The economic events that resulted from the Covid-19 pandemic were not at all typical.
The Unusual Covid Recession
By Austan Goolsbee
Americans everywhere remain concerned about getting past what feels like a never-ending
litany of Covid-19-induced economic problems, from out-of-stock products to inflation and
continued fears of exposure to illness when going out. When will it finally end?
Professional economic forecasters are struggling to answer this question.
Many are turning to previous recessions as a guide to how things will go. But one of the most
important things to understand is that while the pandemic created a collapse—and for some
even an economic disaster—it really wasn’t a recession in the normal sense.
That sounds strange. Indeed, the arbiter of these things, the National Bureau of Economic
Research, declared that the United States had a two-month recession in March and April 2020.
But past business cycles look nothing like what the United States has gone through in the
pandemic, so they are the wrong place to find lessons for where things are going now.
The causes of recessions vary, but they follow a basic pattern: The hardest-hit industries are the
cyclically sensitive sectors where demand dries up. Those sectors include sales of big-ticket
items like furniture, construction materials, appliances and cars, as the Bureau of Labor
Statistics and others have documented. These are purchases that can be delayed when times
are bad. Recoveries begin when demand returns to these cyclical industries, when prices fall
enough or interest rates get cut enough or pent-up needs build sufficiently for demand to
return.
Recessions have much smaller impacts on noncyclical industries like hospitals, nursing care, gas
and electric utilities, and the like. Demand there is steady regardless of the cycle. Some service
sector industries, like education, see demand rise in recessions.
None of these familiar patterns held during the pandemic economic collapse. Spending on
consumer durables went up. Indeed, sales of TVs with screens larger than 65 inches rose 77
percent from April to June 2020, compared to the year before, as the bottom dropped out of
the economy. Watching TV was one of the few things people could still do during lockdown.
Demand for other cyclical industry goods like housing and construction materials boomed too.
During the pandemic downturn, Americans also reversed a decades-long trend toward spending
on services rather than goods. For 75 years, consumers in the United States have been spending
less and less of their money on physical goods (from 60 percent of spending in the 1940s to 31
percent in 2019). Counter to this trend (and contrasting with previous recessions), the share of
consumer spending on physical goods actually jumped during the pandemic to the highest level
in 17 years and among the biggest jumps ever recorded.
In other words, this was a recession like no other in recent memory. The pandemic downturn
was driven by all those industries that are supposed to be recession-proof—trips to the dentist,
electricity usage in offices and malls, and so on. And the normally countercyclical education
sector had big enrollment drops despite the bad economy.
Of course, this was because of the coronavirus. But it means that the recovery from past
recessions doesn’t really say much about how the recovery will go now. Everyone is trying to
predict when there will be a rebound in service sector industries that normally don’t decline,
like health care, child care and education. That’s really more of a question about how quickly we
can control the spread of the virus than it is about recession fundamentals.
At the same time, the unusually large demand for physical goods in the United States and other
rich countries has exceeded supply, driving up inflation and leading to shortages.
So the most important thing to watch if you want to understand the economy is, as has been
the case for a year and half now, the progress made against the virus. Related, and also worth
watching, is how much Americans spend on goods relative to services. (It was 31 percent in
2019 and has risen to 35 percent now.)
While economic growth in the United States was disappointing in the third quarter of 2021, it
could easily turn around if coronavirus case numbers improve. The U.S. employment numbers
released on Friday were encouraging. New Covid-19 cases are down significantly and millions of
children are now eligible for vaccination, which could reduce infection rates even further.
Looking beyond the coming months, though, the most interesting questions aren’t really about
recession and recovery. They center on whether any of the pandemic changes will last. Some
companies, for example, are now trying to hold more inventory and keep their supply chains
local to avoid disruption. Many people are working partly from home and some have moved to
the exurbs. But how long before they rediscover why we ended up with lean manufacturing and
a global supply chain in the first place? And Americans are already moving back to cities.
My view is that reversals of longstanding economic trends are not likely to become permanent.
Once the economic memory of the pandemic has faded, the old lessons from the regular
business cycle will probably become relevant once more. Until that happens, though, best to get
in line for a vaccine booster and keep your eye on the case numbers.
Questions to Discuss
How did your family’s spending change during the coronavirus pandemic?
In your opinion, what economic policies should the government have pursued during the
pandemic?
Mr. Goolsbee is a professor of economics at the University of Chicago.
Source: New York Times, November 10, 2021.
