Aggregate Demand and Aggregate Supply: Negative Demand Shock

Negative demand shock. Have you ever wondered what causes recessions, or how long the long run is? Well, those are complicated questions, but this short overview will help. To distinguish between the short-run and the long-run adjustment, consider an economy in long-run equilibrium. Recall that this occurs when the aggregate demand short-run aggregates supply and long-run aggregates supply curves intersect at a single point, indicating that an economy is experiencing full employment, where aggregate demand and short-run aggregate supply are equal. Now, imagine the scenario where expectations change, when an event occurs that decreases the confidence of businesses. For example, if businesses predict that economic conditions will deteriorate in the future, and that this will reduce their ability to earn profits, they will respond by decreasing their investment spending on capital goods. Examples of this are resources such as tools and equipment. This decrease in investment spending would result in the aggregate demand curve shifting to the left. It is an example of a negative demand shock. Let's look at the short-run and long-run adjustments in two steps. Step one, the short-run adjustment to a negative economic shock. Notice that the shift from point A to point B has moved the economy away from long-run equilibrium, causing a disequilibrium. Note that the movement from point B away from the long-run aggregate supply curve is an example of the scenario we just described, short-run equilibrium. Point B shows that the price level and economic output have decreased. At the lower level of output, employers will reduce the number of workers they employ, increasing the unemployment rate. Looking at the x-axis on the graph, you can see that potential output is still $17 trillion, but current output has decreased to $16.8 trillion. In this case, the gap between output at B and the long-run potential at point A represents a recessionary gap. Let's move on to step 2, the long-run adjustment to a negative economic shock. Market forces tend to move economies from disequilibrium toward long-run equilibrium. As a result, in the face of high unemployment, given sufficient time, workers may be willing to accept lower nominal wages than before. As a result, nominal wages and the prices of other resources will fall. This decrease in the price of resources represents a decrease in the cost of production. This is an example of how prices of inputs are flexible in the long run. Producers will respond to lower production costs by increasing their production of goods and services. This will shift the short-run aggregate supply curve to the right, moving it back toward its long-run equilibrium. This is represented in point C. Notice that output increases as input prices become flexible. The economy has once again reached potential output, but at a lower price level. From 108 to 106. The economy has come out of the recession, meaning the recessionary gap has closed and has experienced some disinflation or even deflation. There are critical distinctions between the long run and the short run. In the short run, the price of inputs such as wages and tool costs do not always immediately change in response to price level changes. It is said that input costs remain sticky in the short run. In the long run, input price adjustments may occur. Input prices are then flexible, such as when unemployed workers are then willing to take lower wages. The main component that distinguishes the short run from the long run is how long it takes the cost of inputs to become flexible. How long does a long-run adjustment take? Well, it varies. John Maynard Keynes, who had been reminded of the self-correcting nature of the economy during the Great Depression, remarked: "In the long run, we are all dead." But rest assured, the economy hardly ever takes an entire lifetime to adjust. Regardless, economists tend to disagree on some of the details of how long these types of adjustments will take. Just remember that the difference between the short run and the long run is not a consistent or specific period of time, but rather the period of time it takes for the cost of inputs to become flexible.