Chapter 11
The AS-AD model: shocks and economic policy reactions

The aggregate supply indicates how many goods companies want to offer at a certain price level. The aggregate demand describes how many goods are in demand at a certain price level. At the intersection of both curves, total supply and demand coincide: the equilibrium of production- and price- level.

The intersection of the long-term supply curve and the aggregate demand curve represents the long-term equilibrium of the economy. If the short-term supply curve also passes through this intersection, then expectations, wages and prices have fully adjusted to the long-term equilibrium. This situation is illustrated in the figure above. There are basically two types of shocks, supply shocks and demand shocks, each with either a positive or negative development. Analogously, two policies are being analyzed in this framework: monetary and fiscal policies, which can be either expansive or restrictive. Also, fiscal policy acts either on the supply or the demand side.

Wirkung Effekt Beispiel

Positiver Angebotsschock GA nach unten/rechts Y steigt, P fällt Technischer Fortschritt, sinkende Energiepreise

Negativer Angebotsschock GA nach oben/links Y fällt, P steigt sprunghaften Anstieg der Produktionskosten, Rohstoffpreisanstieg, Ölkrise

Positiver Nachfrageschock GN nach oben/rechts Y steigt, P steigt Aktienboom

Negativer Nachfrageschock GN nach unten/links Y fällt, P fällt Wirtschaftskrise im Ausland (Exporte sinken)

Fiscal policy
Fiscal policy offers several possibilities for action. On the one hand, the state can directly increase or decrease aggregate demand by changing government consumption. On the other hand, it can change the disposable income of citizens through taxes and transfer payments and thus influence private consumption. The impact of a fiscal policy measure is reduced by the crowding out effect and amplified by the multiplier effect.

Supply-oriented fiscal policy represents the change in taxes, fees and subsidies through which the state can influence the costs and profits of companies and thus the aggregate supply.

Monetary policy
Monetary policy means the regulation of the money supply or the short-term interest rate by the central bank. The respective central bank or agency can apply minimum-reserve-, refinancing- and open-market- policies, the latter being the most important. Also at its disposal are regulatory measures, foreign exchange transactions or, in extreme cases, restrictions on capital movements. In open-market operations, the central bank increases or decreases the money supply by buying or selling bonds. In the first case, the money supply is increased with decreasing interest rate level. In the second case, the money supply is reduced with increasing interest rate level. In the ASAD- model, monetary policy primarily affects aggregate demand. An expansive monetary policy (increase of money supply, decrease of interest rates) shifts the aggregate demand curve to the right. In contrast, a restrictive monetary policy (contraction of the money supply, increase of interest rates) acts like a negative demand shock and shifts the demand curve to the left.




Expansive Fiskalpolitik, angebotsseitig

GA nach unten/rechts Y steigt, P fällt

Senkung der Unternehmenssteuern, laxere Umwelt- und Arbeitsschutzmaßnahmen, Reduzierung des Kündigungsschutzes

