Although we can now recognize that Keynesian analysis did contain an implicit supply curve, prior to the 1970s this supply curve was kept hidden. Rather than using an aggregate-supply/aggregate-demand diagram such as those portrayed in figures 5.3 and 5.4, economists used alternative diagrams that did not explicitly show the supply side of the economy. As a result, they tended to forget about or unintentionally denigrate the role of the supply side in affecting economic activity.

The suppression of the role of aggregate supply became painfully evident when Keynesian analyses were unable to suggest appropriate policies to deal with the major supply shocks of the early 1970s. With the aggregate-supply/aggregate-demand diagram, the impact of a supply-side shock can be analyzed more easily. Suppose the economy is at position A in figure 5.5, and a negative supply-side shock—perhaps an increase in the price of energy—hits the economy. (Since 1970 the world has experienced four major energy price shocks, resulting from the following events: 1973 OPEC oil embargo [causing oil prices to triple], 1979 Iranian revolution, 1985 OPEC price crash, and 1990 Iraq-Kuwait war.) The resulting higher production costs cause the SRAS curve to shift upward to SRAS’. The LRAS curve should also shift slightly to the left to LRAS’, for two reasons. First, because energy is now more expensive, less energy will be used per worker, so workers will become less productive, implying that output produced by a given quantity of labor will be less. Second, the fall in worker productivity causes the real wage corresponding to equilibrium in the labor market to fall, prompting some workers to leave the labor force. In the new long-run equilibrium the number of workers becomes smaller. The LRAS curve reflects long-run activity in the labor market. In the long run a smaller number of less productive workers corresponds to equilibrium in the labor sector, so the LRAS curve must be further to the left. An alternative way of viewing this fall in worker productivity may be helpful: the higher price of energy requires that more output be sent abroad in payment to oil producers, implying that there is less output left over to be distributed to workers. (If energy were produced domestically rather than imported, the result would not be so clear—the fall in output noted earlier would be offset by the rise in the value of our energy output.)

In this situation, firms may begin by increasing prices to pass on the higher cost of energy, moving the economy to point B. The higher price lowers aggregate demand, and firms react by cutting back production, laying off workers, and moving the economy over to point C. At this stage the government may adopt a fiscal policy that shifts AD rightward to AD’.

Care must be taken not to overstimulate and try to push the economy all the way back to the original LRAS—this response would create further price increases. The biggest complication, however, arises from workers’ reaction to the price increase. If workers recognize their decreased productivity and accept the fall in their real wage, the economy could settle at D in figure 5.5. More realistically, however, workers may demand wage increases to prevent their real wage from falling. This would shift the SRAS further upward (not shown in figure 5.5), leading to more price increases and frustrating the fiscal policy. Unemployment will be maintained (i.e., the economy will remain to the left of LRAS’ at a position like C) as long as employed workers prevent the real wage from falling to reflect their decreased productivity.

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To be useful, a supply curve must be paired with a demand curve. In this case an aggregate demand curve is developed by specifying that when the overall price level decreases, real demand for goods and services increases. The negative relationship between the overall price level and aggregate demand for goods and services comes about for three reasons:

1. The wealth effect. Some of people’s wealth is held in the form of financial assets such as cash or bonds. A fall in prices of goods and services means that the purchasing power of these financial assets increases. This rise in people’s wealth may cause them to increase their consumption spending. Suppose, for example, you own a bond worth $10,000. If the price level fell so dramatically that a sports car originally costing $50,000 now only cost $5,000, wouldn’t you feel wealthy enough to buy such a car? In general, a fall in the price level causes the wealth of those who have loaned money to rise, inducing them to increase their consumption spending. Conversely, borrowers experience a decrease in their wealth and, feeling poorer, decrease their consumption. The decrease is quite small, however, because the dominant borrower, the government, is assumed not to change its spending. Consequently, the lenders’ reaction generates a net wealth effect on consumption.

2. International forces. A fall in the price level causes our goods to be cheaper to foreigners and foreign goods to be more expensive to us. Consequently, demand for our exports increases, and we shift some of our demand for imports to domestically produced goods and services that compete against imports.

