On September 16, 2022 an article in the Wall Street Journal had the headline: “Economic Worries, Weak FedEx Results Push Stocks Lower.” Another article in the Wall Street Journal noted that: “The company’s downbeat forecasts, announced Thursday, intensified investors’ macroeconomic worries.”
Why would the news that FedEx had lower revenues than expected during the preceding weeks cause a decline in stock market indexes like the Dow Jones Industrial Average and the S&P 500? As the article explained: “Delivery companies [such as FedEx and its rival UPS) are the proverbial canary in the coal mine for the economy.” In other words, investors were using FedEx’s decline in revenue as a leading indicator of the business cycle. A leading indicator is an economic data series—in this case FedEx’s revenue—that starts to decline before real GDP and employment in the months before a recession and starts to increase before real GDP and employment in the months before a recession reaches a trough and turns into an expansion.
So, investors were afraid that FedEx’s falling revenue was a signal that the U.S. economy would soon enter a recession. And, in fact, FedEx CEO Raj Subramaniam was quoted as believing that the global economy would fall into a recession. As firms’ profits decline during a recession so, typically, do the prices of the firms’ stock. (As we discuss in Macroeconomics, Chapter 6, Section 6.2 and in Economics, Chapter 8, Section 8.2, stock prices reflect investors’ expectations of the future profitability of the firms issuing the stock.)
Monitoring fluctuations in FedEx’s revenue for indications of the future course of the economy is nothing new. When Alan Greenspan was chair of the Federal Reserve from 1987 to 2006, he spoke regularly with Fred Smith, the founder of FedEx and at the time CEO of the firm. Greenspan believed that changes in the number of packages FedEx shipped gave a good indication of the overall state of the economy. FedEx plays such a large role in moving packages around the country that most economists agree that there is a close relationship between fluctuations in FedEx’s business and fluctuations in GDP. Some Wall Street analysts refer to this relationship as the “FedEx Indicator” of how the economy is doing.
In September 2022, the FedEx indicator was blinking red. But the U.S. economy is complex and fluctuations in any indicator can sometimes provide an inaccurate forecast of when a recession will begin or end. And, in fact, some investment analysts believed that problems at FedEx may have been due as much to mistakes the firms’ managers had made as to general problems in the economy. As one analyst put it: “We believe a meaningful portion of FedEx’s missteps here are company-specific.”
At this point, Fed Chair Jerome Powell and the other members of the Federal Open Market Committee are still hoping that they can bring the economy in for a soft landing—bringing inflation down closer to the Fed’s 2 percent target, without bringing on a recession—despite some signals, like those being given by the FedEx indicator, that the probability of the United States entering a recession was increasing.
Sources: Will Feuer, “FedEx Stock Tumbles More Than 20% After Warning on Economic Trends,” Wall Street Journal, September 16, 2022; Alex Frangos and Hannah Miao, “ FedExt Stock Hit by Profit Warning; Rivals Also Drop Amid Recession Fears,” Wall Street Journal, September 16, 2022; Richard Clough, “FedEx has Biggest Drop in Over 40 Years After Pulling Forecast,” bloomberg.com, September 16, 2022; and David Gaffen, “The FedEx Indicator,” Wall Street Journal, February 20, 2007.
As we’ve discussed in several previous blog posts, in early 2021 Lawrence Summers, professor of economics at Harvard and secretary of the treasury in the Clinton administration, argued that the Biden administration’s $1.9 trillion American Rescue Plan, enacted in March, was likely to cause a sharp acceleration in inflation. When inflation began to rapidly increase, Summers urged the Federal Reserve to raise its target for the federal funds rate in order to slow the increase in aggregate demand, but the Fed was slow to do so. Some members of the Federal Open Market Committee (FOMC) argued that much of the inflation during 2021 was transitory in that it had been caused by lingering supply chain problems initially caused by the Covid–19 pandemic.
