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207

In the lower-middle panel, the aggregate demand curve D1D1 is at just the right level to produce an equilibrium at potential GDP. Neither an inflationary gap nor a recessionary gap occurs, as in the diagram just above it.

It may seem, therefore, that we have simply restated our previous conclusions. But, in fact, we have done much more. For now that we have studied the determination of the equilibrium price level, we are able to examine how the economy adjusts to either a recessionary gap or an inflationary gap. Specifically, because wages are fixed in the short run, any one of the three cases depicted in Figure 5 can occur. But, in the long run, wages will adjust to labor market conditions, which will shift the aggregate supply curve. It is to that adjustment that we now turn.

ADJUSTING TO A RECESSIONARY GAP:

DEFLATION OR UNEMPLOYMENT?

Suppose the economy starts with a recessionary gap—that is, an equilibrium below poten-

tial GDP—as depicted in the lower-left panel of Figure 5. Such a situation might be

caused, for example, by inadequate consumer spending or by anemic investment spend-

ing. After the financial crisis (which was centered on the home mortgage market) hit in

2007, many observers began to fear that the United States was headed in that direction for

the first time in years. And these fears mounted in early 2008. But in Japan, recessionary

gaps have been the norm since the early 1990s. What happens when an economy experi-

ences such a recessionary gap?

With equilibrium GDP below potential (point E in Figure 6), jobs will be difficult to find. The

ranks of the unemployed will exceed the number of people who are jobless because of mov-

ing, changing occupations, and so on. In the terminology of Chapter 6, the economy will expe-

rience a considerable amount of cyclical unemployment. Businesses, by contrast, will have little

trouble finding workers, and their current employees will be eager to hang on to their jobs.

Such an environment makes it difficult for workers to win wage increases. Indeed, in

extreme situations, wages may even fall—thereby shifting the aggregate supply curve out-

ward. (Remember: An aggregate supply curve is drawn for a given nominal wage.) But

as the aggregate supply curve shifts to the right—eventually moving from S0S0 to S1S1 in

FIGURE 6

Figure 6—prices decline and the recessionary gap shrinks. By this process, deflation grad-

ually erodes the recessionary gap—leading eventually to an equilibrium at potential GDP

The Elimination of a

(point F in Figure 6).

Recessionary Gap

But there is an important catch. In our modern econ-

omy, this adjustment process proceeds slowly—painfully

Potential

slowly. Our brief review of the historical record in Chap-

GDP

ter 5 showed that the history of the United States in-

cludes several examples of deflation before World War II

S

0

but none since then. Not even severe recessions have

S

1

forced average prices and wages down—although they

)

have certainly slowed their rates of increase to a crawl.

P

(

D

The only protracted episode of deflation in an advanced

Level

economy since the 1930s is the experience of Japan over

Price

E

B

roughly the last decade, and even there the rate of defla-

100

tion has been quite mild.

Recessionary

F

gap

Why Nominal Wages and Prices

S0

D

Won’t Fall (Easily)

S1

Exactly why wages and prices rarely fall in a modern econ-

5,000

6,000

omy is still a subject of intense debate among economists.

Real

GDP (Y )

Some economists emphasize institutional factors such

as minimum wage laws, union contracts, and a variety of

NOTE: Amounts are in billions of dollars per year.

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government regulations that place legal floors under particular wages and prices. Because most of these institutions are of recent vintage, this theory successfully explains why wages and prices fall less frequently now than they did before World War II. But only a small minority of the U.S. economy is subject to legal restraints on wage and price cutting. So it seems doubtful that legal restrictions take us very far in explaining sluggish wage-price adjustments in the United States. In Europe, however, these institutional factors may be more important.

Other observers suggest that workers have a profound psychological resistance to accepting a wage reduction. This theory has roots in psychological research that finds people to be far more aggrieved when they suffer an absolute loss (e.g., a nominal wage reduction) than when they receive only a small gain. So, for example, business may find it relatively easy to cut the rate of wage increase from 3 percent to 1 percent, but excruciatingly hard to cut it from 1 percent to minus 1 percent. This psychological theory has the ring of truth. Think how you might react if your boss announced he was cutting your hourly wage rate. You might quit, or you might devote less care to your job. If the boss suspects you will react this way, he may be reluctant to cut your wage. Nowadays, genuine wage reductions are rare enough to be newsworthy. But although no one doubts that wage cuts can damage morale, the psychological theory still must explain why the resistance to wage cuts apparently started only after World War II.

