Stimulus closes a recessionary gap

The chain in words

1. Step 1

   Inside the recession

   The economy is in a recession. The horizontal axis is real GDP and the vertical axis is the price level. AD and SRAS cross at E₀, to the left of LRAS, so output is below potential and unemployment is high. The dashed line shows where aggregate demand stood before the downturn.

2. Step 2

   Aggregate demand shifts right

   Households spend most of the checks. Consumption rises at every price level, so aggregate demand shifts right, back toward its old position. Firms see more orders and raise output and prices.

3. Step 3

   Back on LRAS

   The economy moves up SRAS to E₁, on LRAS. Output is back at potential and the price level is higher than in the recession. The stimulus was sized to close the gap, no more. A larger package would have overshot into an inflationary gap.

Takeaway. Expansionary fiscal policy shifts AD right and closes a recessionary gap, at the cost of a higher price level.

Draw it yourself

More on the aggregate demand and aggregate supply graph