Case Study: The Economics of the Black Death
In 14th-century Europe, the bubonic plague wiped out about one?third of the population within
a few years—a vastly more calamitous event than even the tragic Covid pandemic of 2020 and
2021, which killed less than 1 percent of the population. This event, called the Black Death,
provides a grisly natural experiment to test the theory of factor markets that we have just
developed. Consider the effects of the Black Death on those who were lucky enough to survive.
What do you think happened to the wages earned by workers and the rents earned by
landowners?
To answer this question, let’s examine the effects of a reduced population on the marginal
product of labor and the marginal product of land. With a smaller supply of workers, the
marginal product of labor rises. This is diminishing marginal product working in reverse. We
would, therefore, expect the Black Death to raise wages. Because land and labor are used
together in production, a smaller supply of workers also affects the market for land, the other
major factor of production in medieval Europe. With fewer workers available to farm the land,
an additional unit of land produced less additional output. This decline in the marginal product
of land would be expected to reduce rents.
Both theoretical predictions conform with the historical evidence. Wages approximately
doubled during this period, and rents declined 50 percent or more. For survivors, the Black
Death led to economic prosperity for the peasant classes and reduced incomes for the landed
classes.
In 2022, as this book was going to press, U.S. inflation was surging. In February of that year,
consumer prices were 7.9 percent higher than a year earlier, the highest inflation rate in 40
years. During the economic downturn caused by the coronavirus pandemic in 2020, the
government alleviated the hardship with large increases in spending, and the quantity of money
in the economy rose significantly. These policies, together with supply disruptions due to the
pandemic, contributed to rising inflation. The key question was whether the inflation surge
would be transitory, as many government officials believed, or whether it would become
embedded in the economy, as occurred in the 1970s. The outcome would depend, in large part,
on future monetary policy.
1-3c. Principle 10: Society Faces a Short-Run Trade-Off between Inflation and Unemployment
While an increase in the quantity of money primarily raises prices in the long run, the short-run
story is more complex. Most economists describe the short-run effects of money growth as
follows:
Increasing the amount of money in the economy stimulates the overall level of spending and
thus the demand for goods and services.
Higher demand will, over time, cause firms to raise their prices, but in the meantime, it
encourages them to hire more workers and produce a larger quantity of goods and services.
More hiring means lower unemployment.
This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off between
inflation and unemployment.
Some economists still question these ideas, but most accept that society faces a short-run
trade-off between inflation and unemployment. This simply means that, over a period of a year
or two, many economic policies push inflation and unemployment in opposite directions.
Policymakers face this trade-off regardless of whether inflation and unemployment both start
out at high levels (as they did in the early 1980s), at low levels (as they did in the late 2010s), or
someplace in between. This short-run trade-off plays a key role in the analysis of the business
cycle—the irregular and largely unpredictable fluctuations in economic activity, as measured by
the production of goods and services or the number of people employed.
Policymakers can exploit the short-run trade-off between inflation and unemployment using
various policy instruments. By changing the amount that the government spends, the amount it
taxes, or the amount of money it prints, policymakers can influence the overall demand for
goods and services. Changes in demand, in turn, influence the combination of inflation and
unemployment that the economy experiences in the short run. Because these instruments of
economic policy are so powerful, how policymakers should use them is the subject of
continuing debate.
In The News: Poverty during the Pandemic
During the Covid-19 pandemic, U.S. policymakers offered a safety net that, by historical
standards, was very generous.
Temporary Pandemic Safety Net Drives Poverty to a Record Low
By Jason DeParle
Washington—The huge increase in government aid prompted by the coronavirus pandemic will
cut poverty nearly in half this year from prepandemic levels and push the share of Americans in
poverty to the lowest level on record, according to the most comprehensive analysis yet of a
vast but temporary expansion of the safety net.
The number of poor Americans is expected to fall by nearly 20 million from 2018 levels, a
decline of almost 45 percent. The country has never cut poverty so much in such a short period
of time, and the development is especially notable since it defies economic headwinds—the
economy has nearly seven million fewer jobs than it did before the pandemic.
The extraordinary reduction in poverty has come at extraordinary cost, with annual spending on
major programs projected to rise fourfold to more than $1 trillion. Yet without further
expensive new measures, millions of families may find the escape from poverty brief. The three
programs that cut poverty most—stimulus checks, increased food stamps and expanded
unemployment insurance—have ended or are scheduled to soon revert to their prepandemic
size.
While poverty has fallen most among children, its retreat is remarkably broad: It has dropped
among Americans who are white, Black, Latino and Asian, and among Americans of every age
group and residents of every state.
“These are really large reductions in poverty—the largest short-term reductions we’ve seen,”
said Laura Wheaton of the Urban Institute, who produced the estimate with her colleagues
Linda Giannarelli and Ilham Dehry. The institute’s simulation model is widely used by
government agencies. The New York Times requested the analysis, which expanded on an
earlier projection.
