Macroeconomics

The Dynamic Response to a Supply

Shock

This figure shows the responses

of the key variables over time to a one-

time supply shock.

F I G U R E

1 4 - 7

Y

t

101.0

100.5

100.0

99.5

99.0

v

t

2.0

1.5

1.0

0.5

0.0

–0.5

–1.0

–1.5

–2.0

r

t

3.0%

2.8

2.6

2.4

2.2

2.0

1.8

1.6

1.4

1.2

1.0

p

t

3.5%

3.0

2.5

2.0

1.5

1.0

0.5

0.0

i

t

6.0%

5.5

5.0

4.5

4.0

3.5

3.0

2.5

2.0

Time

Time

t – 2

t + 2

t + 6

t + 10

t + 4

t + 8

t + 12

t

t – 2

t + 2

t + 6

t + 10

t + 4

t + 8

t + 12

t

t – 2

t + 2

t + 6

t + 10

t + 4

t + 8

t + 12

t

t – 2

t + 2

t + 6

t + 10

t + 4

t + 8

t + 12

t

t – 2

t + 2

t + 6

t + 10

t + 4

t + 8

t + 12

t

Time

Time

Time

(a) Supply Shock

(b) Output

(c) Real Interest Rate

(d) Inflation

(e) Nominal Interest Rate

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nearby FYI box for their description.) As panel (a) shows, the shock 

u

t

spikes

upward by 1 percentage point in period t and then returns to zero in subsequent

periods. Inflation, shown in panel (d), rises by 0.9 percentage point and gradual-

ly returns to its target of 2 percent over a long period of time. Output, shown in

panel (b), falls in response to the supply shock but also eventually returns to its

natural level.

The figure also shows the paths of nominal and real interest rates. In the peri-

od of the supply shock, the nominal interest rate, shown in panel (e), increases by

1.2 percentage points, and the real interest rate, in panel (c), increases by 0.3 per-

centage points. Both interest rates return to their normal values as the economy

returns to its long-run equilibrium.

These figures illustrate the phenomenon of stagflation in the dynamic

AD –AS model. A supply shock causes inflation to rise, which in turn increas-

es expected inflation. As the central bank applies its rule for monetary 

policy and responds by raising interest rates, it gradually squeezes inflation 

out of the system, but only at the cost of a prolonged downturn in econom-

ic activity.

A Shock to Aggregate Demand

Now let’s consider a shock to aggregate demand. To be realistic, the shock is

assumed to persist over several periods. In particular, suppose that 

e

t

=1 for five

periods and then returns to its normal value of zero. This positive shock 

e

t

might represent, for example, a war that increases government purchases or a

stock market bubble that increases wealth and thereby consumption spending.

In general, the demand shock captures any event that influences the demand

for goods and services for given values of the natural level of output Y

−

t

and the

real interest rate r

t

.

Figure 14-8 shows the result. In period t, when the shock occurs, the dynam-

ic aggregate demand curve shifts to the right from DAD

t

−1

to DAD

t

. Because

the demand shock 

e

t

is not a variable in the dynamic aggregate supply equation,

the DAS curve is unchanged from period t

− 1 to period t. The economy moves

along the dynamic aggregate supply curve from point A to point B. Output and

inflation both increase.

Once again, these effects work in part through the reaction of monetary pol-

icy to the shock. When the demand shock causes output and inflation to rise, the

central bank responds by increasing the nominal and real interest rates. Because

a higher real interest rate reduces the quantity of goods and services demanded,

it partly offsets the expansionary effects of the demand shock.

In the periods after the shock occurs, expected inflation is higher because

expectations depend on past inflation. As a result, the dynamic aggregate supply

curve shifts upward repeatedly; as it does so, it continually reduces output and

increases inflation. In the figure, the economy goes from point B in the initial

period of the shock to points C, D, E, and F in subsequent periods.

In the sixth period (t

+ 5), the demand shock disappears. At this time, the

dynamic aggregate demand curve returns to its initial position. However, the

C H A P T E R   1 4

A Dynamic Model of Aggregate Demand and Aggregate Supply

| 427

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428

|

P A R T   I V

Business Cycle Theory: The Economy in the Short Run

economy does not immediately return to its initial equilibrium, point A. The peri-

od of high demand has increased inflation and thereby expected inflation. High

expected inflation keeps the dynamic aggregate supply curve higher than it was ini-

tially. As a result, when demand falls off, the economy’s equilibrium moves to point

G, and output falls to Y

t

+5

, which is below its natural level. The economy then grad-

ually recovers, as the higher-than-target inflation is squeezed out of the system.

Figure 14-9 shows the time path of the key variables in the model in response

to the demand shock. Note that the positive demand shock increases real and

nominal interest rates. When the demand shock disappears, both interest rates

fall. These responses occur because when the central bank sets the nominal inter-

est rate, it takes into account both inflation rates and deviations of output from

its natural level.

A Demand Shock

This figure shows the effects of a positive demand shock in peri-

od t that lasts for five periods. The shock immediately shifts the dynamic aggregate

demand curve to the right from DAD

t

−1

to DAD

t

. The economy moves from point A

to point B. Both inflation and output rise. In the next period, the dynamic aggregate

supply curve shifts to DAS

t

+1

because of increased expected inflation. The economy

moves from point B to point C, and then in subsequent periods to points D, E, and

F.  When the demand shock disappears after five periods, the dynamic aggregate

demand curve shifts back to its initial position, and the economy moves from point

F to point G. Output falls below its natural level, and inflation starts to fall. Over

time, the dynamic aggregate supply curve starts shifting downward, and the econo-

my gradually returns to its initial equilibrium, point A.