Aggregate Demand and Aggregate Supply

This chapter introduces the Aggregate Demand/Aggregate Supply model of macroeconomics. Read the introduction and Section 1 to learn about Aggregate Demand and the three effects (weath, interest rate, and international trade) that cause the downward slope. Recall the difference between quantity demanded and demand - the same logic applies to Aggregate Demand. Identify the variables that change (shift) the Aggregate Demand curve. Read this chapter and attempt the "Try It" exercises. You will revisit certain sections of the chapter later in this unit.

Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium

Case in Point: This Time Is Different, Or Is It?

In an analysis that spans 66 countries over nearly eight centuries, economists Carmen Reinhart and Kenneth Rogoff investigate hundreds of financial crises and the economic busts each leaves in its wake. With a database that includes crisis episodes that go back as far as 12th-century China and medieval Europe and continue until the financial crisis of 2007–2008, the authors look at the patterns of economic behavior that characterize the periods leading up to financial crises and the patterns that characterize the recoveries.

They argue that looking over a long period of history is necessary because financial crises are "rare" events. Financial crises occur at varying intervals, and researchers studying a period of 25 years or so may not encounter the equivalent of a 100-year, category 5 hurricane that hits a major, low-lying city with a faulty levee system.

In general, such crises follow periods of relative economic calm. For example, the period in the United States from the mid-1980s until 2007 was often referred to as the Great Moderation. During such periods, inflationary and recessionary gaps may occur, but they are relatively small and short-lived. Societies begin to feel that they have tamed the business cycle, that policy makers have gotten smarter, and that moderation will continue.

But then it happens. The accumulation of too much debt by governments, businesses, or consumers leads to a financial meltdown. As housing prices are run up, for example, people tend to find ways to justify their heavy borrowing and to rationalize the ascent in prices: Demographics have changed; mortgage terms have improved; the regulation we have put in place is better this time; it's better to buy now, before prices go up even more; housing prices won't fall. Memories of the last crisis fade. "This time is different," they argue.

But Reinhart and Rogoff provide convincing evidence that "this time" is usually not different. Large-scale debt buildups lead to crises of confidence, and a financial crisis ensues. The aftermath is typically a severe and prolonged recessionary gap. On average, they find the following to be true:

  1. The collapse in asset market prices is large and long-lasting. Housing prices decline an average of 35% over 6 years, and stock prices decline an average of 56% over 3.5 years.
  2. Peak-to-trough GDP falls 9% on average, and the recession averages 2 years in length.
  3. The unemployment rate rises 7 percentage points over a 4-year period.
  4. Government debt swells due to bailout costs and, more importantly, because tax revenues fall off due to lower GDP.
  5. V-shaped recoveries in stock prices are more common than V-shaped recoveries in housing prices or employment.

To what extent is the financial crisis of the late 2000s likely to follow this typical pattern? The authors argue that experience with expansionary fiscal policy in such circumstances is actually quite limited. Most often, governments are shut out of borrowing markets when crises hit. Japan's government explicitly tried to implement fiscal stimulus, but the authors warn against drawing conclusions from one such example. The authors caution that governments should weigh any potential benefit of fiscal stimulus against the problem of higher public debt. They also note that central banks in 2007–2008 acted quickly and aggressively with expansionary monetary policies. But, they caution against "push[ing] too far the conceit that we are smarter than our predecessors". The global nature of the current situation only adds to the difficulty of recovering fully.

There was a company failure around 15 years ago that looked like a big deal at the time, but now seems like little more than a blip. The authors quote a trader who, during this event, presciently remarked, "More money has been lost because of four words than at the point of a gun. Those words are 'This time is different'".