A housing boom overheats

The chain in words

1. Step 1

   Before the boom

   The economy starts at potential output on LRAS. The horizontal axis is real GDP. The vertical axis is the price level. E₀ is the long-run equilibrium.

2. Step 2

   Aggregate demand shifts right

   Builders invest in new homes and homeowners spend against rising house prices. Spending rises at every price level, so aggregate demand shifts right. Firms raise output and prices. The economy moves to E₁: output above potential, an inflationary gap.

3. Step 3

   Running hot

   Firms are running overtime and hiring anyone they can find. That cannot last. Workers ask for raises and suppliers charge more.

4. Step 4

   Wages rise, SRAS shifts left

   Higher wages and input prices raise the cost of any level of output, so SRAS shifts left. The economy climbs the AD curve to E₂, back on LRAS.

5. Step 5

   Back at potential, higher prices

   Output is back at potential, but the price level is much higher. The boom bought a temporary rise in output at the price of permanently higher prices.

Takeaway. A positive demand shock raises output above potential only in the short run, and in the long run it leaves just a higher price level.

Draw it yourself

More on the aggregate demand and aggregate supply graph