A third explanation is based on a fact we emphasized in Chapter 5—that business cycles have been less severe in the postwar period than they were in the prewar period. As workers and firms came to realize that recessions would not turn into depressions, the argument goes, they decided to wait out the bad times rather than accept wage or price reductions that they would later regret.

Yet another theory is based on the old adage, “You get what you pay for.” The idea is that workers differ in productivity but that the productivities of individual employees are difficult to identify. Firms therefore worry that they will lose their best employees if they reduce wages—because these workers have the best opportunities elsewhere in the economy. Rather than take this chance, the argument goes, firms prefer to maintain high wages even in recessions.

Other theories also have been proposed, none of which commands a clear majority of professional opinion. But regardless of the cause, we may as well accept it as a wellestablished fact that wages fall only sluggishly, if at all, when demand is weak.

The implications of this rigidity are quite serious, for a recessionary gap cannot cure itself without some deflation. And if wages and prices will not fall, recessionary gaps like EB in Figure 6 will linger for a long time. That is,

When aggregate demand is low, the economy may get stuck with a recessionary gap for a long time. If wages and prices fall very slowly, the economy will endure a prolonged period of production below potential GDP.

Does the Economy Have a Self-Correcting Mechanism?

Now a situation like that described earlier would, presumably, not last forever. As the recession lengthened and perhaps deepened, more and more workers would be unable to find jobs at the prevailing “high” wages. Eventually, their need to be employed would overwhelm their resistance to wage cuts. Firms, too, would become increasingly willing to cut prices as the period of weak demand persisted and managers became convinced that the slump was not merely a temporary aberration. Prices and wages did, in fact, fall in many countries during the Great Depression of the 1930s, and they have fallen in Japan for about a decade, albeit very slowly.

Thus, starting from any recessionary gap, the economy will eventually return to potential GDP—following a path something like the brick-colored arrow from E to F in Figure 6 on the previous page. For this reason, some economists think of the vertical line at potential GDP as representing the economy’s long-run aggregate supply curve. But this “long run” might be long indeed.

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209

Nowadays, political leaders of both parties—and in virtually all countries—believe that it is folly to wait for falling wages and prices to eliminate a recessionary gap. They agree that government action is both necessary and appropriate under recessionary conditions. Nevertheless, vocal—and highly partisan—debate continues over how much and what kind of intervention is warranted. One reason for the disagreement is that the self-correcting mechanism does operate—if only weakly—to cure recessionary gaps.

An Example from Recent History: Deflation in Japan

Fortunately for us, recent U.S. history offers no examples of long-lasting recessionary gaps. But the world’s second-largest economy does. The Japanese economy has been weak for most of the period since the early 1990s—including several recessions. As a result, Japan has experienced persistent recessionary gaps for 15 years or so. Unsurprisingly, Japan’s modest inflation rate of the early 1990s evaporated and, from 1999 through 2005, turned into a small deflation rate. Qualitatively, this is just the sort of behavior the theoretical model of the self-correcting mechanism predicts. But it took a long time! Hence, the practical policy question is: How long can a country afford to wait?

The economy’s selfcorrecting mechanism refers to the way money wages react to either a recessionary gap or an inflationary gap. Wage changes shift the aggregate supply curve and therefore change equilibrium GDP and the equilibrium price level.

ADJUSTING TO AN INFLATIONARY GAP: INFLATION

Let us now turn to what happens when the economy finds itself beyond full employ-

ment—that is, with an inflationary gap like that shown in Figure 7. When the aggregate

supply curve is S0S0 and the aggregate demand curve is DD, the economy will initially

reach equilibrium (point E) with an inflationary gap, shown by the segment BE.

According to some economists, a situation like this arose in the United States in 2006

and 2007 when the unemployment rate dipped below 5 percent. What should happen un-

der such circumstances? As we shall see now, the tight labor market should produce an

inflation that eventually eliminates the inflationary gap, although perhaps in a slow and

painful way. Let us see how.