Restriktive Fiskalpolitik, angebotsseitig

GA nach oben/links Y fällt, P steigt

Stärkere Auflagen und Regulierungen, Steuererhöhungen

Expansive Geldpolitik / Expansive Fiskalpolitik, nachfrageseitig

GN nach oben/rechts Y steigt, P steigt

Geldmenge steigt, Zins fällt / Höhere Staatsausgaben, Steuersenkungen

Restriktive Geldpolitik / Restriktive Fiskalpolitik, nachfrageseitig

GN nach unten/links Y fällt, P fällt

Geldmenge fällt, Zins steigt / Sparmaßnahmen, Austerität, Steuerhöhung

Goals, conflicting goals and solutions
In principle, price level targets and growth targets are suitable for analysis using the AS-AD model. Obviously, these targets can conflict with each other. For example, after a positive demand shock or expansive fiscal policy, the GDP might rise but with impending inflation, thus the price level target is at risk. Also, in most cases, separate institutions are responsible for monetary and fiscal policy: the government for fiscal policy and the central bank for monetary policy. The standard scenario for Europe assumes an independent central bank setting a price level target and a government having a growth target (i.e. GDP does not fall, balancing short-term economic fluctuations). Thus, depending on the kind of shock, one or both institutions may have to take action and, depending on the measures taken, policies may be complementary or mutually disruptive. For example, the European Central Bank (ECB) is obliged to ensure price level stability. Measures serving this objective can have negative effects on economic growth (cf. negative supply shock). There is thus a conflict between the government and the central bank over the necessary measures. Examples are listed below. With the help of the graphs, these can be easily understood and you can also conduct your own analyses. One rule of thumb is obvious: any shock can be canceled out by a policy measure acting in the opposite direction on the same curve, so that both the price level and GDP return to their original level.
A recipe for analysis
  1. Definition of the goal: goal of price stability or GDP, or both? Which institutions have which measures at their disposal?
  2. Determining the nature of the shock
  3. Determining the shock reaction: change of Y and P
  4. Which target variables need to be corrected? Selection of possible measures.
  5. Determining the response to the measures.
Example 1: Negative supply shock
In the initial equilibrium, companies experience a negative supply shock, for example, through a drastic increase in oil prices as in the 1970s. The AS-curve shifts to the left, GDP falls and inflation rises. Unemployment increases and the economy is in a state of stagflation (stagnation & inflation).

There are now four non-exclusive policy options:

  1. Sit it out: The first option is to do nothing and wait. Self-healing processes slowly raise production and prices back to their natural levels. This type of policy is very painful because the economy remains in recession with high unemployment for a relatively long time. A long period of high unemployment and low production levels push wages down. With low wage rates, companies are increasing their production again. In addition, downward rigidity in wages can delay or halt the self-healing process.
  2. Fiscal policy measures to strengthen the supply side: Examples of such policy measures are the reduction of taxes on profits or non-wage labor costs, reduction of taxes on raw materials and energy, reduction of regulations and subsidies. If a negative supply shock is responded to by an appropriately counter-directed supply policy, the effects of the shock can be reduced without conflicting objectives.
  3. Demand-oriented fiscal policy (Hollande): A strengthening of the demand side through tax cuts or an increase in government demand creates a conflict of goals between the government and the central bank. An increase in aggregate demand increases inflation even further and forces an inflation-oriented central bank to react (s. 5)
  4. Growth-oriented monetary policy: If, however, monetary policy is geared more towards the current state of the economy than to the risks of inflation, then it will support demand-oriented fiscal policy with an expansive monetary policy. This is referred to as concerted action or accommodative policy.
  5. Price-level-oriented monetary policy: In order to counteract the rise of the price level, the central bank must implement a restrictive monetary policy. However, the rise of interest rates and the reduction in the money supply will drive the economy deeper into recession and initially worsen the economic situation.

In the case of the oil price shocks in the 1970s, stimulative monetary and fiscal policies from 1975 onward helped to overcome the recession faster than otherwise would have been the case, albeit at the cost of higher inflation. By contrast, the ECB nowadays is only committed to stabilizing price levels, so that today there would be a conflict between policy measures.

Example 2: Negative demand shock
An example of a negative shock to aggregate demand are the consequences of September 11 in 2001 in the USA, which also coincides with the aftermath of the bursting of the dotcom-bubble. The latter led to large losses of wealth of households and, as a consequence, to a collapse of demand. The former led to increased precaution- and saving- behavior. Both effects significantly dampened aggregate demand. (Left shift of the AD curve, falling GDP and falling price level).

Monetary policy response: The FED under Allan Greenspan lowered the interest rates significantly and flooded the markets with fresh central bank money to prevent the markets from collapsing completely. Critics call this a "Greenspan put," since these measures, similar to a put-option, reduce the risk of falling stocks. As a result, the low interest rates fueled, in particular, the real estate market and are now considered one of the main causes of the 2008 real estate market crisis. However, in 2000 and 2001 they actually helped to dampen the negative effects of the crisis (positive boost of aggregate demand). Fiscal policy also reacted expansively to the consequences of 9/11 and massively increased government spending. While the US government budget still showed a surplus of 200 billion in 2000, it was in deficit by 160 billion in 2002. A large part of the additional government spending went into the military budget to prepare and finance the war in Iraq. In addition, further very high government expenditure went to internal and external security. These measures also have a positive effect on aggregate demand (besides the official task) and counteract the negative demand shock.

Military budget, just like public medical care and most of the education sector, is one of the areas in which the crowding-out effects are very low. Hence, from an economic point of view investments there are an efficient crisis management strategy. In the education sector, however, the multiplier effects would have been much higher in the long term, therefore investments in this sector would have been preferable from an macroeconomic perspective.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743