The finding—that poverty plunged amid hard times at huge fiscal costs—comes at a moment of
sharp debate about the future of the safety net.
The Biden administration has started making monthly payments to most families with children
through an expansion of the child tax credit. Democrats want to make the yearlong effort
permanent, which would reduce child poverty on a continuing basis by giving their families an
income guarantee.
Progressives said the new numbers vindicated their contention that poverty levels reflected
political choices and government programs could reduce economic need.
“Wow—these are stunning findings,” said Bob Greenstein, a longtime proponent of safety net
programs who is now at the Brookings Institution. “The policy response since the start of the
pandemic goes beyond anything we’ve ever done, and the antipoverty effect dwarfs what most
of us thought was possible.”
Conservatives say that pandemic-era spending is unsustainable and would harm the poor in the
long run, arguing that unconditional aid discourages work and marriage. The child tax credit
offers families up to $300 per child a month whether or not parents have jobs, which critics call
a return to failed welfare policies.
“There’s no doubt that by shoveling trillions of dollars to the poor, you can reduce poverty,” said
Robert Rector of the Heritage Foundation. “But that’s not efficient and it’s not good for the poor
because it produces social marginalization. You want policies that encourage work and
marriage, not undermine it.”
Poverty rates had reached new lows before the pandemic, Mr. Rector added, under policies
meant to discourage welfare and promote work.
To understand how large the recent aid expansion has been, consider the experience of Kathryn
Goodwin, a single mother of five in St. Charles, Mo., who managed a group of trailer parks
before the pandemic eliminated her $33,000 job.
Without the pandemic-era expansions—passed in three rounds under both the Trump and
Biden administrations—Ms. Goodwin’s job loss would have caused her income to plunge to
about $29,000 (in jobless benefits, food stamps and other aid), leaving her officially poor.
Instead, her income rose above its prepandemic level, though she has not worked for a year.
She received about $25,000 in unemployment benefits (about three times what she would have
received before the pandemic) and $12,000 in stimulus checks. With increased food stamp
benefits and other help, her income grew to $67,000—almost 30 percent more than when she
had a job.
“Without that help, I literally don’t know how I would have survived,” she said. “We would have
been homeless.”
Still, Ms. Goodwin, 29, has mixed feelings about large payments with no stipulations.
“In my case, yes, it was very beneficial,” she said. But she said that other people she knew
bought big TVs and her former boyfriend bought drugs. “All this free money enabled him to be a
worse addict than he already was,” she said. “Why should taxpayers pay for that?”
The Urban Institute’s projections show poverty falling to 7.7 percent this year from 13.9 percent
in 2018. That decline, 45 percent, is nearly three times the previous three-year record,
according to historical estimates by researchers at Columbia University. The projected drop in
child poverty, to 5.6 from 14.2 percent, amounts to a decline of 61 percent. That exceeds the
previous 50 years combined, the Columbia figures show….
Jessica Moore of St. Louis said the expanded aid helped her make a fresh start.
A single mother of three, Ms. Moore, 24, lost work as a banquet server at the pandemic’s start
but received enough in unemployment insurance and stimulus checks to buy a car and enroll in
community college. She is studying to become an emergency medical technician, which
promises to raise her earnings 50 percent.
“When you lose your job, you don’t expect benefits that are more than you were making,” she
said. “It was a pure blessing.”
21-4. Conclusion
People have long reflected on the distribution of income in society. Plato, the ancient Greek
philosopher, said that in an ideal society, the highest income would be no more than four times
the lowest. Measuring inequality is difficult, but it is clear that most nations around the world,
especially the United States, have much more inequality than Plato recommended.
One of the Ten Principles of Economics in Chapter 1 is that governments can sometimes
improve market outcomes. This principle is important when considering the distribution of
income. Even when the allocation of resources reached by the invisible hand is efficient, it is
usually far from equal, and it is not necessarily fair. Yet there is no broad consensus about what
fairness means or how much the government should redistribute income. Lawmakers often
debate the progressivity of the tax code and the generosity of the social safety net. Economics
alone cannot settle the disagreement.
Two other of the Ten Principles of Economics in Chapter 1 are that people face trade-offs and
that people respond to incentives. These principles are intertwined in discussions of economic
inequality. When the government enacts policies to partly equalize incomes, it may distort
incentives, alter behavior, and make the allocation of resources less efficient. As a result,
policymakers face a trade-off between equality and efficiency. The more equally they slice the
economic pie, the smaller it may become. This doesn’t mean that policymakers should
necessarily refrain from income redistribution. But it does suggest that they approach
redistributive policies aware of their potential costs.