At the beginning of 2022, most members of the FOMC became convinced that in fact increases in aggregate demand were playing an important role in causing high inflation rates. Accordingly, the FOMC began increasing its target for the federal funds rate in March 2022. After two more rate increases, on the eve of the FOMC’s meeting on July 26–27, the federal funds rate target was a range of 1.50 percent to 1.75 percent. The FOMC was expected to raise its target by at least 0.75 percent at the meeting. The following figure shows movements in the effective federal funds rate—which can differ somewhat from the target rate—from January 1, 2015 to July 21, 2022.
In an opinion column in the Wall Street Journal, Massachusetts Senator Elizabeth Warren argued that the FOMC was making a mistake by increasing its target for the federal funds rate. She also criticized Summers for supporting the increases. Warren worried that the rate increases were likely to cause a recession and argued that Congress and President Biden should adopt alternative measures to contain inflation. Warren argued that a better approach to dealing with inflation would be to, among other steps, increase the federal government’s support for child care to enable more parents to work, provide support for strengthening supply chains, and lower prescription drug prices by allowing Medicare to negotiate the prices with pharmaceutical firms. She also urged a “crack down on price gouging by large corporations.” (We discussed the argument that monopoly power is responsible for inflation in this blog post.)
Summers responded to Warren in a Twitter thread. He noted that: “In the 18 months since the massive stimulus policies & easy money that [Senator Warren] has favored & I have opposed, the inflation rate has risen from below 2 to above 9 percent & workers purchasing power has, as a consequence, declined more rapidly than in any year in the last 50.” And “[Senator Warren] opposes restrictive monetary policy or any other measure to cool off total demand. Why does she think at a time when there are twice as many vacancies as jobs that inflation will come down without some drop in total demand?”
Clearly, economists and policymakers continue to hotly debate monetary policy.
Source: Elizabeth Warren, “Jerome Powell’s Fed Pursues a Painful and Ineffective Inflation Cure,” Wall Street Journal, July 24, 2022.
To answer the question in the title: Negative supply shocks—shifts to the left in the short-run aggregate supply (SRSAS) curve—and positive demand shocks—shifts to the right in the aggregate demand (AD) curve—both contributed to the acceleration in inflation that began in the spring of 2021. But were the aggregate supply shifts, such as the semiconductor shortage that reduced the supply of new automobiles, more or less important than the aggregate demand shifts, such as the expansionary monetary and fiscal policies?
Adam Hale Shapiro of the Federal Reserve Bank of San Francisco used a basic piece of microeconomic analysis to estimate the contribution of shifts in aggregate supply and shifts in aggregate demand to inflation during this period. He looked at the prices of the more than 100 categories of goods and services in the personal consumption expenditures(PCE) price index. The PCE price index is a measure of the price level similar to the GDP deflator, except it includes only the prices of goods and services from the consumption category of GDP. Changes in the PCE price index are the Federal Reserve’s preferred measure of the inflation rate because that index includes the prices of more goods and services than are included in the consumer price index (CPI).
Shapiro explains how he used microeconomic reasoning to determine whether prices in one of the more than 100 categories of goods and services were increasing because of shifts in supply or because of shifts in demand:
“Shifts in demand move both prices and quantities in the same direction along the upward-sloping supply curve, meaning prices rise as demand increases. Shifts in supply move prices and quantities in opposite directions along the downward-sloping demand curve, meaning prices rise when supplies decline.”
For example, the figure on the left shows the effect on the market for toys of an increase in the demand for toys. (We discuss how shifts in demand and supply curves in a market affect equilibrium price and quantity in Chapter 3, Section 3.4 of Economics, Macroeconomics, and Microeconomics.) The demand curve for toys shifts to the right from D1 to D2, the equilibrium price increases from P1 to P2, and the equilibrium quantity increases from Q1 to Q2. The figure on the right shows the effect on the market for toys if the price increase results from a decrease in the supply of toys rather than from an increase in demand. The supply curve shifts to the left from S1 to S2, the equilibrium price increases from P1 to P2, and the equilibrium quantity decreases from Q1 to Q2.
