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Monetary and Fiscal Policy
Recessions and Booms
Unanticipated Changes in Aggregate Supply
Page 1 of 3
We’ve described bad deflation as a period of falling prices that coincides with falling output; that is, during a period of
recession, prices often drop, particularly when the recession is driven by a reduction in demand. When the action
starts on the supply side, however, you can get an odd alternative, which is that falling prices are actually occurring
during the period of increased output. That is the best of both worlds; a lower price level and a higher standard of
living. On the one hand, you can also get the worst of both worlds; that is, rising prices during a period of high
unemployment. When the supply side is the main actor in the story, we wind up with prices and output moving in
opposite directions. Let’s see how this works.
Consider now a change in the environment that shifts the short-run aggregate supply curve. The short-run aggregate
supply curve shifts independently of long run supply when there’s a change in something that influences the prices
that businesses have to charge for their goods and services. That would result, if for example, there was a supply
shock like an increase in the price of some important resource input like oil or if wages were suddenly increased
because of activity on the part of unions. If wages go up or if supply shocks occur, then the short-run aggregate
supply curve moves independently of the green curve because businesses then have to pass these higher costs onto
their customers in the form of higher prices for the output. So, for instance, if there is a supply shock, say during the
early 1970’s when war in the Middle East increased the price of oil substantially, it showed up in the model on this
form. The short-run supply curve shifted upward meaning that businesses were now going to be charging higher
prices than before for the same outputs. So here we now wind up with a new short- run aggregate supply curve.
What’s going to happen is the economy adjusts in the short run. At the original price level now we have excess
demand for goods; that is, on the red curve businesses, households, foreigners and the government still want to buy
the same quantity of goods and services. However on the supply side, because of the rising cost of doing business,
businesses want to produce less. The result of this excess demand for goods is going to be a rise in prices and rise in
prices then are going to have an effect on both sides of the market. As the price level rises on the demand side, the
aggregate demand, the quantity of goods and services that people want to buy is going to be shrinking. First of all,
because of the wealth effect. Consumers now feel less wealthy because higher prices shrink the purchasing power of
their mutual funds and savings accounts and nominal wealth. Businesses want to spend less because the increased
demand for money that accompanies rising prices bids up the interest rate and as the interest rate rises, businesses
find it less profitable to invest in factories and equipment. And finally, foreigners are going to be buying less because
our prices in the U.S. are rising relative to prices abroad.
On the supply side of the economy, we’re going to find that the quantity of goods supplied increases, because as the
price level rises three things happen. First, the price of output rising relative to the price of wages, and when that
happens then, businesses see a temporary profit opportunity and expand their output. The second thing is because
of sticky prices not all of the businesses in the economy are able to get their prices up with the general price level and
they experience a short term surge in demand for their products which are relatively under-priced. And finally there’s
confusion. Businesses don’t know yet whether these rising prices represent increased demand for their particular
products or whether it’s just general economy-wide inflation so they take advantage of what they think may be a
business opportunity by increasing their output in the short run. The end result is with the supply shock we wind up
with the following change. Output in equilibrium falls below its full employment level at the same time as the price
level increases from the original level of P0 to a new higher level of P1.
Well, look, there you have it; stagflation. Rising prices at the same time as a recession is occurring because output is
falling below full employment. Unemployment coexists with rising prices. You can only get that outcome whenever
the story is driven by a change on the supply side. Supply shocks create stagflation. Now the question is what could
the government do, what could the Fed do to mitigate the impact of this change in the environment. Well, the problem
is two fold. We’ve got rising prices; that is, inflation which has its own costs and we’ve got unemployment which has
its own costs. It turns out that anything the government does is going to improve one of these problems by making
the other one worse. Let’s see how this might work.
