A Shift in Aggregate Demand: An Increase in Government Purchases

Suppose an economy is initially in equilibrium at potential output YP as in Figure 7.15 "Long-Run Adjustment to an Inflationary Gap". Because the economy is operating at its potential, the labor market must be in equilibrium; the quantities of labor demanded and supplied are equal.

Figure 7.15 Long-Run Adjustment to an Inflationary Gap

An increase in aggregate demand to AD₂ boosts real GDP to Y₂ and the price level to P₂, creating an inflationary gap of Y₂ − Y_P. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS₂. Real GDP returns to potential.

Now suppose aggregate demand increases because one or more of its components (consumption, investment, government purchases, and net exports) has increased at each price level. For example, suppose government purchases increase. The aggregate demand curve shifts from AD₁ to AD₂ in Figure 7.15 "Long-Run Adjustment to an Inflationary Gap". That will increase real GDP to Y₂ and force the price level up to P₂ in the short run. The higher price level, combined with a fixed nominal wage, results in a lower real wage. Firms employ more workers to supply the increased output.

The economy’s new production level Y₂ exceeds potential output. Employment exceeds its natural level. The economy with output of Y₂ and price level of P₂ is only in short-run equilibrium; there is an inflationary gap equal to the difference between Y₂ and Y_P. Because real GDP is above potential, there will be pressure on prices to rise further.

Ultimately, the nominal wage will rise as workers seek to restore their lost purchasing power. As the nominal wage rises, the short-run aggregate supply curve will begin shifting to the left. It will continue to shift as long as the nominal wage rises, and the nominal wage will rise as long as there is an inflationary gap. These shifts in short-run aggregate supply, however, will reduce real GDP and thus begin to close this gap. When the short-run aggregate supply curve reaches SRAS₂, the economy will have returned to its potential output, and employment will have returned to its natural level. These adjustments will close the inflationary gap.

A Shift in Short-Run Aggregate Supply: An Increase in the Cost of Health Care

Again suppose, with an aggregate demand curve at AD₁ and a short-run aggregate supply at SRAS₁, an economy is initially in equilibrium at its potential output Y_P, at a price level of P₁, as shown in Figure 7.16 "Long-Run Adjustment to a Recessionary Gap". Now suppose that the short-run aggregate supply curve shifts owing to a rise in the cost of health care. As we explained earlier, because health insurance premiums are paid primarily by firms for their workers, an increase in premiums raises the cost of production and causes a reduction in the short-run aggregate supply curve from SRAS₁ to SRAS₂.

Figure 7.16 Long-Run Adjustment to a Recessionary Gap

A decrease in aggregate supply from SRAS₁ to SRAS₂ reduces real GDP to Y₂ and raises the price level to P₂, creating a recessionary gap of Y_P − Y₂. In the long run, as prices and nominal wages decrease, the short-run aggregate supply curve moves back to SRAS₁ and real GDP returns to potential.

As a result, the price level rises to P₂ and real GDP falls to Y₂. The economy now has a recessionary gap equal to the difference between Y_P and Y₂. Notice that this situation is particularly disagreeable, because both unemployment and the price level rose.

With real GDP below potential, though, there will eventually be pressure on the price level to fall. Increased unemployment also puts pressure on nominal wages to fall. In the long run, the short-run aggregate supply curve shifts back to SRAS₁. In this case, real GDP returns to potential at Y_P, the price level falls back to P₁, and employment returns to its natural level. These adjustments will close the recessionary gap.

How sticky prices and nominal wages are will determine the time it takes for the economy to return to potential. People often expect the government or the central bank to respond in some way to try to close gaps. This issue is addressed next.

Nonintervention or Expansionary Policy?

Figure 7.17 "Alternatives in Closing a Recessionary Gap" illustrates the alternatives for closing a recessionary gap. In both panels, the economy starts with a real GDP of Y₁ and a price level of P₁. There is a recessionary gap equal to Y_P − Y₁. In Panel (a), the economy closes the gap through a process of self-correction. Real and nominal wages will fall as long as employment remains below the natural level. Lower nominal wages shift the short-run aggregate supply curve. The process is a gradual one, however, given the stickiness of nominal wages, but after a series of shifts in the short-run aggregate supply curve, the economy moves toward equilibrium at a price level of P₂ and its potential output of Y_P.

Figure 7.17 Alternatives in Closing a Recessionary Gap

Panel (a) illustrates a gradual closing of a recessionary gap. Under a nonintervention policy, short-run aggregate supply shifts from SRAS₁ to SRAS₂. Panel (b) shows the effects of expansionary policy acting on aggregate demand to close the gap.