Shapiro used statistical methods to determine the part of a change in price or quantity that was unexpected. He took this approach in order to focus on short-run changes in these markets caused by shifts in demand and supply rather than long-run changes resulting from “factors such as technological improvements, cost-of-living adjustments to wages, or demographic changes like population aging.” In some cases, the quantity or the price in a market were very close to their expected values, so Shapiro labeled the cause of a price increase in this market as “ambiguous.”
Shapiro notes that: “Categories that experience frequent supply-driven price changes include food and household products such as dishes, linens, and household paper items. Categories that experience frequent demand-driven price changes include motor vehicle-related products, used cars, and electricity.”
The following figure shows Shapiro’s results for the period from January 2020 through April 2022. The height of each column gives the inflation rate in the month measured as the percentage change in the PCE price index from the same month in the previous year. For example, in March 2022, the inflation rate was 6.6 percent. The height of the yellow segment is the part of inflation in that month attributable to increases in demand, the height of the green segment is the part of the inflation in that month that is attributable to decreases in supply, and the height of the green segment is the part of the inflation that Shapiro can’t assign to either demand or supply. In March 2022, increased in demand accounted for 2.2 percentage points of the total 6.6 percentage point increase in inflation. Decreases in supply accounted for 3.3 percentage points, and the remaining 1.2 percentage points had an ambiguous cause.
We can conclude that, measured this way, the increase in inflation from the spring of 2021 through the spring of 2022 was due more to negative supply shocks than to positive demand shocks.
Source: Adam Hale Shapiro, “How Much Do Supply and Demand Drive Inflation?” Federal Reserve Bank of San Francisco Economic Letter, 22-15, June 21, 2022.
In January 2022, the Bureau of Labor Statistics (BLS) announced that inflation, measured as the percentage change in the consumer price index (CPI) from December 2020 to December 2021, was 7 percent. That was the highest rate since June 1982, which was near the end of the Great Inflation that lasted from 1968 to 1982. The following figure shows the inflation rate since the beginning of 1948.
What explains the surge in inflation? Most economists believe that it is the result of the interaction of increases in aggregate demand resulting from very expansionary monetary and fiscal policy and disruptions to supply in some industries as a result of the Covid-19 pandemic. (We discuss movements in aggregate demand and aggregate supply during the pandemic in the updated editions of Economics, Chapter 23, Section 23.3 and Macroeconomics, Chapter 13, Section, 13.3.)
But President Joe Biden has suggested that mergers and acquisitions in some industries—he singled out meatpacking—have reduced competition and contributed to recent price increases. Massachusetts Senator Elizabeth Warren has made a broader claim about reduced competition being responsible for the surge in inflation: “Market concentration has allowed giant corporations to hide behind claims of increased costs to fatten their profit margins. [Corporations] are raising prices because they can.” And “Corporations are exploiting the pandemic to gouge consumers with higher prices on everyday essentials, from milk to gasoline.”
Do many economists agree that reduced competition explains inflation? The Booth School of Business at the University of Chicago periodically surveys a panel of more than 40 well-known academic economists for their opinions on significant policy issues. Recently, the panel was asked whether they agreed with these statements:
A significant factor behind today’s higher US inflation is dominant corporations in uncompetitive markets taking advantage of their market power to raise prices in order to increase their profit margins.
Antitrust interventions could successfully reduce US inflation over the next 12 months.
Price controls as deployed in the 1970s could successfully reduce US inflation over the next 12 months.
Large majorities of the panel disagreed with statements 1. and 2.—that is, they don’t believe that a lack of competition explains the surge in inflation or that antitrust actions by the federal government would be likely to reduce inflation in the coming year. A smaller majority disagreed with statement 3., although even some of those who agreed that price controls would reduce inflation stated that they believed price controls were an undesirable policy. For instance, while he agreed with statement 3., Oliver Hart of Harvard noted that: “They could reduce inflation but the consequence would be shortages and rationing.”
One way to characterize the panel’s responses is that they agreed that the recent inflation was primarily a macroeconomic issue—involving movements in aggregate demand and aggregate supply—rather than a microeconomic issue—involving the extent of concentration in individual industries.
