Consumer Spending Habits: How a Decrease in Aggregate Supply Can Affect

How a Decrease in Aggregate Supply Can Affect the Economy Suppose there is a decrease in aggregate supply caused by an increase in the general level of nominal wages not matched by productivity increases or a sharp increase in the price of a key input such as oil. The decrease in aggregate supply shown in graph A in Box 16 moves the economy from its initial equilibrium at point E, to a new equilibrium at point Ez. Note that at the new equilibrium after the decrease in aggregate supply, real GNP is lower than it was initially and the price level is higher. Decreases in aggregate supply are therefore particularly harmful because they result in both decreased production and upward pressure on the price level. A decrease in aggregate supply thus can simultaneously contribute to increased unemployment and increases in the price level that erode the purchasing power of income! Thus, recessions can be caused not only by decreases in aggregate demand but also by decreases in aggregate supply. For example, the soaring price of oil in 1990, resulting from Iraq's invasion of Kuwait, caused a decrease in aggregate supply which increased the price level and cut job growth in the United States. Inflation caused by continual decreases in aggregate supply is called cost-push inflation. Cost-push inflation is usually found in an overheated economy for which the actual unemployment rate has fallen below the natural rate of unemployment. Except for cases in which the economy overheats, cost-push inflation is relatively rare. In most cases a decrease in aggregate supply results in a one-time increase in the price level that increases the rate of inflation only in the year the decrease in aggregate supply occurs. In later years unless aggregate supply decreases again, there is no acceleration in the rate of inflation. How an Increase in Aggregate Supply Can Affect the Economy An increase in aggregate supply can improve the performance of the economy by simultaneously increasing production and putting downward pressure on the price level. In graph B of Box 16, the economy is in equilibrium at point E,, at which real GNP is $4,500 billion and the price level is 135. As aggregate supply increases, the economy moves to a new equilibrium at point Ez. Real GNP is equal to $5,000 billion, which is its potential level, while the price level falls during the year to 125. Increases in aggregate supply are particularly desirable for the economy because they can reduce cyclical unemployment and keep inflationary pressures down. For example, in early 1988 the news that the price of oil was decreasing was greeted very favorably by those who evaluate the economy. Because a decrease in aggregate demand was feared in 1988, the forecast of a likely increase in aggregate supply was viewed as reducing the likelihood that there would be a recession in 1988. Similarly, an increase in aggregate supply also occurred as a result of decrease in oil prices in 1991 after it became clear that the conflict in the Persian Gulf could not disrupt oil supplies. A Recap: Economic Fluctuations and Their Causes Recessions can be caused by both decreases in aggregate supply and decreases in aggregate demand. A recession induced by a decrease in aggregate supply is likely to be accompanied by both inflation and excessive unemployment. A recession caused by a decrease in aggregate demand will result in both excessive unemployment and some downward pressure on the price level. As you'll soon learn, except for very severe economic contractions (such as the Great Depression of the 1930), there's usually little if any actual decline in the price level during a typical recession. Inflation can be explained by either increases in aggregate demand or decreases in aggregate supply. Both demand-pull and cost-push inflations occur, and sometimes both types of inflation exist simultaneously. In the chapters that follow we'll be carefully examining the underlying forces that cause aggregate demand and aggregate supply to fluctuate. A good understanding of these forces is essential to help formulate macroeconomic stabilization policies.