When equilibrium GDP exceeds potential GDP, jobs are plentiful and labor is in great

demand. Firms are likely to have trouble recruiting new workers or even holding onto

their old ones as other firms try to lure workers away with higher wages.

Rising nominal wages add to business costs, which shift the aggregate supply curve to

FIGURE 7

the left. As the aggregate supply curve moves from S0S0 to S1S1

in Figure 7, the inflation-

The Elimination of an

Inflationary Gap

ary gap shrinks. In other words, inflation eventually

erodes the inflationary gap and brings the economy to an

equilibrium at potential GDP (point F).

There is a straightforward way of looking at the eco-

Potential

nomics underlying this process. Inflation arises because

GDP

S1

buyers are demanding more output than the economy can

produce at normal operating rates. To paraphrase an old

D

S0

cliché, there is too much demand chasing too little supply.

(P )

Such an environment encourages price hikes.

Ultimately, rising prices eat away at the purchasing

Level

F

power of consumers’ wealth, forcing them to cut back on

Price

E

consumption, as explained in Chapter 8. In addition, ex-

B

ports fall and imports rise, as we learned in Chapter 9.

Eventually, aggregate quantity demanded is scaled back to

S1

the economy’s capacity to produce—graphically, the econ-

D

omy moves back along curve DD from point E to point F.

Inflationary

S

0

gap

At this point the self-correcting process stops. In brief:

If aggregate demand is exceptionally high, the economy

Real

GDP

(Y )

may reach a short-run equilibrium above full employment

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Stagflation is inflation that occurs while the economy is growing slowly or having a recession.

(an inflationary gap). When this occurs, the tight situation in the labor market soon forces nominal wages to rise. Because rising wages increase business costs, prices increase; there is inflation. As higher prices cut into consumer purchasing power and net exports, the inflationary gap begins to close.

As the inflationary gap closes, output falls and prices continue to rise. When the gap is finally eliminated, a long-run equilibrium is established with a higher price level and with GDP equal to potential GDP.

This scenario is precisely what some economists believe happened in 2006 and 2007. Because they believed that the U.S. economy had a small inflationary gap in 2006 and 2007, they expected inflation to rise slightly—which it did, before receding again. But remember once again that the self-correcting mechanism takes time because wages and prices do not adjust quickly. Thus, while an inflationary gap sows the seeds of its own destruction, the seeds germinate slowly. So, once again, policy makers may want to speed up the process.

Demand Inflation and Stagflation

Simple as it is, this model of how the economy adjusts to an inflationary gap teaches us a number of important lessons about inflation in the real world. First, Figure 7 reminds us that the real culprit is an excess of aggregate demand relative to potential GDP. The aggregate demand curve is initially so high that it intersects the aggregate supply curve beyond full employment. The resulting intense demand for goods and labor pushes prices and wages higher. Although aggregate demand in excess of potential GDP is not the only possible cause of inflation, it certainly is the cause in our example.

Nonetheless, business managers and journalists may blame inflation on rising wages. In a superficial sense, of course, they are right, because higher wages do indeed lead firms to raise product prices. But in a deeper sense they are wrong. Both rising wages and rising prices are symptoms of the same underlying malady: too much aggregate demand. Blaming labor for inflation in such a case is a bit like blaming high doctor bills for making you ill.

Second, notice that output falls while prices rise as the economy adjusts from point E to point F in Figure 7. This is our first (but not our last) explanation of the phenomenon of stagflation—the conjunction of inflation and economic stagnation. Specifically:

A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand.

It is easy to understand why. When aggregate demand is excessive, the economy will temporarily produce beyond its normal capacity. Labor markets tighten and wages rise. Machinery and raw materials may also become scarce and so start rising in price. Faced with higher costs, business firms quite naturally react by producing less and charging higher prices. That is stagflation.

A U.S. Example

The stagflation that follows a period of excessive aggregate demand is, you will note, a rather benign form of the dreaded disease. After all, while output is falling, it nonetheless remains above potential GDP, and unemployment is low. The U.S. economy last experienced such an episode at the end of the 1980s.