Sources for Biden and Warren quotes: Greg Ip, “Is Inflation a Microeconomic Problem? That’s What Biden’s Competition Push Is Betting,” Wall Street Journal, January 12, 2022; and Patrick Thomas and Catherine Lucey, “Biden Promotes Plan Aimed at Tackling Meat Prices,” Wall Street Journal, January 3, 2022; and https://twitter.com/SenWarren/status/1464353269610954759?s=20
Supports: Macroneconomics Chapter 15, Section 15.3; Economics Chapter 25, Section 25.3; and Essentials of Economics Chapter 17, Sections 17.3.
Solved Problem: The Fed’s Policy Dilemma
In the fall of 2021, the inflation rate was at its highest level since 2008. The unemployment rate was above 5 percent, which was much lower than in the spring of 2020, but still well above its level of early 2020 before the Covid-19 pandemic. In testifying before Congress, Fed Chair Jerome Powell stated that he believed the high inflation rate was transitory and in the longer run “inflation is expected to drop back toward our longer-run 2 percent goal.”
But Powell also stated that if inflation continued to remain high the Fed would face a policy dilemma. “Almost all of the time, inflation is low when unemployment is high, so interest rates work on both problems.” But in contrast, in the fall of 2021 both the unemployment and inflation rates were high: “That’s the very difficult situation we find ourselves in.”
a. Briefly explain what Powell meant by saying that almost all of the time “interest rates work on both problems.”
b. Why did macroeconomic conditions in the fall of 2021 present Fed policymakers with a “very difficult” situation?
Source: Kate Davidson and Nick Timiraos, “Powell Says Fed Faces ‘Difficult Trade-Off’ if Inflation Doesn’t Moderate,” Wall Street Journal, September 30, 2021; and Chair Jerome H. Powell, “Testimony Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.” September 28, 2021, federalreserve. gov..
Solving the Problem
Step 1: Review the chapter material. This problem is about the policy situation the Fed faces when the unemployment and inflation rates are both high, so you may want to review Chapter 15, Section 15.3, “Monetary Policy and Economic Activity,” and the discussion of staflation, including Figure 13.7, in Chapter 13, Section 13.3, “Macroeconomic Equilibrium in the Long Run and the Short Run.”
Step 2: Explain what Powell meant by “interest rates work on both problems.” We’ve seen that in the typical recession the unemployment rate increases while the inflation rate decreases. We’ve also seen that if the economy is above potential GDP, the unemployment rate is very low but the inflation rate increases. (To review these facts, see Chapter 10, Section 10.3 “The Business Cycle.”) The Fed uses changes in its target for the federal funds rate to affect the level of real GDP and the price level, as it attempts to hit its policy goals of high employment and price stability.
So “almost all of the time,” the Fed can use interest rates–changes in the target for the federal funds rate–to work on the problems of high unemployment and high inflation–depending on which is occuring during a particular period.
Step 3: Explain why macroeconomic conditions in the fall of 2021 presented Fed policymakers with a “very difficult” situation. As Powell observes, “almost all the time” Fed policy is focused on reducing either high unemployment or high inflation, but not both. As we note in Chapter 13, Section 13.3, economists refer to a situation when the unemployment and inflations rates are both high at the same time as a period of stagflation. If the inflation rate is high, then expansionary monetary policy–a low target for the federal funds rate–will reduce the unemployment rate but make an already high inflation rate even higher. Similarly, if the unemployment rate is high, then contractionary monetary policy–a high target for the federal funds rate–will reduce the inflation rate but make an already high unemploument rate even higher. A very difficult policy dilemma for the Fed!
How did Fed policymakers expect to resolve this difficulty? In his testimony, Powell explained that he believed that the high inflation rate the U.S. economy was experiencing during the fall of 2021 was transitory and would begin to decline once the supply problems caused by the Covid-19 pandemic were resolved in the coming months. Referring to the supply problems he noted that “These aren’t things that we [the Fed] can control.” Therefore, the Fed did not intend to use policy to address the high inflation rate and could continue to pursue an expansionary monetary policy to push the labor market back to full employment.
How to Keep the Economy Booming — And Meet the Demand for Workers
In recent economic news, optimists and pessimists could both find evidence to support their outlooks.