18-3d. Policy 3: Government Budget Deficits and Surpluses
A perpetual topic of political debate is the status of the government budget. Recall that a
budget deficit is an excess of government spending over tax revenue. Governments finance
budget deficits by borrowing in the bond market, and the accumulation of past government
borrowing is called the government debt. A budget surplus, an excess of tax revenue over
government spending, can be used to repay some of the government debt. If government
spending exactly equals tax revenue, the government is said to have a balanced budget.
Imagine that the government starts with a balanced budget and then, because of an increase in
government spending, starts to run a budget deficit. We can analyze the effects of the budget
deficit by following our three steps in the market for loanable funds, as illustrated in Figure 5.
Figure 5 The Effect of a Government Budget Deficit
Details
When the government spends more than it receives in tax revenue, the resulting budget deficit
lowers national saving. The supply of loanable funds decreases, and the equilibrium interest
rate rises. Thus, when the government borrows to finance its budget deficit, it crowds out
households and firms that otherwise would borrow to finance investment. Here, when the
supply curve shifts from
�
1
to
�
2
, the equilibrium interest rate rises from 5 percent to 6 percent, and the equilibrium quantity of
loanable funds saved and invested falls from $1,200 billion to $800 billion.
First, which curve shifts when the government starts running a budget deficit? Recall that
national saving—the source of the supply of loanable funds—is composed of private and public
saving. A change in the government budget balance represents a change in public saving and,
therefore, in the supply of loanable funds. Because the budget deficit does not influence the
amount that households and firms want to borrow to finance investment at any interest rate, it
does not alter the demand for loanable funds.
Second, in which direction does the supply curve shift? When the government runs a budget
deficit, public saving is negative, so national saving declines. In other words, when the
government borrows to finance its budget deficit, it reduces the supply of loanable funds
available to finance investment. Thus, a budget deficit shifts the supply curve for loanable funds
to the left from
�
1
to
�
2
, as shown in Figure 5.
Third, compare the old and new equilibria. In the figure, when the budget deficit reduces the
supply of loanable funds, the interest rate rises from 5 percent to 6 percent. The quantity of
loanable funds demanded then decreases from $1,200 billion to $800 billion as the higher
interest rate discourages many demanders of loanable funds. Fewer families buy new homes,
and fewer firms choose to build new factories. The fall in investment caused by government
borrowing is represented by the movement along the demand curve and is called crowding out.
That is, when the government borrows to finance its budget deficit, it crowds out private
borrowers who are trying to finance investment.
In this standard model, the most basic lesson about budget deficits follows directly from their
effects on the supply and demand for loanable funds: When the government reduces national
saving by running a budget deficit, the interest rate rises, and investment falls. Because
investment is important for long-run growth, government budget deficits reduce the economy’s
growth rate.
Why, you might ask, does a budget deficit affect the supply of loanable funds rather than the
demand for them? After all, the government finances a budget deficit by selling bonds, thereby
borrowing from the private sector. Why does increased borrowing by the government shift the
supply curve, while increased borrowing by private investors shifts the demand curve? To
answer this question, we need to examine more precisely the meaning of “loanable funds.” The
model as presented here takes this term to mean the flow of resources available to fund private
investment; for that reason, a government budget deficit reduces the supply of loanable funds.
If, instead, we had defined the term “loanable funds” to mean the flow of resources available
from private saving, then the government budget deficit would increase demand rather than
reduce supply. Changing the interpretation of the term would cause a semantic change in how
we described the model, but the upshot of the analysis would be the same: In either case, a
budget deficit increases the interest rate, thereby crowding out private borrowers who are
relying on financial markets to fund private investment projects.
So far, we have examined a budget deficit that results from an increase in government spending,
but a budget deficit that results from a tax cut has similar effects. A tax cut reduces tax revenue
T and public saving, T − G. Private saving, Y − T − C, might increase because of lower T, but as
long as households respond to the lower taxes by consuming more, C increases, so private
saving rises by less than public saving falls. National saving (S = Y − C − G), the sum of public
saving and private saving, declines. Once again, the budget deficit reduces the supply of
loanable funds, drives up the interest rate, and crowds out borrowers trying to finance capital
investments.
Having examined the impact of budget deficits, we can turn the analysis around and see the
opposite effects of government budget surpluses. When the government collects more in tax
revenue than it spends, it saves the difference by retiring some of the government debt. This
budget surplus, or public saving, contributes to national saving. Thus, a budget surplus increases
the supply of loanable funds, reduces the interest rate, and stimulates investment. Higher
investment, in turn, means greater capital accumulation and more rapid economic growth.
