typically one to two years after the initial shock — which is why monetary policy acts with long and variable lags.
In the long run, markets fully adjust. The economy cannot sustainably produce above potential — capital depreciates, workers demand rest, and the supply of productive inputs is ultimately bounded. As inflation rises, it erodes the real purchasing power of the original demand stimulus: higher prices reduce the real value of government spending, household purchasing power, and net exports. AD shifts back toward potential output. The long-run result of a permanent positive demand shock that goes unaddressed by policy is: output returns to potential, but the price level is permanently higher (or, for a persistent shock, the inflation rate is permanently higher). The demand shock bought temporary output gains at the cost of lasting inflation — the classic short-run/long-run tradeoff at the heart of macroeconomic stabilization policy.