The long economic expansion of the 1980s brought the unemployment rate down to a 15-year low of 5 percent by March 1989. Almost all economists believed at the time that 5 percent was below the full-employment unemployment rate, that is, that the U.S. economy had an inflationary gap. As the theory suggests, inflation began to accelerate—from 4.4 percent in 1988 to 4.6 percent in 1989 and then to 6.1 percent in 1990.

In the meantime, the economy was stagnating. Real GDP growth fell from 3.5 percent during 1989 to 1.8 percent in 1990 and down to 20.5 percent in 1991. Inflation was eating away at the inflationary gap, which had virtually disappeared by mid-1990, when the

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211

A Tale of Two Graduating Classes: 2003 Versus 2007

Timing matters in life. The college graduates of 2007 were pretty fortunate. The unemployment rate was a low 4.5 percent in May and June of that year—close to its lowest level in a generation. With employers on the prowl for new hires, starting salaries rose and many graduating seniors had numerous job offers.

Things were not nearly that good for the Class of 2003 when it hit the job market four years earlier. The U.S. economy had been sluggish for a while, and job offers were relatively scarce. The unemployment rate in May–June 2003 averaged 6.2 percent. Many companies were less than eager to hire more workers, salary increases were modest, and “perks” were being trimmed.

This accident of birth meant that the college grads of 2003 started their working careers in a less advantageous position than their more fortunate brothers and sisters four years later. What’s more, recent research suggests that the initial job market advantage of the Class of 2007, compared to the Class of 2003, is likely to be maintained for many years.

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recession started. Yet inflation remained high through the early months of the recession. The U.S. economy was in a stagflation phase.

Our overall conclusion about the economy’s ability to right itself seems to run something like this:

The economy does, indeed, have a self-correcting mechanism that tends to eliminate either unemployment or inflation. But this mechanism works slowly and unevenly. In addition, its beneficial effects on either inflation or unemployment are sometimes swamped by strong forces pushing in the opposite direction (such as rapid increases or decreases in aggregate demand). Thus, the self-correcting mechanism is not always reliable.

STAGFLATION FROM A SUPPLY SHOCK

We have just discussed the type of stagflation that follows in the wake of an inflationary boom. However, that is not what happened when unemployment and inflation both soared in the 1970s and early 1980s. What caused this more virulent strain of stagflation? Several things, though the principal culprit was rising energy prices.

In 1973, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of crude oil. American consumers soon found the prices of gasoline and home heating fuels increasing sharply, and U.S. businesses saw an important cost of doing business— energy prices—rising drastically. OPEC struck again in the period 1979–1980, this time doubling the price of oil. Then the same thing happened again, albeit on a smaller scale, when Iraq invaded Kuwait in 1990. Most recently, oil prices have been on an irregular upward climb since 2002 because of the Iraq war, other political issues in the Middle East and elsewhere, problems with refining capacity, and surging energy demand from China.

Higher energy prices, we observed earlier, shift the economy’s aggregate supply curve inward in the manner shown in Figure 8 on the next page. If the aggregate supply curve shifts inward, as it surely did following each of these “oil shocks,” production will decline. To reduce demand to the available supply, prices will have to rise. The result is the worst of both worlds: falling production and rising prices.

This conclusion is displayed graphically in Figure 8, which shows an aggregate demand curve, DD, and two aggregate supply curves. When the supply curve shifts inward, the economy’s equilibrium shifts from point E to point A. Thus, output falls while prices

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FIGURE 8

Stagflation from an Adverse Shift in Aggregate Supply

Level = 100)		S1
	D	S
		0
	A
Price (2000
	36.0
	31.8	E
		D
	S1
	S0
	4,275	4,342
	Real GDP

NOTE: Amounts are in billions of dollars per year.

rise, which is precisely our definition of stagflation. In sum:

Stagflation is the typical result of adverse shifts of the aggregate supply curve.

The numbers used in Figure 8 are meant to indicate what the big energy shock in late 1973 might have done to the U.S. economy. Between 1973 (represented by supply curve S0S0 and point E) and 1975 (represented by supply curve S1S1 and point A), it shows real GDP falling by about 1.5 percent, while the price level rises more than 13 percent over the two years. The general lesson to be learned from the U.S. experience with supply shocks is both clear and important:

The typical results of an adverse supply shock are lower output and higher inflation. This is one reason why the world economy was plagued by stagflation in the mid-1970s and early 1980s. And it can happen again if another series of supply-reducing events takes place.