Ask the Experts Fiscal Policy and Saving
“Sustained tax and spending policies that boost consumption in ways that reduce the saving
rate are likely to lower long-run living standards.”
Details
Source: IGM Economic Experts Panel, July 8, 2013.
Case Study: The History of U.S. Government Debt
How indebted is the U.S. government? The answer to this question varies substantially over
time. Figure 6 shows the debt of the U.S. federal government expressed as a percentage of U.S.
GDP. It shows that the government debt has fluctuated from zero in 1836 to 106 percent of GDP
in 1946.
Figure 6 The U.S. Government Debt
Details
Source: U.S. Department of Treasury; U.S. Department of Commerce; and T. S. Berry,
“Production and Population since 1789,” Bostwick Paper No. 6, Richmond, 1988. The data here
are for government debt held by the public, which excludes government debt held in
government accounts, such as the Social Security trust fund.
The debt of the U.S. federal government, expressed here as a percentage of GDP, has varied
throughout history. Wars and deep economic downturns are typically associated with
substantial increases in government debt.
The debt-to-GDP ratio is one gauge of the government’s finances. Because GDP is a rough
measure of the government’s tax base, a declining debt-to-GDP ratio indicates that the
government’s indebtedness is shrinking relative to its ability to raise tax revenue. This suggests
that the government is, in some sense, living within its means. By contrast, a rising debt-to-GDP
ratio means that the government indebtedness is increasing relative to its ability to raise tax
revenue. It is often interpreted as meaning that fiscal policy—government spending and taxes—
cannot be sustained forever at current levels.
Throughout history, a primary cause of fluctuations in government debt has been war. When
wars occur, government spending on national defense rises substantially to pay for soldiers and
military equipment. Taxes sometimes rise as well but typically by much less than the increase in
spending. The result is a budget deficit and increasing government debt. When the war is over,
government spending declines, and the debt-to-GDP ratio starts declining as well.
There are two reasons to believe that debt financing of war is an appropriate policy. First, it
allows the government to keep tax rates smooth over time. Without debt financing, wars would
require sharp increases in tax rates, which would cause a substantial decline in economic
efficiency. Second, debt financing of wars shifts part of the cost of wars to future generations,
who will have to pay off the government debt. Putting some of the tax burden on future
generations is arguably fair if there is an enduring benefit from a war fought by a previous
generation.
Another notable cause of increases in government debt is deep economic downturns, such as
the Great Depression of the 1930s, the Great Recession associated with the financial crisis of
2008–2009, and the Covid Recession of 2020. During downturns, government revenue
automatically falls as receipts from income and payroll taxes decline. Spending on government
programs such as unemployment insurance also rises automatically. In addition, policymakers
usually enact policies to soften the downturn and mitigate the economic hardship, further
increasing the budget deficit.
Going forward, many budget analysts are concerned about further increases in the debt-to-GDP
ratio. As members of the large baby-boom generation reach retirement age, they will become
eligible for Social Security and Medicare benefits, putting upward pressure on government
spending. Without sizable increases in tax revenue or cuts in government spending, the U.S.
federal government will likely experience substantially rising debt over the next few decades.
According to a 2021 projection by the Congressional Budget Office, the debt-to-GDP ratio is on
track to reach 140 percent by 2040, which is larger than anything that has been experienced
historically.
FYI Financial Crises
In 2008 and 2009, the U.S. economy and many others around the world experienced a financial
crisis, which led to a deep downturn in economic activity. We will examine these events in detail
later in this book. For now, here are the key elements of typical financial crises.
The first element of a financial crisis is a large decline in the prices of some assets. In 2008 and
2009, that asset was real estate. House prices, after booming earlier in the decade, fell by about
30 percent over just a few years. Such a large decline in real estate prices had not been seen in
the United States since the 1930s.
The second element of a financial crisis is widespread insolvencies at financial institutions. (A
company is insolvent when its liabilities exceed the value of its assets.) In 2008 and 2009, many
banks and other financial firms had, in effect, placed bets on house prices by holding mortgages
backed by that real estate. When house prices plummeted, large numbers of homeowners
stopped repaying their loans. These defaults pushed several major financial institutions toward
bankruptcy.
The third element is a decline in confidence in financial institutions. Although some deposits in
banks are insured by government policies, not all are. As insolvencies mounted in 2008 and
2009, every financial institution became a candidate for bankruptcy. Individuals and firms with
uninsured deposits in those institutions pulled out their money. Needing cash to pay back
depositors, banks started selling off assets (sometimes at reduced “fire-sale” prices) and cut
back on new lending.
