Imagine that the economy experiences a negative demand shock, like the one shown in Figure 12-15. As we’ve discussed in this chapter, monetary and fiscal policy shift the aggregate demand curve. If policy makers react quickly to the fall in aggregate demand, they can use monetary or fiscal policy to shift the aggregate demand curve back to the right. And if policy were able to perfectly anticipate shifts of the aggregate demand curve, it could short-circuit the whole process shown in Figure 12-15. Instead of going through a period of low aggregate output and falling prices, the government could manage the economy so that it would stay at E₁.

Why might a policy that short-circuits the adjustment shown in Figure 12-15 and maintains the economy at its original equilibrium be desirable? For two reasons. First, the temporary fall in aggregate output that would happen without policy intervention is a bad thing, particularly because such a decline is associated with high unemployment. Second, as we explained in Chapter 8, price stability is generally regarded as a desirable goal. So preventing deflation—a fall in the aggregate price level—is a good thing.

Does this mean that policy makers should always act to offset declines in aggregate demand? Not necessarily. As we’ll see in later chapters, some policy measures to increase aggregate demand, especially those that increase budget deficits, may have long-term costs in terms of lower long-run growth. Furthermore, in the real world policy makers aren’t perfectly informed, and the effects of their policies aren’t perfectly predictable. This creates the danger that stabilization policy will do more harm than good; that is, attempts to stabilize the economy may end up creating more instability. We’ll describe the long-running debate over macroeconomic policy in Chapter 18. Despite these qualifications, most economists believe that a good case can be made for using macroeconomic policy to offset major negative shocks to the AD curve.

Should policy makers also try to offset positive shocks to aggregate demand? It may not seem obvious that they should. After all, even though inflation may be a bad thing, isn’t more output and lower unemployment a good thing? Not necessarily. Most economists now believe that any short-run gains from an inflationary gap must be paid back later. So policy makers today usually try to offset positive as well as negative demand shocks. For reasons we’ll explain in Chapter 15, attempts to eliminate recessionary gaps and inflationary gaps usually rely on monetary rather than fiscal policy. In 2007 and 2008 the Federal Reserve sharply cut interest rates in an attempt to head off a rising recessionary gap; earlier in the decade, when the U.S. economy seemed headed for an inflationary gap, it raised interest rates to generate the opposite effect.

But how should macroeconomic policy respond to supply shocks?