Panel (b) illustrates the stabilization alternative. Faced with an economy operating below its potential, public officials act to stimulate aggregate demand. For example, the government can increase government purchases of goods and services or cut taxes. Tax cuts leave people with more after-tax income to spend, boost their consumption, and increase aggregate demand. As AD₁ shifts to AD₂ in Panel (b) of Figure 7.17 "Alternatives in Closing a Recessionary Gap", the economy achieves output of YP, but at a higher price level, P₃. A stabilization policy designed to increase real GDP is known as an expansionary policyA stabilization policy designed to increase real GDP..

Nonintervention or Contractionary Policy?

Figure 7.18 "Alternatives in Closing an Inflationary Gap" illustrates the alternatives for closing an inflationary gap. Employment in an economy with an inflationary gap exceeds its natural level—the quantity of labor demanded exceeds the long-run supply of labor. A nonintervention policy would rely on nominal wages to rise in response to the shortage of labor. As nominal wages rise, the short-run aggregate supply curve begins to shift, as shown in Panel (a), bringing the economy to its potential output when it reaches SRAS₂ and P₂.

Figure 7.18 Alternatives in Closing an Inflationary Gap

Panel (a) illustrates a gradual closing of an inflationary gap. Under a nonintervention policy, short-run aggregate supply shifts from SRAS₁ to SRAS₂. Panel (b) shows the effects of contractionary policy to reduce aggregate demand from AD₁ to AD₂ in order to close the gap.

A stabilization policy that reduces the level of GDP is a contractionary policyA stabilization policy designed to reduce real GDP.. Such a policy would aim at shifting the aggregate demand curve from AD₁ to AD₂ to close the gap, as shown in Panel (b). A policy to shift the aggregate demand curve to the left would return real GDP to its potential at a price level of P₃.

For both kinds of gaps, a combination of letting market forces in the economy close part of the gap and of using stabilization policy to close the rest of the gap is also an option. Later chapters will explain stabilization policies in more detail, but there are essentially two types of stabilization policy: fiscal policy and monetary policy. Fiscal policyThe use of government purchases, transfer payments, and taxes to influence the level of economic activity. is the use of government purchases, transfer payments, and taxes to influence the level of economic activity. Monetary policyThe use of central bank policies to influence the level of economic activity. is the use of central bank policies to influence the level of economic activity.

To Intervene or Not to Intervene: An Introduction to the Controversy

How large are inflationary and recessionary gaps? Panel (a) of Figure 7.19 "Real GDP and Potential Output" shows potential output versus the actual level of real GDP in the United States since 1960. Real GDP appears to follow potential output quite closely, although you see some periods where there have been inflationary or recessionary gaps. Panel (b) shows the sizes of these gaps expressed as percentages of potential output. The percentage gap is positive during periods of inflationary gaps and negative during periods of recessionary gaps. The economy seldom departs by more than 5% from its potential output.

Figure 7.19 Real GDP and Potential Output

Panel (a) shows potential output (the blue line) and actual real GDP (the purple line) since 1960. Panel (b) shows the gap between potential and actual real GDP expressed as a percentage of potential output. Inflationary gaps are shown in green and recessionary gaps are shown in yellow.

Source: Bureau of Economic Analysis, NIPA Table 1.1.6. Real Gross Domestic Product, Chained Dollars [Billions of chained (2000) dollars]. Seasonally adjusted at annual rates 2008 is through 3rd quarter; Congressional Budget Office, The Budget and Economic Outlook, September 9, 2008.

Panel (a) gives a long-run perspective on the economy. It suggests that the economy generally operates at about potential output. In Panel (a), the gaps seem minor. Panel (b) gives a short-run perspective; the view it gives emphasizes the gaps. Both of these perspectives are important. While it is reassuring to see that the economy is often close to potential, the years in which there are substantial gaps have real effects: Inflation or unemployment can harm people.

Some economists argue that stabilization policy can and should be used when recessionary or inflationary gaps exist. Others urge reliance on the economy’s own ability to correct itself. They sometimes argue that the tools available to the public sector to influence aggregate demand are not likely to shift the curve, or they argue that the tools would shift the curve in a way that could do more harm than good.

Economists who advocate stabilization policies argue that prices are sufficiently sticky that the economy’s own adjustment to its potential will be a slow process—and a painful one. For an economy with a recessionary gap, unacceptably high levels of unemployment will persist for too long a time. For an economy with an inflationary gap, the increased prices that occur as the short-run aggregate supply curve shifts upward impose too high an inflation rate in the short run. These economists believe it is far preferable to use stabilization policy to shift the aggregate demand curve in an effort to shorten the time the economy is subject to a gap.