The fourth element is a credit crunch. With many financial institutions facing difficulties,
prospective borrowers had trouble getting loans, even if they had profitable investment
projects. In essence, the financial system had trouble directing the resources of savers into the
hands of borrowers with the best investment opportunities.
The fifth element is an economic downturn. With people unable to obtain financing for new
investment projects, the overall demand for goods and services declined. As a result, for
reasons discussed more fully later in the book, national income fell, and unemployment rose.
The sixth and final element of a financial crisis is a vicious circle. The downturn reduced the
profitability of many companies and the value of many assets, putting the economy back at step
one. The problems in the financial system and the overall economy reinforced each other.
Financial crises, such as the one of 2008 and 2009, can have severe consequences. Fortunately,
sooner or later, they end. The financial system eventually gets back on its feet, perhaps with
help from government, and it returns to its normal function of financial intermediation.
23-5b. The Effects of a Shift in Aggregate Supply
Imagine once again an economy in long-run equilibrium. Now suppose that the costs of
production suddenly increase for some firms. For example, bad weather in farm states might
destroy crops, driving up the cost of food products. Or a war in the Middle East might interrupt
the shipping of crude oil, driving up the cost of oil-intensive goods.
To analyze the macroeconomic impact of such an increase in production costs, follow the same
four steps as always. First, which curve is affected? Because production costs affect the firms
that supply goods and services, changes in production costs alter the position of the aggregatesupply curve. Second, in which direction does the curve shift? Because higher production costs
make selling goods and services less profitable, firms now supply a smaller quantity of output
for any price level. As Figure 10 shows, the short-run aggregate-supply curve shifts to the left,
from
AS
1
to
AS
2
. (Depending on the event, the long-run aggregate-supply curve might also shift. To keep things
simple, however, we will assume that it does not.)
Figure 10 AN Adverse Shift in Aggregate Supply
Details
When some event increases firms’ costs, the short-run aggregate-supply curve shifts to the left
from
AS
1
to
AS
2
. The economy moves from point A to point B. The result is stagflation: Output falls from
�
1
to
�
2
, and the price level rises from
�
1
to
�
2
.
The figure allows us to perform step three of comparing the initial and new equilibria. In the
short run, the economy goes from point A to point B, moving along the existing aggregatedemand curve. The output of the economy falls from
�
1
to
�
2
, and the price level rises from
�
1
to
�
2
. Because the economy is experiencing both stagnation (falling output) and inflation (rising
prices), such an event is sometimes called stagflation.
Now consider step four—the transition from the short-run equilibrium to the long-run
equilibrium. According to the sticky-wage theory, the key issue is how stagflation affects
nominal wages. Firms and workers may, at first, respond to the higher level of prices by raising
their expectations of the price level and setting higher nominal wages. In this case, firms’ costs
will rise yet again, and the short-run aggregate-supply curve will shift farther to the left, making
the problem of stagflation even worse. This phenomenon of higher prices leading to higher
wages, which in turn leads to even higher prices, is sometimes called a wage-price spiral.
At some point, the spiral of ever-rising wages and prices will slow. The low level of output and
employment will put downward pressure on wages because workers have less bargaining power
when unemployment is high. As nominal wages fall, producing goods and services becomes
more profitable, and the short-run aggregate-supply curve shifts to the right. As it shifts back
toward
AS
1
, the price level falls, and the quantity of output approaches its natural level. In the long run,
the economy returns to point A, where the aggregate-demand curve crosses the long-run
aggregate-supply curve.
This transition back to the initial equilibrium assumes, however, that aggregate demand is held
constant throughout the process. In the real world, that may not be the case. Monetary and
fiscal policymakers might attempt to offset some of the effects of the shift in the short-run
aggregate-supply curve by shifting the aggregate-demand curve. This possibility is shown in
Figure 11. In this case, changes in policy shift the aggregate-demand curve to the right, from
AD
1
to
AD
2
—exactly enough to prevent the shift in aggregate supply from affecting output. The economy
moves directly from point A to point C. Output remains at its natural level, and the price level
rises from
�
1
to
�
3
. In this case, policymakers are said to accommodate the shift in aggregate supply. An
accommodative policy accepts a permanently higher level of prices to maintain a higher level of
output and employment.
Figure 11 Accommodating an Adverse Shift in Aggregate Supply
Details
Faced with an adverse shift in aggregate supply from
AS
1
to
AS
2
, policymakers who can influence aggregate demand might try to shift the aggregate-demand
curve to the right from
AD
1
to
AD
2
. The economy would move from point A to point C. This policy would prevent the supply shift
from reducing output in the short run, but the price level would permanently rise from
�
1
to
�
3
.
