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

A

B

B

C

AD2

AD1

AD3

P

Y* Y0

SRASLRAS

/\Y/Y

10

0

-10

-20

-30-20 -10 0 10 20

A 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

D

AE

P

Y* Y

AD

0

SRAS2 SRAS1

SRAS3

LRAS

C D

10

0

-10

-20

-30-20 -10 0 10 20

/\Y/Y

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.