CFA® Program Curriculum, Volume 2, page 162 Having explained the factors that cause shifts in the aggregate demand and aggregate supply curves, we now turn our attention to the effects of fluctuations in aggregate supply and demand on real GDP and the business cycle. Our starting point is an
economy that is in long-run full-employment equilibrium, as illustrated in Figure 16.10.
Figure 16.10: Long-Run Equilibrium Real Output
First consider a decrease in aggregate demand, which can result from a decrease in the growth rate of the money supply, an increase in taxes, a decrease in government
spending, lower equity and house prices, or a decrease in the expectations of consumers and businesses for future economic growth. As illustrated in Figure 16.11, a decrease in aggregate demand will reduce both real output and the price level in the short run. The new short-run equilibrium output, GDP1, is less than full employment (potential) GDP.
The decrease in aggregate demand has resulted in both lower real output and a lower price level.
Figure 16.11: Adjustment to a Decrease in Aggregate Demand
Because real GDP is less than full employment GDP, we say there is a recessionary gap. A recession is a period of declining GDP and rising unemployment. Classical economists believed that unemployment would drive down wages, as workers compete for available jobs, which in turn would increase SRAS and return the economy to its full employment level of real GDP. Keynesian economists, on the other hand, believe that this might be a slow and economically painful process and that increasing aggregate demand through government action is the preferred alternative. Both expansionary fiscal policy (increasing government spending or decreasing taxes) and expansionary monetary policy (increasing the growth rate of the money supply to reduce interest rates) are methods to increase aggregate demand and return real GDP to its full employment (potential) level.
PROFESSOR’S NOTE
We will describe Classical, Keynesian, and other business cycle theories in the topic review of Understanding Business Cycles.
A second case to consider is an increase in aggregate demand that results in an equilibrium at a level of GDP greater than full-employment GDP in the short run, as illustrated in Figure 16.12. Note that both GDP and the price level are increased. The economy can operate at a level of GDP greater than full-employment GDP in the short run, as workers work overtime and maintenance of productive equipment is delayed, but output greater than full-employment GDP cannot be maintained in the long run. In the long run, the economy always returns to full-employment GDP along the LRAS curve.
Figure 16.12: Adjustment to an Increase in Aggregate Demand
We term the difference between GDP1 and full-employment GDP in Figure 16.12 an inflationary gap because the increase in aggregate demand from its previous level causes upward pressure on the price level. Competition among producers for workers, raw materials, and energy may shift the SRAS curve to the left, returning the economy to full-employment GDP but at a price level that is higher still. Alternatively,
government policy makers can reduce aggregate demand by decreasing government spending, increasing taxes, or slowing the growth rate of the money supply, in order to move the economy back to the initial long run equilibrium at full-employment GDP.
Changes in wages or the prices of other important productive inputs can shift the SRAS curve, affecting real GDP and the price level in the short run. An important case to consider is a decrease in SRAS caused by an increase in the prices of raw materials or energy. As illustrated in Figure 16.13, the new short-run equilibrium is at lower GDP and a higher overall price level for goods and services compared to the initial long-run equilibrium. This combination of declining economic output and higher prices is termed stagflation (stagnant economy with inflation).
Figure 16.13: Stagflation
A subsequent decrease in input prices can return the economy to its long-run
equilibrium output. An increase in aggregate demand from either expansionary fiscal or
monetary policy can also return the economy to its full employment level, but at a price level that is higher still compared to the initial equilibrium.
Stagflation is an especially difficult situation for policy makers because actions to increase aggregate demand to restore full employment will also increase the price level even more. Conversely, a decision by policy makers to fight inflation by decreasing aggregate demand will decrease GDP even further. A decrease in wages and the prices of other productive inputs may be expected to increase SRAS and restore full-
employment equilibrium. However, this process may be quite slow and doing nothing may be a very risky strategy for a government when voters expect action to restore economic growth or stem inflationary pressures.
The fourth case to consider is an increase in SRAS due to a decrease in the price of important productive inputs. As illustrated in Figure 16.14, the resulting new short-run equilibrium is at a level of GDP greater than full-employment GDP and a lower overall price level.
Figure 16.14: Decrease in Input Prices
In Figure 16.15, we present a summary of the short-run effects of shifts in aggregate demand and in aggregate supply on real GDP, unemployment, and the price level.
Figure 16.15: Short-Run Macroeconomic Effects