To sum up, this story about shifts in aggregate supply has two important lessons:
Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and
inflation (rising prices).
Policymakers who can influence aggregate demand can mitigate the adverse impact on output
but only at the cost of exacerbating the problem of inflation.
Case Study: Oil and the Economy
Some of the largest economic fluctuations in the U.S. economy since 1970 originated in the oil
fields of the Middle East. Crude oil is an input into the production of many goods and services,
and much of the world’s oil comes from Saudi Arabia, Kuwait, and other Middle Eastern
countries. When some event (often political in origin) reduces the supply of crude oil flowing
from this region, the price of oil rises around the world. Firms in the United States that produce
gasoline, tires, and many other products experience rising costs, so they find it less profitable to
supply their output of goods and services at any price level. The result is a leftward shift in the
aggregate-supply curve, which, in turn, leads to stagflation.
The first episode of this sort occurred in the mid-1970s. The countries with large oil reserves
started to exert their influence on the world economy as members of OPEC, the Organization of
the Petroleum Exporting Countries. OPEC is a cartel—a group of sellers that attempts to thwart
competition and reduce production to raise prices. And indeed, oil prices rose substantially.
From 1973 to 1975, oil approximately doubled in price. Oil-importing countries around the
world experienced simultaneous inflation and recession. The U.S. inflation rate as measured by
the CPI exceeded 10 percent for the first time in decades. Unemployment rose from 4.9 percent
in 1973 to 8.5 percent in 1975.
Almost the same thing happened a few years later. In the late 1970s, the OPEC countries again
restricted the supply of oil. From 1978 to 1981, the price of oil more than doubled. Once again,
the result was stagflation. Inflation, which had subsided somewhat after the first OPEC event,
again rose above 10 percent per year. But because the Fed was not willing to accommodate
such a large rise in inflation, a recession soon followed. Unemployment rose from about 6
percent in 1978 and 1979 to about 10 percent a few years later.
Developments in the world market for oil can also be a source of favorable shifts in aggregate
supply. In 1986, squabbling broke out among members of OPEC. Member countries reneged on
their agreements to restrict oil production. In the world market for crude oil, prices fell by about
half. This fall in oil prices reduced costs to U.S. firms, which now found it more profitable to
supply goods and services at any price level. As a result, the aggregate-supply curve shifted to
the right. The U.S. economy experienced the opposite of stagflation: Output grew rapidly,
unemployment fell, and the inflation rate reached its lowest level in many years.
In recent years, developments in the world oil market have not been as important a source of
fluctuations for the U.S. economy. One reason is that conservation efforts, advancing
technology, and the increased availability of alternative energy sources have reduced the
economy’s dependence on oil. The amount of oil used to produce a unit of real GDP has
declined by more than 60 percent since the OPEC shocks of the 1970s. As a result, the impact of
any change in oil prices on the U.S. economy is smaller today than it was in the past.
YASSER AL-ZAYYAT/AFP/GETTY IMAGES
Changes in Middle East oil production are one source of U.S. economic fluctuations.
FYI The Origins of the Model of Aggregate Demand and Aggregate Supply
Now that we have seen the model of aggregate demand and aggregate supply, let’s step back
and consider its history. How did this model of short-run fluctuations develop? The answer is
that this model is largely a by-product of the Great Depression of the 1930s. Economists and
policymakers at the time were puzzled about what had caused this calamity and were uncertain
about how to deal with it.
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John Maynard Keynes
In 1936, the economist John Maynard Keynes published The General Theory of Employment,
Interest, and Money, a landmark book that attempted to explain short-run economic
fluctuations in general and the Great Depression in particular. Keynes’s main message was that
recessions and depressions can occur because of inadequate aggregate demand for goods and
services.
Keynes had long been a critic of classical economic theory because it could explain only the
long-run effects of policies. A few years before offering The General Theory, Keynes had written
the following about classical economics:
The long run is a misleading guide to current affairs. In the long run we are all dead. Economists
set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when
the storm is long past, the ocean will be flat.
Keynes’s message was aimed at policymakers as well as economists. As the world’s economies
suffered from high unemployment, Keynes advocated policies to increase aggregate demand,
including government spending on public works.
The next chapter examines in detail how policymakers can use the tools of monetary and fiscal
policy to influence aggregate demand. The analysis in that chapter, as well as in this one, owes
much to the legacy of John Maynard Keynes.
Case Study: The Covid Recession of 2020
In 2020, the U.S. economy and most others around the world experienced a downturn with
three unusual features.