Economists who favor a nonintervention approach accept the notion that stabilization policy can shift the aggregate demand curve. They argue, however, that such efforts are not nearly as simple in the real world as they may appear on paper. For example, policies to change real GDP may not affect the economy for months or even years. By the time the impact of the stabilization policy occurs, the state of the economy might have changed. Policy makers might choose an expansionary policy when a contractionary one is needed or vice versa. Other economists who favor nonintervention also question how sticky prices really are and if gaps even exist.

The debate over how policy makers should respond to recessionary and inflationary gaps is an ongoing one. These issues of nonintervention versus stabilization policies lie at the heart of the macroeconomic policy debate. We will return to them as we continue our analysis of the determination of output and the price level.

Case in Point: Survey of Economists Reveals Little Consensus on Macroeconomic Policy Issues

Figure 7.20

“An economy in short-run equilibrium at a real GDP below potential GDP has a self-correcting mechanism that will eventually return it to potential real GDP.”

Of economists surveyed, 36% disagreed, 33% agreed with provisos, 25% agreed, and 5% did not respond. So, only about 60% of economists responding to the survey agreed that the economy would adjust on its own.

“Changes in aggregate demand affect real GDP in the short run but not in the long run.”

On this statement, 36% disagreed, 31% agreed with provisos, 29% agreed, and 4% did not respond. Once again, about 60% of economists accepted the conclusion of the aggregate demand–aggregate supply model.

This level of disagreement on macroeconomic policy issues among economists, based on a fall 2000 survey of members of the American Economic Association, stands in sharp contrast to their more harmonious responses to questions on international economics and microeconomics. For example,

“Tariffs and import quotas usually reduce the general welfare of society.”

Seventy-two percent of those surveyed agreed with this statement outright and another 21% agreed with provisos. So, 93% of economists generally agreed with the statement.

“Minimum wages increase unemployment among young and unskilled workers.”

On this, 45% agreed and 29% agreed with provisos.

“Pollution taxes or marketable pollution permits are a more economically efficient approach to pollution control than emission standards.”

On this environmental question, only 6% disagreed and 63% wholeheartedly agreed.

The relatively low degree of consensus on macroeconomic policy issues and the higher degrees of consensus on other economic issues found in this survey concur with results of other periodic surveys since 1976.

So, as textbook authors, we will not hide the dirty laundry from you. Fortunately, though, the model of aggregate demand–aggregate supply we present throughout the macroeconomic chapters can handle most of these disagreements. For example, economists who agree with the first proposition quoted above, that an economy operating below potential has self-correcting mechanisms to bring it back to potential, are probably assuming that wages and prices are not very sticky and hence that the short-run aggregate supply curve will shift rather easily to the right, as shown in Panel (a) of Figure 7.17 "Alternatives in Closing a Recessionary Gap". In contrast, economists who disagree with the statement are saying that the movement of the short-run aggregate supply curve is likely to be slow. This latter group of economists probably advocates expansionary policy as shown in Panel (b) of Figure 7.17 "Alternatives in Closing a Recessionary Gap". Both groups of economists can use the same model and its constructs to analyze the macroeconomy, but they may disagree on such things as the slopes of the various curves, on how fast these various curves shift, and on the size of the underlying multiplier. The model allows economists to speak the same language of analysis even though they disagree on some specifics.

Source: Dan Fuller and Doris Geide-Stevenson, “Consensus on Economic Issues: A Survey of Republicans, Democrats and Economists,” Eastern Economic Journal 33, no. 1 (Winter 2007): 81–94.

Answer to Try It! Problem

To the graph in the previous Try It! problem we add the long-run aggregate supply curve to show that, with output below potential, the U.S. economy in 1933 was in a recessionary gap. The unemployment rate was above the natural rate of unemployment. Indeed, real GDP in 1933 was about 30% below what it had been in 1929, and the unemployment rate had increased from 3% to 25%. Note that during the period of the Great Depression, wages did fall. The notion of nominal wage and other price stickiness discussed in this section should not be construed to mean complete wage and price inflexibility. Rather, during this period, nominal wages and other prices were not flexible enough to restore the economy to the potential level of output. There are two basic choices on how to close recessionary gaps. Nonintervention would mean waiting for wages to fall further. As wages fall, the short-run aggregate supply curve would continue to shift to the right. The alternative would be to use some type of expansionary policy. This would shift the aggregate demand curve to the right. These two options were illustrated in Figure 7.18 "Alternatives in Closing an Inflationary Gap".

Figure 7.21