The May jobs report showed a gain of 559,000 jobs in May and a decline in the unemployment rate to 5.8 percent. It also showed a marked improvement from last month’s weaker showing across a number of sectors, and average hourly earnings continued to rise. Ahead of the monthly report, the unemployment insurance weekly claims report on Thursday showed the number of new unemployment insurance claims fell from 405,000 the week before to 385,000 — lower than levels typically indicative of a recession (400,000). This is the first time this has happened since the pandemic-induced closures began. Further wage growth should help draw more workers back to the labor force.
Yet at the same time, the recent jobs report showed a big miss relative to the expected gain of 650,000 jobs. Constraints in supply chains and business reopenings still complicate the return to work. And workers still aren’t out of the woods: Thursday’s report indicated the total number of already unemployed individuals claiming benefits hasn’t dropped since mid-March. If job creation is robust, that contrast between falling new claims and those still on the jobless rolls is odd.
What explains these confounding tensions? To unpack them, consider the legacies of the economists John Maynard Keynes and Friedrich Hayek.
In his day, Keynes argued for boosting aggregate demand during a recession to keep workers afloat — a prescription that has clearly shaped the ultra-stimulative fiscal and monetary policies from both the Trump and the Biden administrations. His influence also resonates in the recent jobs reports: The coming rebound in the consumption of services — restaurant meals, entertainment and travel — will lift demand above its prepandemic level, and reopening and abundant consumer cash, bolstered by policy, will increase the demand for workers.
While Keynes may have lit the path to recovery after last spring’s cataclysmic job loss, he offers little to guide us through the coming labor-supply crunch. If policy actively disincentivizes the unemployed from returning to the fold, as recent reports suggest, there will be no one in place to meet the coming surge in demand, imperiling our economic rehabilitation.
To preserve the still-shaky recovery, we must now turn to Hayek, the godfather of free-market thinking. He argued that policy should allow workers to adjust to changes in the economy. Looking ahead, policymakers must consider curbing elevated unemployment benefits and a focus on old, prepandemic jobs in order to let workers and the economy adjust to new activities and new jobs that are more promising in the postpandemic world. We don’t want unemployed workers to find the postpandemic economy has passed them by.
As demand revives, supply will need to keep pace. Those in some industries, like carmakers, can simply sell off excess inventories, something that is already happening. Tool and machinery makers can increase imports to keep up. But eventually, demand must be met by higher domestic production from workers. Once businesses are freed from pandemic restrictions, we can expect to see some improvements in supply.
But holding back a faster improvement in employment and output are the very challenges Hayek identifies, including slowing down the process of matching dislocated workers to new, postpandemic jobs. That is to say, demand growth with supply constraints won’t produce the sustainable jobs recovery we need.
Many workers are taking their time to find a new job or are choosing to work less, thanks to their generous pandemic unemployment insurance benefits. These benefits provided extra income for those who lost their jobs early in the crisis. As a result, the economy’s adjustment to a postpandemic paradigm will be slow. These benefits also slow future gains in the form of higher wages workers might earn from a new and better job. But as Hayek tells us, the longer it takes for these workers to rejoin the work force, the longer it will take for them to gain these benefits.
In the coming months, we will be able to assess the potency of dealing with these forces of supply and demand by comparing employment gains in the 25 states choosing to end federal pandemic benefit supplements with the 25 states retaining them. While employment is likely to rise quickly as the pandemic fades and extra unemployment insurance benefits fall away, unemployment rates are still likely to remain high relative to prepandemic levels for another year.
If we look ahead, wage gains should be robust for those employed, particularly for lower-skilled service-sector workers — especially if some employees delay returning to work. Those higher real wages are good news for recipients.
A less welcome wild card would be inflationary pressures, fueled by demand outstripping supply. Those pressures could be a brief blip in an adjusting economy. Or they could suggest a reduction in purchasing power from higher inflation for an extended period. Higher recent inflation readings in consumer prices are a cause for concern.
Whether this happens hinges on whether the federal government and the Federal Reserve dial back their extra Keynesian demand support in time to avoid increases in expected inflation. Inflation risks robbing them of purchasing power gains from their higher wages.