The first was its cause: the Covid-19 pandemic. This infectious and dangerous virus initially
appeared in China in late 2019 and then in the United States in early 2020. To slow its spread,
health experts advised people to avoid close interactions with others. Elected leaders ordered
large segments of the economy to be closed, including movie theaters, sporting events,
concerts, restaurants (except for take-out), and non-essential retail stores. Commercial air travel
stopped almost completely.
The second unusual feature of the 2020 downturn was its speed and depth. From February
2020 to April 2020, employment in the United States fell from 61.1 percent of the adult
population to 51.3 percent—by far the largest two-month drop ever recorded. The
unemployment rate in April 2020 was 14.8 percent, the highest level since the Great
Depression.
The third unusual feature of this downturn was that, in a sense, it was intentional. Most
recessions are accidents: Some unexpected event shifts aggregate supply or aggregate demand,
reducing production and employment. When this occurs, policymakers usually want to return
the economy to normal levels of production and employment as quickly as possible. By contrast,
the 2020 downturn was a recession by design. To curb the Covid-19 pandemic, policymakers
compelled changes in behavior that reduced production and employment. Of course, the
pandemic itself was neither intended nor desired. But given the circumstances, a large,
temporary decline in economic activity was arguably the best possible outcome.
The economic downturn of 2020 can be interpreted using the model of aggregate supply and
aggregate demand. Consider first aggregate demand. Starting in March 2020, many places
where people normally buy things, such as restaurants and retail stores, were closed by
government decree. And people avoided many businesses that remained open to reduce the
risk of infection. As a result, the quantity of goods and services demanded was lower at every
price level. The aggregate demand curve shifted to the left.
Now consider aggregate supply. When the health crisis caused many businesses to temporarily
shut down, it caused a sudden, massive reduction in the quantity of goods and services supplied
at every price level. The aggregate supply curve shifted to the left. The simultaneous shifts in
aggregate demand and aggregate supply led to a sharp reduction in production and
employment.
Once the enormity of the downturn became clear, policymakers responded swiftly. On March
27, 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law.
Together with other legislation enacted around the same time, it authorized a combination of
spending increases and tax reductions of about $2 trillion, roughly 10 percent of GDP, making it
the largest fiscal response to a recession in history. The CARES Act is sometimes called a
stimulus bill, but the goal was not actually to end the recession by stimulating the economy. The
recession was inevitable, given the pandemic. The policy’s goal was to alleviate the hardship
people faced and to prevent the downturn from leaving permanent scars on the economy.
A large part of the policy response might be called social insurance or disaster relief. All
households, except those with high incomes, were given tax rebates of $1,200 per adult and
$500 per child. Eligibility for unemployment insurance was expanded, and benefits were
temporarily increased by $600 per week. Small businesses were offered loans that would be
forgiven and turned into grants if they did not lay off any workers for the next two months.
To prevent permanent damage from the recession, the CARES Act had various provisions to
promote business continuity. This was part of the motivation for the forgivable loans to small
businesses. Not only did workers continue getting paychecks, but they stayed connected to their
employers, so normal business could quickly resume when the crisis passed. The CARES Act also
provided funds that enabled the Federal Reserve, working with the Treasury, to lend to larger
businesses, states, and municipalities, expanding the Fed’s role as lender of last resort. At the
same time, the Fed cut its target for the federal funds rate to near zero.
In the United States, the number of daily deaths from Covid-19 peaked in late April 2020 and
then started to slowly decline. By June 2020, many restrictions on economic activity were
relaxed, leading to a quick economic rebound. The unemployment rate, after increasing from
3.5 percent in February 2020 to 14.8 percent in April 2020, declined to 6.9 percent in October
2020.
The pandemic, however, was not over. Cases surged in January 2021 and then again in October
2021 and January 2022.
As the pandemic persisted, subsequent legislation continued and expanded the relief offered by
the CARES Act. President Trump signed a $900 billion relief package in December 2020, and
President Biden signed a $1.9 trillion package in March 2021.
Some economists—most notably the former Treasury Secretary Lawrence Summers—suggested
that the fiscal response was excessive. They worried that, together with supply-chain
disruptions from the pandemic, these monetary and fiscal policies might lead to excessive
inflation. As measured by the CPI, the 12-month inflation rate rose to 7.5 percent in January
2022—the highest level in 40 years. Policymakers initially believed that this inflation surge
would prove temporary. But in March 2022, the Fed started raising interest rates to contain
inflationary pressures.
The eventual solution to this economic downturn came more from microbiology than from
macroeconomics. Economic activity started to return to normal after several vaccines were
developed and distributed in 2021. But the hesitancy of large segments of the U.S. population
to get vaccinated, along with the appearance of the new Omicron variant of the virus, delayed
the pandemic’s end and slowed the pace of economic recovery.