3. The real money supply. A fall in the price level causes the real supply of money in the economy to rise. As we will see in chapter 9, this increase in money serves to increase aggregate demand through several channels. For example, a rise in the real supply of money causes its price, the interest rate, to fall. Lower interest rates, in turn, cause people to increase spending because borrowing costs have fallen.

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Although our earlier example of the multiplier process was couched in terms of a policy of increasing government spending, any policy that influences aggregate demand has similar effects. An alternative way of increasing aggregate demand is to decrease taxes, which increases aggregate demand indirectly by increasing consumers’ disposable income, thereby enticing them to increase consumption demand C.

Changing government spending or taxation is referred to as fiscal policy because each involves a direct change in the government budget deficit, calculated as government spending G less tax receipts T. (Fiscalis is Latin for “pertaining to the public purse.”)

In particular, an expansionary fiscal policy (an increase in government spending or a decrease in taxes) creates a government budget deficit. Keynesians believe this is a natural side effect of a fiscal policy designed to maintain an economy at full employment—a side effect that should be reversed when in boom times governments cut back on spending or increase taxes to cool off the economy. In the Keynesian view, running a deficit is a small price to pay for jump-starting the economy so that the multiplier process can pull it out of a recession. They believe that the deficit can be offset later by a budget surplus when the economy is strong.

Keynesians also believe that an economy can become stuck in a recession when its natural recovery forces operate far too slowly, creating prolonged periods of high unemployment. They further believe that the government is able to move the economy out of a recession through fiscal policy and that it should do so. This advocacy of government intervention in the economy has been opposed by others who believe that as a matter of principle the government has no business interfering in the economy, and that government intervention, however well-intentioned, too often makes things worse, not better.

Another facet of this debate concerns the issue of whether fiscal policy should be undertaken through increases in government spending or decreases in taxes: The former involve more government influence over the production and distribution of goods and services in the economy, whereas the latter involve less. Those on the left of the political spectrum—liberals, socialists, and Democrats—believe that more control by the government over resource allocation in the economy is a good thing because they do not believe that market forces produce the right kind of outputs or distribute them fairly. Those on the right of the political spectrum—conservatives and Republicans—believe the government already plays too big a role in the economy, that it is an inefficient allocator of resources, and that individuals, through their spending financed by tax reductions, can cause the market to produce and distribute more desirable outputs in a more efficient fashion.

This is a sensitive issue. Everyone agrees that there is a prominent role to be played by government spending—on education, on infrastructure, on parks, and on operating things such as a legal system and an army. The disagreement comes from differing opinions about what the extent of the role of government should be.

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Inventory changes play an important role, mainly serving as a signaling device that alerts producers to changes in aggregate demand. They also play two other important roles in macroeconomics.

First, desired inventory changes are a component of aggregate demand that affects the dynamics of an economy’s reaction to disequilibrium, thereby playing an important role in the propagation and maintenance of business cycles. Consider a stimulating dose of fiscal policy. As the economy goes through the multiplier process, inventories are constantly falling because aggregate demand is continually a bit higher than output. If firms do nothing about these reductions, after the multiplier process has worked itself out inventories will have fallen to an undesirably low level. To prevent this result, firms must produce some extra output during the multiplier process. The time path followed by the economy during the multiplier process is affected by when and how quickly the firm decides to do so. If, for example, the firm elects to increase output to restore inventory levels at a late stage in the multiplier process, the level of national income could temporarily overshoot its final level.

Second, inventory changes can help in forecasting the direction of the economy. Their use in this regard occurs frequently in newspaper commentary, where they play a more prominent role than complex economic models built expressly for forecasting purposes.

When inventory levels are unusually high or are rising rapidly, firms should react by cutting back on production—meeting demand out of inventory—to decrease inventory levels to a more desirable level. This production cutback decreases income, however, setting the multiplier process in motion and pushing the economy toward a recession. We should forecast a downturn in the economy.

When inventory levels are unusually low or are falling rapidly, firms should react by increasing production to build inventories up to a more desirable level. The production increase also increases income, however, setting the multiplier process in motion and thereby pushing the economy to an even higher level of income. We should forecast an upturn in the economy.