Government spending and taxes, that is, fiscal policy, could be used to try to offset the effect of this supply shock. If
the government wanted to try to take pressure off of prices, it could reduce government spending or raise taxes and
shift the aggregate demand curve inwards. If the aggregate demand curve is shifted inwards, then what happens is
the price level is going to fall back to its original level in the short run equilibrium. However getting this aggregate
demand curve down here is going to mean that output falls even further, the recession deepens. So the government
Monetary and Fiscal Policy
Recessions and Booms
Unanticipated Changes in Aggregate Supply
Page 2 of 3
can take the pressure off the prices, but only at the expense of reducing output further and increasing unemployment.
On the other hand if the government wants to get unemployment down to its original level or increase output back to
full employment, it could spend more money or cut taxes to stimulate demand. In that case what happens is the
economy returns to full employment. On the other hand the price level is going to wind up going higher in equilibrium.
So, you see we’re stuck here with the tradeoff, the typical tradeoff that the Phillips Curve describes. You can either
fight inflation or you can fight unemployment; but you can’t do both simultaneously. This is the tradeoff that these
supply shocks create for the economy.
So let’s suppose that the government is particularly concerned about unemployment. If it is, then what’s going to
happen is this. The government is going to spend more money pushing the aggregate demand curve from its original
level of AB0 out to AB1. In this case, the increased demand for goods and services means that more output is
required at any price level to satisfy demand. What that does then is in the short run pushes prices up even higher
and as these prices rise, businesses are willing to produce more output and some of the demand from consumers and
businesses is choked off even further till we get to the new equilibrium. But because the situation began with a supply
shock, we wind up with a higher price level. If the government wants to close this unemployment gap and bring us
back to full employment, the cost is going to be higher prices. And prices noticed wind up going up by exactly the
amount that businesses were trying to raise originally in response to the supply shock. So prices wind up going up by
the full amount of what it was that fed into the economy originally and created the problem.
What could the Fed do? Well, the Fed could reduce the money supply and fight the inflation by shifting the aggregate
demand curve inward. If the Fed reduced the money supply, then the aggregate demand curve would shift back here
as interest rates rose and businesses cut back their spending. That would push the price level back to its original
level, but it would deepen the recession. Alternatively, the Fed could increase the money supply and lower interest
rates and stimulate the economy pushing the aggregate demand curve to this level. Prices are going to go up further,
but at least we don’t have to suffer the recession. That’s the way things work whenever the story is driven on the
supply side.
Let’s consider one more possibility and that’s the case where the green curve actually shifts. If the green curve shifts,
then the full employment level of output is going to increase in equilibrium. So we’re going to move from an original
long-run aggregate supply curve, 0, to a new one and we’ll call this long run aggregate supply curve 1. What would
cause this to happen? What causes a long-run aggregate supply curve to increase? What causes the economy to be
able to produce more goods and services than before without having to worry about inflation? Well, the things that
could do that would be an improvement in technology or immigration, which increases the labor supply to the
economy. Also capital accumulation, building more factories increases the amount of output that we can produce
before inflation becomes a risk. Alternatively the long-run aggregate supply curve could be shifted inward by an
adverse development such as war that destroys capital stock or reduces the labor supply or bad weather, which
makes the economy less productive. All of these things shift the green curve, that is, they change the economy’s
speed limit; the amount of output that can be produced before the fear of inflation kicks in.
Well, let’s look now at how aggregate supply and demand interact in this situation. Here’s the original aggregate
demand curve, AD0 and the original short-run aggregate supply curve, SRAS0. So the economy’s original position is
at the intersection of aggregate demand and aggregate supply. We’re going to start here in long-run macroeconomic
equilibrium. So the red curve and the blue curve cross on top of the green curve. That’s where every story begins. In
this situation now suppose there’s an increase in productivity and the increase in productivity is going to shift out the
green curve and the green curve, any time it shifts, drags the blue curve with it so we wind up with a new short-run
curve, as well as a new long-run curve. Well, what’s the situation going to be in the short run? In the short run we’re
always going to be where the red curve and the blue curve cross.