The latest jobs report, then, favors a more Hayekian solution — with a nudge: Policy should support returning to work and matching workers to jobs by supporting re-employment and training for new skills, not just boosting demand. That shift offers the best chance for a sustained lift in jobs as well as demand as the pandemic recedes. In the matter Keynes v. Hayek, then: Let Hayek now prevail.
On April 17th, Glenn Hubbard and Tony O’Brien continued their podcast series by spending just under 30 minutes discuss varied topics such as the Federal Reserve’s monetary response, record unemployment numbers, panic buying of toilet paper as compared to bank runs, as well as recent books they’ve been reading with increased downtime from the pandemic.
During the initial UNWRITTEN webinar from Pearson, Glenn Hubbard had a conversation with Jaylen Brown, a Pearson Campus Ambassador as well as a student at University of Central Florida -also Glenn’s undergrad alma mater!
Over the 30-minute broadcast, they discussed topics of relevance to all students – real world outlook on jobs, supply and demand, and the policies aimed at relief. Glenn talks of recovery shaped like a Nike swoosh with a sharp decline and a slightly longer climb back to normalcy. Check out the full episode now posted on YouTube!
Supports: Hubbard/O’Brien, Chapter 23, Aggregate Demand and Aggregate Supply Analysis; Macroeconomics Chapter 13; Essentials of Economics Chapter 15.
Apply the Concept: Using the Aggregate Demand and Aggregate Supply Model to Analyze the Coronavirus Pandemic
Here’s the key point: The coronavirus caused large shifts in short-run aggregate supply and in aggregate demand, so this virus caused by far the largest decline in real GDP and largest increase in unemployment over such a brief period in U.S. history.
In early 2020, the United States experienced an epidemic from a novel coronavirus that causes the disease Covid-19. We can use the aggregate demand and aggregate supply model to analyze some of the key macroeconomic effects on the U.S. economy from this epidemic. As we’ve seen, economists distinguish between recessions caused by an aggregate supply shock, such as an unexpected increase in oil prices, or an aggregate demand shock, such as a decline in spending on new houses. The effects of the coronavirus combined both an aggregate supply shock and an aggregate demand shock.
To this point, we have discussed negative aggregate supply shocks that shift only the short-run aggregate supply curve to the left, leaving the aggregate demand curve unaffected. It’s usually reasonable to assume that the aggregate demand curve doesn’t shift when analyzing the effects of the two main types of supply shocks: (1) a supply shock caused by an increase in the cost of producing goods and services; or (2) a supply shock that reduces the capacity of firms to produce goods and services.
An example of the first type of supply shock is an increase in oil prices. Higher oil prices increase the cost of producing many goods and services, shifting the short-run aggregate supply curve to the left. (See panel (a) of Figure 23.7 in the Hubbard and O’Brien 8th edition text). Total spending in the economy declines, which we show as a movement along the aggregate demand curve (not as a shift in the aggregate demand curve). That movement is the result of the higher price level reducing the spending of households and firms on consumption, investment, and net exports.
The second type of supply shock reduces the capacity of firms and is typically the result of a natural disaster such as the Tohoku earthquake that Japan experienced in 2011. The earthquake triggered a tsunami that disabled the nuclear power plant in the city of Fukushima. The disruption in the power supply to several cities, including Tokyo took months to resolve. During this period, the ability of many Japanese firms to produce goods and services was reduced, causing the short-run aggregate supply curve to shift to the left. Notice that a natural disaster will also have some effect on aggregate demand if there are deaths (about 16,000 people in Japan died as a result of the Tohoku earthquake and tsunami) or if some firms are physically destroyed, making their workers unemployed, thereby reducing the workers’ incomes and their consumption spending. But because the resulting shift of the aggregate demand curve is likely to be small relative to the shift in the short-run aggregate supply curve, it makes sense to concentrate on the effects of the shift in short-run aggregate supply.
