## Wednesday, August 31, 2005

### The Short-Run and Long-Run Consequences of AS and AD Shocks

I thought I'd try and sort out the economic consequences of the hurricane and of aggregate supply and demand shocks more generally.  In the first graph below, there are two lines, a straight line representing the trend or natural rate of GDP and a wavy line representing actual GDP.  David Altig should rightly chastise me for drawing the trend as a straight line given all he’s done to try and straighten out how to properly measure the gap and to explain how the natural rate is also a wavy line, not a straight line, but it is easier for the present purposes to draw it this way so I hope he will forgive me.

At the point in time indicated on the graph by “Shock” suppose that there is a negative AD shock that hits the economy causing actual GDP to fall as shown in the diagram.  In this first case, there is no AS shock. The recession in the short-run is shown as a fall in actual GDP just after the AD shock. How the economy responds in the longer run depends upon the nature of the shock.  If it is a pure demand shock and supply is unaffected, as in this case, then the first graph describes the adjustment of the economy.  GDP falls after the negative AD shock, but trend GDP, the supply side, grows normally.  After a sufficient time period, the AD shock dissipates and the economy returns to its long-run equilibrium. Notice that AD shocks have no long-run impact on the economy.

Negative AD Shock, No AS Shock

In the second graph there is both an AD shock and a temporary AS shock. The AS shock temporarily lowers the natural rate of GDP as shown by the dashed line, but over time the shock dies out. As drawn, during the recovery the temporary decline in trend GDP constrains the recovery of actual GDP but both eventually return to the long-run trend.

Negative AD Shock, Temporary Negative AS Shock

In the final graph the supply shock is permanent (it could even dip lower initially with a temporary component tacked on).  Once again, the economy returns to trend in the long-run, but the trend itself is lower.

Negative AD Shock, Permanent Negative AS Shock

There are many remaining issues about the speed of adjustment to both types of shocks, the relative size of the two types of shocks, how policy might impact these scenarios, and so on, but I hope this at least helps to clarify some of the basic issues.  For example, I suspect some would, if applying this to the hurricane, not see the demand side shock being as large as I've drawn it (or even exist at all), and the position of the economy right now is below the trend not above it as shown in the figures.  In such a case the AS shock itself could depress output independent of and demand side considerations.  To imagine such a case, take AD shocks out of the diagram entirely by assuming the economy is initially at trend (no wavy line).  Then, with GDP always at the natural rate, the path of trend GDP after the shock traces out the path of actual GDP.  The goal is to illustrate basic dynamics (constrained by my limited skill at drawing these figures - that's why I started above trend) not to capture every feature of the present situation.  However, comments today by Bernanke and others indicate that they see a scenario along the lines of the middle case as most likely (with small AD shocks and moderately sized temporary AS shocks).  Supply will be disrupted, but only temporarily, and although there will be negative consequences in the short-run, the economy will recover over time.  A path something like:

No AD Shock, Temporary Negative AS Shock

But in any case, you can see the possibilities depending on the size of the shock(s) , whether the shock(s) are permanent or temporary, and the intitial position of the economy when the shock(s) hit.

Posted by on Wednesday, August 31, 2005 at 05:04 PM in Economics, Macroeconomics | Permalink  TrackBack (1)  Comments (2)