So here we are and the situation that’s created is we have excess supply at the original price level so the price level
falls and as the price level falls, consumers and businesses buy more goods and services through the usual wealth
effects and the effects from the money market and interest rates. Over here we have producers now. As prices are
falling willing to produce less than they would have produced if prices had stayed at their original level. Until we wind
up at short-run equilibrium and at short-run equilibrium, Y1, and this new lower price level, P1, occur because
productivity has increased in its economy somehow. Notice what we have. Falling prices and output increasing
Monetary and Fiscal Policy
Recessions and Booms
Unanticipated Changes in Aggregate Supply
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relative to its original level. This is good deflation. Deflation that stimulates the economy, and increases the standard
of living. And what’s really driving it here is the supply side activity. This is why some economists are very optimistic
about changes in the economy that begin on the supply side. Because when the productive capacity of the economy
increases, you can get more stuff at lower prices. That’s good deflation. Well, what’s going to happen in the long
run? In the long run the blue short run aggregate supply curve is going to start shifting downward because, look;
we’re below full employment. The new full employment curve involves a greater output than the economy is
producing in the short run. Therefore, prices are going to keep falling and they’re going to keep falling for inputs in
labor until we wind up at the new long-run equilibrium with a short-run aggregate supply curve in infinity. The new
price level is going to be lower.
Now why would the government want to do anything about this? Well, it maybe a long time before these prices
actually fall and it maybe the intention in this case of the policymakers that we quickly move to an expanded economy
because of the technological change that’s occurred. If there’s been technological change in immigration, the
economy is not capable of creating a lot more wealth. So why not go ahead and stimulate the economy and get us
there quickly rather than waiting for prices to fall; especially if prices are not inclined to fall because of sticky wages
and things like that. What the government might do in that case is spend more money. The government might cut
taxes or the Fed might stimulate the economy by increasing the money supply and lowering interest rates. In all of
these cases the aggregate demand curve is going to shift outwards until it reaches this new level. Expansionary fiscal
policy, expansionary monetary policy moves the aggregate demand curve to this new level and gives us an
equilibrium with a higher output and the same price level as we had before. Right here. So prices have remained
unchanged but now we’re all better off because the output of the economy has increased. Alternatively we can wait
for falling prices to bring that result about, but if the government wants to get us there quickly, that’s how it does it.
Some people argue that that’s what the Fed is doing today by loosening the money supply, that is, making money
easier to get, pursuing expansionary monetary policy. The Fed is doing that as the economy is booming due to
technology changes. Therefore there’s been very little change in the price level, but there’s been a big growth in the
economy. Output is expanded. The Federal Reserve has provided the money that allows the output to grow without
a change in the price level.
Let me summarize then by talking about the difference between good deflation and bad deflation. Good deflation is
deflation that’s driven by technological change. A period where prices are falling and output is increasing. That’s
probably what’s happening today. The only reason prices aren’t falling any faster than they are is because the
Federal Reserve is allowing the money supply to grow. In the 1870’s in the United States, we had a similar position.
The rapid growth of the railroads then caused prices to fall because businesses became very productive and
competitive. Prices fall at a time when the economy was growing rapidly. The alternative is bad deflation. Deflation
that’s driven by an inward shift in the demand curve. This is what happened in the United States during the Great
Depression. People started saving and stopped spending. Therefore, prices fall and we had a huge increase in
unemployment as the economy contracted. This was also the case in Japan in the late 1980’s and early 1990’s. The
Japanese household stopped spending, therefore prices fell markedly in Japan as unemployment increased and the
economy contracted.
So when prices are falling because the supply side of the economy is showing good development like increased
productivity and expanding capacity for the economy, we call that good deflation because it’s usually associated with
an increased standard of living and economic growth. However, when it’s driven by the demand side of the economy,
falling prices typically mean more unemployment and a contraction in the economy.