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Concretionary Shocks

Again we take example of an economy with a stable equilibrium with actual GDP being equal to potential GDP. Now, suppose the entrepreneurs decide to reduce the investment expenditure. It will causes a downward shift in the aggregate demand curve, also called concretionary shock. The new equilibrium will now be attained at the lower level of GDP and price level. It sets in motion the econtractionary forces resulting into decreasing demand forces all inputs, including the demand for labour. Input costs fall and the aggregate supply curve shifts rightwards setting a new and original level of output which is equal to potential output, but it is obtained at a lower price level as shown.

In both the parts (i) and  (ii) E0 is the initial equilibrium, where AD0 curve intersects SRAS0 curve. The actual level of output (GDP) equals the potential level (Y*) at the price level P0. Now, a fall in the investment spending causes a demand shock and the AD0 curve in part (i) shifts downwards to AD1. This causes a fall in both GDP and the price level. At the new equilibrium E1 in both the parts (i) and (ii), the new and lower level of GDP is Y1 and the price level also falls to P1. But, this is not the final equilibrium.

Aggregate demand shocks sets in motion the recessionary forces. Since actual GDP (Y1) is less than potential GDP (Y*) results into a fall in input costs, including the cost of labour, shifting the SRAS0 curve downwards to SRAS1, as shown in part (ii), New equilibrium if E2, where AD1 intersects the new aggregate supply curve SRAS1. At point E2, recessionary gap is eliminated, as shown by arrow in part (ii), and actual GDP again becomes equal to potential GDP, but at a lower price level P2.

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