APPLYING THE MODEL TO A GROWING ECONOMY

You may have noticed that ever since Chapter 5 we have been using the simple aggregate supply and aggregate demand model to determine the equilibrium price level and the equilibrium level of real GDP, as depicted in several graphs in this chapter. But in the real world, neither the price level nor real GDP remains constant for long. Instead, both normally rise from one year to the next.

The growth process is illustrated in Figure 9, which is a scatter diagram of the U.S. price level and the level of real GDP for every year from 1972 to 2007. The labeled points show the clear upward march of the economy through time—toward higher prices and higher levels of output.

Why Was There No Stagflation in 2006–2008?

As noted earlier, oil prices have climbed steeply, if irregularly, since early 2002. Yet this succession of “oil shocks” seems not to have caused much, if any, stagflation in the United States or in other industrial economies. This recent experience stands in sharp contrast to the 1970s and early 1980s. What has been different this time around?

In truth, economists do not have a complete answer to this question, and research on it continues. But we do understand a few things. Most straightforwardly, the world has learned to live with less energy (relative to GDP). In the United States and many other countries, for example, the energy content of $1 worth of GDP is now only about half of what it was in the 1970s. That alone cuts the impact of an oil shock in half.

In addition, for reasons that are not entirely understood, the United States and other economies seem to have become less volatile since the mid-1980s. Sound macroeconomic policies have probably contributed to the reduction in volatility, and so have a variety of structural changes that have made these economies more flexible. But in the view of most researchers who have studied the

question, part of the story is plain old good luck. Naturally, we cannot expect good luck to continue forever.

Finally, it can be argued that we DID have a little bit of stagflation. In late 2007 and early 2008, growth slowed sharply and inflation rose.

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213

																				2007
		120																		2005
		110																	2003	2006
												D		S				2001		2004
		100														1997	1999		2002
															1995			2000
)
																	1998
LEVEL (GDP DEFLATOR		90										1992				1996
															1994
											1991
	(2000 = 100)	80							S		1989		S 1993		D
							D
									1987			1990
		70						1985			1988
						1983
									1986
				1982
							S	1984			D
		60
							1981
				1980
PRICE
		50		1978		1979
			1976
		40
			1975		1977
				1974
		30		1973
			1972
		20
			4,000	4,500	5,000		5,500		6,000	6,500		7,000	7,500		8,000	8,500	9,000	9,500 10,000 10,500 11,000 11,500 12,000
											REAL GDP IN BILLIONS OF 2000 DOLLARS

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

FIGURE 9

The Price Level and

Real GDP Output in

This upward trend is hardly mysterious, for both the aggregate demand curve and the

the United States,

aggregate supply curve normally shift to the right each year. Aggregate supply grows be-

1972–2007

cause more workers join the workforce each year and because investment and technology

improve productivity (Chapter 7). Aggregate demand grows because a growing popula-

tion generates more demand for both consumer and investment goods and because the

government increases its purchases (Chapters 8 and 9). We can think of each point in Fig-

ure 9 as the intersection of an aggregate supply curve and an aggregate demand curve for

that particular year. To help you visualize this idea, the curves for 1984 and 1993 are

sketched in the diagram.

Figure 10 is a more realistic version of the aggregate supply-and-demand diagram that

illustrates how our theoretical model applies to a growing economy. We have chosen the

numbers so that the black curves D0D0 and S0S0 roughly represent the year 2005, and the

FIGURE 10

brick-colored curves D1D1 and S1S1 roughly represent 2006—except that we use nice round

Aggregate Supply and

numbers to facilitate computations. Thus, the equilibrium in 2005 was at point A, with a

Demand Analysis of a

real GDP of $11,000 billion (in 2000 dol-

Growing Economy

lars) and a price level of 113. A year later,

D1

S0

the equilibrium was at point B, with real

S1

GDP at $11,330 billion and the price level

at 116.5. The blue arrow in the diagram

shows how equilibrium moved from

D

0

B

2005 to 2006. It points upward and to the

116.5

right, meaning that both prices and out-

put increased. In this case, the economy

EVELP)(

100)=

A

grew by 3 percent and prices also rose

113

D1

about 3 percent, which is close to what

ICEL

(2000

actually happened in the United States

PR

S

over that year.

