Principles of Macroeconomics / Unit 8 MAC 0728 review, 2 to 3 minutes
One Shock, Two Stories
The idea
The most useful thing this model does is force a single event to be traced through both curves, and the pandemic recession is the case that shows why. Read as a supply shock, it removed workers from production: people fell ill, stayed home, cared for children out of school, or left the workforce entirely, while supply chains and ports stopped clearing. Short-run aggregate supply shifted left, and potential GDP itself may have moved left with it for a time. That predicts falling output with rising prices. Read as a demand shock, it stopped spending: travel, restaurants, events and services that require people to be near each other stopped altogether, and households facing uncertainty saved instead of spending. Aggregate demand shifted left. That predicts falling output with falling prices. Both readings agree that output falls. They disagree about the price level, and that disagreement is the whole diagnostic question.
In practice
Worked example: take the two shifts one at a time, then together. Supply left alone gives lower output and a higher price level. Demand left alone gives lower output and a lower price level. Put both together and output falls hard, because the two reinforce each other on that axis, while the price level moves whichever way the larger shift pushes it, and may barely move at all if the two are close in size. That is why the same downturn can show falling prices in some sectors and rising prices in others at the same moment, and why an aggregate index can look almost still while the economy underneath is anything but.
Where people slip
Three cautions to carry into the rest of the course. First, when both curves move, output or the price level may be determinate while the other is not, exactly as in unit two when supply and demand both shifted, and claiming certainty about the indeterminate one is the error. Second, the model gives directions and not magnitudes, so it can say prices will rise without saying by how much, and every later unit inherits that limit. Third, the diagnosis decides the policy: a demand shock calls for supporting demand, a supply shock does not, and getting the reading wrong means prescribing a remedy that makes one of the two problems worse. Units nine through fourteen are largely an argument about how to read this diagram correctly and what to do once you have.
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