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.