0

S

1

Demand-Side Fluctuations

D0

Let us now use our theoretical model to

11,000

11,330

R

EAL GDP

(

Y )

IN

B

ILLIONS

OF

2000 DOLLAR

S

rewrite history. Suppose that aggregate

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		D2
		S0
		S1
		C
	120
PriceLevel (P )		D2
	D0
	A
	100)(2000=
	113
	S0
	S1
		D0
	11,000	11,500
	Real GDP (Y ) in Billions of 2000 Dollars

FIGURE 11

demand grew faster than it actually did between 2005 and 2006. What difference would this have made to the performance of the U.S. economy? Figure 11 provides answers. Here the black demand curve D0D0 is exactly the same as in the previous diagram, as are the two supply curves, indicating a given rate of aggregate supply growth. But the brick-colored demand curve D2D2 lies farther to the right than the demand curve D1D1 in Figure 10. Equilibrium is at point A in 2005 and point C in 2006. Comparing point C in Figure 11 with point B in Figure 10, you can see that both output and prices would have increased more over the year—that is, the economy would have experienced faster growth and more inflation. This is generally what happens when the growth rate of aggregate demand speeds up.

	The Effects of Faster	For any given growth rate of aggregate supply, a faster growth rate of aggregate demand
	Growth of Aggregate
		will lead to more inflation and faster growth of real output.
	Demand

Figure 12 illustrates the opposite case. Here we imagine that the aggregate demand curve shifted out less than in Figure 10. That is, the brick-colored demand curve D3D3 in Figure 12 lies to the left of the demand curve D1D1 in Figure 10. The consequence, we see, is that the shift of the economy’s equilibrium from 2005 to 2006 (from point A to point E) would have entailed less inflation and slower growth of real output than actually took place. Again, that is generally the case when aggregate demand grows more slowly.

For any given growth rate of aggregate supply, a slower growth rate of aggregate demand will lead to less inflation and slower growth of real output.

Putting these two findings together gives us a clear prediction:

		If fluctuations in the economy’s real growth rate from year to year arise primarily from
	FIGURE 12	variations in the rate at which aggregate demand increases, then the data should show
		the most rapid inflation occurring when output grows most rapidly and the slowest
	The Effects of Slower
		inflation occurring when output grows most slowly.
	Growth of Aggregate
	Demand			Is it true? For the most part, yes. Our
				brief review of U.S. economic history
				back in Chapter 5 found that most
	D3		S0	episodes of high inflation came with
				rapid growth. But not all. Some surges
			S1
				of inflation resulted from the kinds of
	D0			supply shocks we have considered in
	LevelPrice(P ) =(2000100)			this chapter.
		A	E
	115
	113			Supply-Side Fluctuations
	S0		D3	As an historical example, let’s return to
				the events of 1973 to 1975 that were
	S1
				depicted in Figure 8 (page 212). But
			D0	now let’s add in something we ignored
		11,000	11,165	there: While the aggregate supply curve
				was shifting inward because of the
		Real GDP (Y ) in Billions of 2000 Dollars
				oil shock, the aggregate demand was

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215

shifting outward. In Figure 13, the

black

aggregate demand

curve

D

0

D

0

and aggregate supply curve

S1

S0S0 represent the economic situa-

D1

tion in 1973. Equilibrium was at

B

point E, with a price level of 31.8

39

D

S0

(based on 2000 = 100) and real out-

0

D1

put of $4,342 billion. By 1975, the

PriceLevelP)(

(2000100)=

E

aggregate

demand curve

had

31.8

S1

shifted out to the position indi-

D

0

cated by the brick-colored curve

D1D1,

but

the aggregate supply

S

0

curve had shifted inward from S0S0

to the brick-colored curve S1S1. The

equilibrium for 1975 (point B in the

4,311

4,342

figure) therefore wound up to the

Real

GDP

(

Y )

in

Billions

of

2000

Dollars

left of the equilibrium point for

1973 (point E in the figure). Real

output declined slightly (although less than in Figure 8) and prices— led by energy costs—rose rapidly (more than in Figure 8).

