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.

Comments

[William Polley]

Yep. That about covers it. Here's what I find interesting... There has been a little back and forth on a few blogs, mine included, about the Broken Windows Fallacy with folks like me being a bit critical of those who say that there will be a big boost to GDP after a disaster. The fact that GDP counts "bads" as well as "goods" is part of it, of course. But Bastiat wrote of the Broken Windows Fallacy before there was national income accounting. The real issue is micro. It's really about opportunity cost, productive activities foregone, and a redistribution of wealth.

Yep. There will be spending after a disaster. Lots of it. There's a multiplier effect too. No argument there. I think even Bastiat would have agreed with that much. But is it really appropriate to think of this spending as beneficial? The question is, beneficial relative to what? Bastiat spoke of the foregone spending as unseen. Suppose that the spending on repairs is balanced exactly by reduced spending on other investment projects. What is gained? The growth associated with disaster recovery that everyone is talking about is just that, recovery. The last chart in your post is the big story. Yes, there is spending, there is growth that returns you to potential, but watch that first step... it's a doozie! The picture you described is of lower lifetime present discounted value of income, no?

I want to clear up any misconception people might have that those of us who cite the Broken Windows Fallacy don't believe there will be growth and that we're stuck in some pre-Keynesian world. Of course there will be growth! In a Solow growth model if you suddenly reduce the capital stock, the growth rate goes up temporarily! But lifetime utility goes down. Will a disaster cause the economy to jump to a permanently higher growth rate? I don't think so. There would have to be some really strong evidence for me to buy that. I can hypothesize some cases where it might happen, but they'd really be special cases.

Sometimes you hear folks (in the media and on the street) say, "Every cloud has a silver lining" when talking about post-disaster growth. Couldn't the very same statement be made about recessions in general? Post recession growth tends to be faster. Your chart would work as a description for a typical recession, not just a disaster event like a hurricane. How far would we get with a phrase like that about recessions? Not far! Imagine a president trying to sell that idea during a recession! All I'm saying, and I think this is consistent with Bastiat, is that such pronouncements of increased growth are no more appropriate after a disaster than they are during a recession.

[Mark Thoma]

Thanks. I was hoping a graph would help to clear it up. To recover, you must grow faster than trend, but in the end you only end up back where you started if there are no permanent AS shocks. And from a well-being point of view, I like the preset value statement you made as a way of looking at this - that is absolutely correct and I agree. The "beneficial" terminology in a strict macro sense has bothered me too. At a micro level as resources move to housing, furniture, etc., sure, there will be winners and losers as resources are redistributed. Some benefit, some lose. But overall there is less GDP than there would have been.

Thanks again...