Aggregate Demand and Aggregate Supply

This is Unit Eight of Principles of Macroeconomics, part two of two. Part one built the model and taught the distinction it turns on. This part puts it to work, and closes on two capstones. Carry the unit's idea to its payoff. Where the economy sits on the supply curve decides what a demand shift accomplishes, and the diagnosis of an event decides which policy helps. Both capstones turn on that: one shows why the remedies for the two kinds of inflation conflict, and the other traces a single shock through both curves. By the end you will name the zone and say what extra demand would do there, name a gap and check the labor market agrees, say what closes a gap if nothing is done, draw both kinds of inflation in the model, and trace one event through both curves.

Two entries on the three zones of the supply curve, and how to tell which one you are looking at.

Three zones, three answers.

MAC 0720 The Three Zones

The short-run supply curve has three zones: flat far to the left, near vertical at the right, and sloping in between. In the flat zone demand decides output; in the vertical zone potential GDP does. The zone decides what a demand shift accomplishes, which is why one policy can raise output here and only prices there.

Identifying the zone.

MAC 0721 Naming the Zone

Locate the economy by comparing output with potential, then read what a rightward demand shift would do. Far below potential, with idle workers and factories, the curve is flat: extra demand raises output with little effect on prices, and this is the zone Keynes described. At or near potential the curve is nearly vertical: extra demand mostly raises the price level, and this is the zone Say described. In between, extra demand raises output and prices together. Unemployment at ten percent with factories idle puts the economy in the flat zone, so spending mostly raises output; unemployment at the natural rate with capacity strained puts it in the steep zone, so the same spending mostly raises prices. Economists disagree about where economies usually sit, and that disagreement is most of the difference between the schools in units nine and ten. The model does not settle it; it says the answer depends on the zone.

Two entries naming the distance from potential, and checking that reading against the labor market.

Naming the distance from potential.

MAC 0722 Recessionary and Inflationary Gaps

When equilibrium output falls short of potential GDP the difference is a recessionary gap, and when it exceeds potential the difference is an inflationary gap. A recessionary gap means unemployment above the natural rate; an inflationary gap means it is below. An inflationary gap is not sustainable, because output above potential relies on overtime and extra shifts that cannot continue.

Spotting which one it is.

MAC 0723 Gap or No Gap?

Compare equilibrium real GDP with potential GDP and name the gap, then check that the labor market agrees. Output below potential is a recessionary gap, and unemployment should be above the natural rate. Output above potential is an inflationary gap, and unemployment should be below it. Output at potential is neither. The two readings always match, because employment and output move together, so a question giving you one lets you state the other. Potential GDP of twenty trillion with equilibrium output of nineteen is a recessionary gap of one trillion; equilibrium of twenty point five against the same potential is an inflationary gap of half a trillion that cannot last. The word inflationary describes pressure, not a measured inflation rate: an economy can have an inflationary gap while reported inflation is still low.

Three entries on what happens if nothing is done, whether to wait, and the two directions policy can push.

What happens if nothing is done.

MAC 0724 Self-Correction

Gaps close on their own eventually. In a recessionary gap wages fall, so short-run supply shifts right until output returns to potential, and an inflationary gap works in reverse. The mechanism is the labor market: the real wage returns toward natural employment. Eventually is doing heavy work there, and unit ten takes the sequence apart step by step.

Whether to wait.

MAC 0725 Nonintervention or Stabilization

Faced with a gap there are two choices. Nonintervention lets the economy correct itself; stabilization policy acts to close the gap sooner. Both are policies, and choosing to wait is a choice. The case for acting is that self-correction is slow and the unemployment real; the case for waiting is that policy arrives late and may push the wrong way.

The two directions policy pushes.

MAC 0726 Expansionary and Contractionary Policy

Expansionary policy raises real GDP by shifting aggregate demand right; contractionary policy lowers it by shifting aggregate demand left. Higher government purchases or a tax cut expand, and the reverse contracts. Expansionary policy closes a recessionary gap at the cost of a higher price level, and contractionary policy closes an inflationary gap at the cost of lower output on the way.

Two entries to close the unit: the two kinds of inflation drawn in the model, and one shock read two ways.

The two ways prices rise.

MAC 0727 Demand-Pull and Cost-Push in the Diagram

Here the unit's governing idea is at work. Unit six named two kinds of inflation; this diagram shows them, and shows why the distinction decides what should be done. Demand-pull inflation is aggregate demand shifting right while the economy is at or near potential, in the steep zone. There is little spare capacity, so the extra spending cannot call out much extra output and mostly raises the price level instead: output rises a little, the price level rises a lot, and unemployment falls below the natural rate. Cost-push inflation is short-run supply shifting left because input prices rose across the economy, so the price level rises while output falls and unemployment rises with it. The two are told apart by what happened to output, and they are told apart for a reason: the policies that help one make the other worse. An economy already at potential that receives a large increase in spending should have demand damped back down, which costs little output because there was little extra output to begin with. The same economy suffering a tripling of energy prices is different: damping demand would lower prices but deepen the fall in output, while supporting demand would hold output up but push prices higher still. There is no move that improves both, which is what made the nineteen seventies so hard. Three cautions. A single shift of either curve raises the price level once and then stops, so it is a one-time rise rather than ongoing inflation; sustained inflation needs demand shifting right repeatedly, or expectations that keep feeding into wages and prices. The diagram cannot say which shift caused an episode when both happen together, which is usually what happens. And the labels describe the mechanism, not the blame.

One shock, read two ways.

MAC 0728 One Shock, Two Stories

The most useful thing this model does is force a single event 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, while supply chains and ports stopped clearing. Short-run 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 needing people close together stopped altogether, and households facing uncertainty saved instead. 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. 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, and both together make output fall hard while the price level moves whichever way the larger shift pushes it — or barely moves at all if the two are close in size. That is why the same downturn shows falling prices in some sectors and rising prices in others, and why an aggregate index can look almost still while the economy underneath is anything but. Three cautions carry forward. When both curves move, one of output and the price level may be determinate while the other is not, exactly as in unit two, and claiming certainty about the indeterminate one is the error. The model gives directions and not magnitudes. And the diagnosis decides the policy: a demand shock calls for supporting demand and a supply shock does not, so a wrong reading prescribes a remedy that makes one of the two problems worse.

Look at what you can now do. You can name the zone by comparing output with potential, and say whether extra demand there would buy output or only prices. You can name a gap and confirm it against unemployment, since the two readings always agree. You can say what closes a gap if nothing is done, through wages and the real wage, and why choosing to wait is itself a policy. You can draw both kinds of inflation in the model, and say why the remedy for one worsens the other. And you can trace a single shock through both curves, and say which of output and the price level is determinate. Unit nine turns to the model Keynes built for the short run.