What about the opposite case? Suppose the economy experiences a favorable supply shock, as it did in the late 1990s, so that the aggregate supply curve shifts outward at an unusually rapid rate.

Figure 14 depicts the consequences. The aggregate demand curve shifts out from D0D0 to D1D1 as usual, but the aggregate supply curve shifts all the way out to S1S1. (The dotted line indicates what would happen in a “normal” year.) So the economy’s equilibrium winds up at point B rather than at point C. Compared to C, point B represents faster economic growth (B is to the right of C) and lower inflation (B is lower than C). In brief, the economy wins on both fronts: Inflation falls while GDP grows rapidly, as happened in the late 1990s.

Combining these two cases, we conclude that

If fluctuations in economic activity emanate mainly from the supply side, higher rates of inflation will be associated with lower rates of economic growth.

		D1		S0	Nor mal growth
					of aggregate supply
	D0				S1
(P )			C
		A
Price Level			B		Effect of favorable
					supply shock
	S	0			D1
		S1		D0
			Real GDP (Y )

FIGURE 13

Stagflation from an Adverse Supply Shock

FIGURE 14

The Effects of a

Favorable Supply Shock

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LICENSED TO:
216	PART 2 The Macroeconomy: Aggregate Supply and Demand
		PUZZLE RESOLVED:		EXPLAINING STAGFLATION

What we have learned in this chapter helps us to understand why the U.S. economy performed so poorly in the 1970s and early 1980s, when both unemployment and inflation rose together. The OPEC cartel first flexed its muscles in 1973–1974, when it quadrupled the price of oil, thereby precipitating the first bout of serious stagflation in the United States and other oil-importing nations. Then OPEC struck again in 1979–1980, this time doubling the price of

oil, and stagflation returned. Unlucky? Yes. But mysterious? No. What was happening was that the economy’s aggregate supply curve was shifted inward by the rising price of energy, rather than moving outward from one year to the next, as it normally does.

Unfavorable supply shocks tend to push unemployment and inflation up at the same time. It was mainly unfavorable supply shocks that accounted for the stunningly poor economic performance of the 1970s ands early 1980s.3

A ROLE FOR STABILIZATION POLICY

Chapter 8 emphasized the volatility of investment spending, and Chapter 9 noted that changes in investment have multiplier effects on aggregate demand. This chapter took the next step by showing how shifts in the aggregate demand curve cause fluctuations in both real GDP and prices—fluctuations that are widely decried as undesirable. It also suggested that the economy’s self-correcting mechanism works, but slowly, thereby leaving room for government stabilization policy to improve the workings of the free market. Can the government really accomplish this goal? If so, how? These are some of the important questions for Part 3.

| SUMMARY |

1.The economy’s aggregate supply curve relates the quantity of goods and services that will be supplied to the price level. It normally slopes upward to the right because the costs of labor and other inputs remain relatively fixed in the short run, meaning that higher selling prices make input costs relatively cheaper and therefore encourage greater production.

2.The position of the aggregate supply curve can be shifted by changes in money wage rates, prices of other inputs, technology, or quantities or qualities of labor and capital.

3.The equilibrium price level and the equilibrium level of real GDP are jointly determined by the intersection of the economy’s aggregate supply and aggregate demand schedules.

4.Among the reasons why the oversimplified multiplier formula is wrong is the fact that it ignores the inflation that is caused by an increase in aggregate demand. Such

3 As we mentioned in the box on page 212, questions have been raised, and only partially answered, about why stagflation did not return in the 2003–2007 period.

inflation decreases the multiplier by reducing both consumer spending and net exports.

5.The equilibrium of aggregate supply and demand can come at full employment, below full employment (a recessionary gap), or above full employment (an inflationary gap).

6.The economy has a self-correcting mechanism that erodes a recessionary gap. Specifically, a weak labor market reduces wage increases and, in extreme cases, may even drive wages down. Lower wages shift the aggregate supply curve outward. But it happens very slowly.

7.If an inflationary gap occurs, the economy has a similar mechanism that erodes the gap through a process of inflation. Unusually strong job prospects push wages up, which shifts the aggregate supply curve to the left and reduces the inflationary gap.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.