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IS-LM/AD-AS
Demand and Supply Shocks:
Exploring Business Cycles
Learning Objectives
• To understand the difference between demand
shocks and supply shocks.
• To understand how demand shocks and supply
shocks cause business cycles.
• To consider the efficacy of government policy
designed to stabilize the economy.
Business Cycles
• Causes:
– Fluctuations in aggregate demand
• Collapse of confidence of investors
• Inappropriate monetary policy
• Inappropriate fiscal policy
– Fluctuations in aggregate supply
• Change in the availability of a crucial natural resource
• Technology
Demand Shocks
• If most shocks experienced by an economy are
demand shocks, the relationship between GDP
growth and inflation will be direct or as GDP
increases, so does inflation.
• Therefore, a plot of GDP growth points and
their associated inflation levels would follow
an upward-sloping aggregate supply curve.
• Prices are procyclical.
Demand Shocks
p
P
10
LRAS
SRAS
0
C
-10
A
AD3
B
AD1
AD2
0
Y*
Y
A
-20
-30
-20
-10
0
10
20
/\Y/Y
B
B
Macroeconomics, Farmer, p. 270
Demand Shocks: 1921-1939
• Panel A
– When aggregate demand shifts to the right, output
and the price level increase.
– When aggregate demand shifts to the left, output
and the price level decrease.
• Panel B
– Note that the pattern of observations follow an
upward slope as expected.
Demand Shocks
• Great Depression
– Economists argue that the depression was caused
by a left-ward shift of the aggregate demand curve
from AD1 to AD2.
– As the price level fell, real wages increased,
causing a rise in unemployment above the natural
rate.
• Nominal wages did fall during the depression, but they
fell more slowly than the price level.
Demand Shocks
• World War II
– During WWII, the aggregate demand curve shifted
from AD1 to AD3.
– As the price level rose, real wages decreased,
causing a fall in unemployment below the natural
rate.
• Nominal wages were controlled by wage and price
controls during much of WWII.
Supply Shocks
• If most shocks experienced by an economy are
supply shocks, the relationship between GDP
growth and inflation will be inverse or as GDP
increases, inflation decreases.
• Therefore, a plot of GDP growth points and
their associated inflation levels would follow a
downward-sloping aggregate demand curve.
• Prices are counter-cyclical.
Supply Shocks
p
P
LRAS
SRAS2
10
SRAS1
0
SRAS3
-10
D
-20
A
E
AD
0
Y*
C
Y
-30
-20
-10
0
10
20
/\Y/Y
D
Macroeconomics, Farmer, p. 270
Supply Shocks: 1970-1989
• Panel C
– When aggregate supply shifts to the right, output
increases and the price level decreases.
– When aggregate supply shifts to the left, output
decreases and the price level increases.
• Panel D
– Note that the pattern of observations follow a
downward slope as expected.
Supply Shocks
• Oil Shocks
– During the 1970s and in 1990, the short-run
aggregate supply curve shifted from AS1 to AS2.
– Oil price increases cause domestic technology to
produce less output for a given input of labor and
capital because many technologies rely heavily on
oil products. Costs and prices rise.
– Inflation increased and output decreased.
Supply Shocks
• Technology Shocks
– During the late 1990s, the short-run aggregate
supply curve shifted from AS1 to AS3.
– Improvements in technology increased labor
productivity and shifted aggregate supply to the
right.
– Inflation decreased and output increased.
Macroeconomic Stabilization
• Does economic stabilization work?
– The government must first recognize that there is a
recession. Data available are often incomplete.
– Once the problem is recognized, the government
may use either fiscal policy or monetary policy.
• Fiscal policy can take a year or more to get through
Congress.
• Monetary policy can be implemented more quickly, but
there is a long and unpredictable lag between
implementation and impact.
Macroeconomic Stabilization
• Does economic stabilization work?
– Expectations are not exogenous, but rather change
as the economic environment changes.
– If people take actions to protect their own
economic welfare that counter government
policies, those policies will be less effective.