The coronavirus pandemic was an unprecedented supply shock to the U.S. economy. The virus originated in the city of Wuhan in China. A number of U.S. firms rely on Chinese suppliers in the Wuhan area. In January 2020, as the government of China closed factories in that area to control the spread of the virus, some U.S. firms, including Apple and Nike, announced that they would be unable to meet their production goals because some of their suppliers had shut down. By March, as the virus began to become widespread in the United States, governors in a number of states ordered all non-essential firms to close.
The following figure illustrates the effects of the virus on U.S. real GDP and the price level. In the figure, at the beginning of 2020, the economy was in long-run macroeconomic equilibrium, with the short-run aggregate supply curve, SRAS1, intersecting the aggregate demand curve, AD1, at point A on the long-run aggregate supply curve, LRAS. Equilibrium occurred at real GDP of $19.2 trillion and a price level of 113. By disrupting the global supply chains of U.S. firms and by leading governments to order the closure of many businesses, the virus caused the short-run aggregate supply curve to shift to the left from SRAS1 to SRAS2. (Note that in the following discussion, we are using the basic aggregate demand and aggregate supply model. In this model, there is no economic growth, so the long-run aggregate supply curve (LRAS) doesn’t shift.)
If the virus had caused a supply shock of the first type that we described earlier—affecting the economy in a way similar to a large increase in oil prices—the new short-run equilibrium would have occurred at point B. Real GDP would have declined from $19.2 trillion to Y2 and the price level would have risen from 113 to P2. (We prepared this content and graph in early April, so we don’t yet know the full effects of the virus on the economy. We therefore don’t attempt to put actual values on the new short-run equilibrium real GDP and price level.)
But point B was not the new short-run equilibrium for several reasons:
Reduced consumption spending The government closed many businesses, directly reducing output resulting in millions of workers losing their jobs. As workers experienced falling incomes, they reduced their consumption spending.
Reduced investmentspending Many residential and business construction projects had to be suspended, reducing investment spending.
Reduced exports U.S. exports declined because the pandemic also led to closures of businesses in Europe, Canada, Japan, and other U.S. trading partners.
As a result of these factors, the United States experienced a sharp decline in total spending in the economy, shifting the aggregate demand curve to the left from AD1 to AD2. In analyzing the supply shock resulting from the coronavirus, we have to include the effect on aggregate demand, which we ignore when considering supply shocks caused by higher oil prices or by a natural disaster, such as an earthquake.
Because the coronavirus pandemic caused both the SRAS and the AD curves to shift to the left, the new short-run equilibrium occurred at point C, with real GDP having fallen to Y3 and the price level having declined to P3. Note that if the shift of the SRAS curve had been larger than the shift of the AD curve, real GDP would have fallen further and the price level would have risen, rather than fallen.
The coronavirus pandemic resulted in very large shifts in short-run aggregate supply and in aggregate demand, so this virus caused by far the largest decline in real GDP and largest increase in unemployment over such a brief period in the history of the United States. The U.S. economy also suffered a large decline in real GDP and a substantial increase in unemployment during the Great Depression of the 1930s. But the decline in the U.S. economy during that economic contraction had been stretched out over the period from August 1929 to March 1933, rather than happening suddenly as was true with the contraction caused by the coronavirus.
Sources: Ruth Simon and Austen Hufford, “Not Just Nike and Apple: Small U.S. Firms Disrupted by Coronavirus,” Wall Street Journal, February 21, 2020; Eric Morath, Jon Hilsenrath, and Sarah Chaney, “Record 3.28 Million File for U.S. Jobless Benefits,” Wall Street Journal, March 26, 2020; and “158 Million Americans Told to Stay Home, but Trump Pledges to Keep It Short,” New York Times, March 26, 2020.
During the spring of 2020, many state and local governments ordered most non-essential businesses to close. Suppose that, as a result, the short-run aggregate supply curve, SRAS, shifted to the left by more than did the aggregate demand curve, AD. On the graph shown here, draw in a new SRAS given this assumption. Label this curve SRAS3. Label the new equilibrium level of real GDP Y4 and the new equilibrium price level P4. Briefly explain the relationship between Y3 and Y4 and between P3 and P4, as shown in your graph.
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