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In the previous chapter, we explained the basics of the aggregate demand-aggregate supply model. The driving forces in that model were real shocks (shifts in the long-run aggregate supply curve) and aggregate demand shocks (shifts in the AD curve). In this chapter, we explain in greater detail how economic forces can amplify shocks and transmit them across sectors of the economy and through time. When a shock is amplified, a mild negative shock can be transformed into a more serious reduction in output and a positive shock can be transformed into a boom. In addition, we will show in this chapter how real shocks and aggregate demand shocks can interact—one type of shock can lead to the other, for example.

We focus on five transmission mechanisms: intertemporal substitution, uncertainty and irreversible investments, labor adjustment costs, time bunching, and shocks to collateral and net worth, which we call collateral damage.