20: Aggregate Demand and Aggregate Supply

!arrow! What You Will Learn in This Section

  • How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy

  • How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy

  • Why the aggregate supply curve is different in the short run compared to the long run

  • How the AD–AS model is used to analyze economic fluctuations

  • How monetary policy and fiscal policy can stabilize the economy

WHAT KIND OF SHOCK?

The Federal Open Market Committee, which decides whether to pump cash into the economy to fight unemployment or pull cash out of the economy to fight inflation, got its priorities wrong in 2008.

The Federal Open Market Committee, or FOMC, is the branch of the Federal Reserve System that sets U.S. monetary policy and arguably has much more power over the economy than anyone else—including the president. It held one of its regular meetings on September 16, 2008. That was, it turned out, a very important day. Simmering problems in the financial industry had just boiled over with the failure of the investment bank Lehman Brothers, and the U.S. economy, already in recession, was about to go into free fall. Not surprisingly, the officials around the table were worried.

But many committee members, it turns out, were worried about the wrong thing. When the committee released transcripts of its 2008 meetings—which it didn’t do until 2014—we learned that during the summer of 2008 most of the people around the table were much more worried about inflation than they were about the financial crisis or the prospect of a sharp rise in unemployment from a crisis-caused recession—an attitude that persisted into September. In the June and August 2008 meetings the word inflation came up more than ten times as often as the word unemployment. Even in that fateful September meeting, inflation mentions outnumbered unemployment mentions five to one.

Later events showed that this was a case of misplaced priorities, with important consequences. Why? Because the appropriate policy responses to soaring unemployment, on one side, and soaring inflation, on the other, are more or less opposite. If unemployment is the main problem, the Fed should be cutting interest rates in an attempt to boost spending; if inflation is the main problem, the Fed should be raising rates to cool things off. By focusing on inflation, which turned out not to be a problem at all during the fall and summer of 2008, as opposed to unemployment, which was about to skyrocket, the committee was looking for trouble in all the wrong places.

How could the committee have had its priorities so wrong? Well, we know now that the big shock hitting the economy in 2008 was the financial crisis, which in turn led to plunging spending by businesses and consumers. For much of that year, however, the eyes of the Federal Reserve and, to be fair, many other observers were instead focused on a different shock: the soaring price of oil, which had jumped from $60 a barrel in the summer of 2007 to a peak of $145 a barrel in July 2008. And many members of the committee worried more about the effects of oil prices than they did about the gathering financial storm.

As we’ve just suggested, financial crises and soaring oil prices can both create devastating economic problems—but the problems they create are very different, and so is the appropriate policy response. A financial crisis hurts the economy by reducing spending—it’s a demand shock, which raises unemployment while cutting inflation and possibly even leading to deflation, as it did during the worst slump in history, the economy’s plunge from 1929 to 1933. And the appropriate policy in response to such a shock involves propping up spending, among other things by cutting interest rates.

A surge in the price of oil, however, does much of its damage by raising costs and discouraging production; it’s a supply shock. Like negative demand shocks, adverse supply shocks cause the economy to shrink and unemployment to rise. But they also cause inflation—specifically, they cause the unpleasant combination of high inflation and high unemployment known as stagflation, which afflicted the U.S. economy during much of the 1970s (largely thanks to two spikes in the price of oil, in 1973 and again in 1979). And responding to stagflation is tricky: you might want to cut interest rates to defend employment, but on the other hand you might want to raise interest rates to fight inflation.

In the end, what the FOMC did in response to these conflicting stories about what ailed the economy was . . . nothing. It kept interest rates unchanged all through the summer and left them unchanged in September of 2008. Within a few weeks it became clear that demand, not supply, was the serious concern, at which point the Fed began a frantic effort to pull the economy out of its accelerating tailspin. But the perplexity of the Fed in 2008 tells us both that such decisions aren’t always easy to understand and that we need a model of the economy that goes beyond the income–expenditure framework we developed in the last section.

We should mention, by the way, that the Fed’s policy response to the financial crisis was, in the end, a partial success at best. With the Fed‘s help the economy did stabilize over the course of 2009, but the subsequent recovery was painfully slow. Even if the Fed had realized the true danger sooner, the economy probably would have still suffered a lot of damage. But its confusion in 2008 certainly didn’t help.

In this section, we’ll develop a model that goes beyond the income–expenditure model and shows us how to distinguish between different types of short-run economic fluctuations.

To develop this model, we’ll proceed in three steps. First, we’ll develop the concept of aggregate demand. Then we’ll turn to the parallel concept of aggregate supply. Finally, we’ll put them together in the AD–AS model.