David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 21 Aggregate supply, prices and adjustment to shocks
supply schedule SAS'. The goods market now clears at E". Output and employment recover a bit, but
some unemployment persists. Since inflation has fallen, the central bank is less worried about the
amount by which inflation exceeds its new target and cuts real interest rates, moving the economy
down AD' to E".
In the long run, adjustment is complete. Wage growth and inflation fall to 7t. The short-run aggregate
supply schedule is SAS3 in Figure 21.8. The economy is in full equilibrium at E3, on AS, SAS3 and AD'.
Output is Y* and the labour market is back at full employment.
The real world lies between the extreme simplifications of the simple Keynesian model and classical
models. In practice, prices and wages are neither fully flexible nor fully fixed. A tougher inflation target has
real effects in the short run, since output and employment are reduced. But after wages and prices adjust
fully, output and employment return to normal. Inflation is permanently lower thereafter.
Output gaps 1998-2010
II
The output gap (Y- Y*) is the percentage deviation of actual output Y from potential output Y*.
Each year the Paris-based Organization for Economic Cooperation and Development (OECD)
estimates potential output for all its member countries. The diagram below shows estimates for the UK, US
and Germany. Positive output gaps are booms; negative gaps indicate slumps.
The diagram shows the relative stability of
the period 1998-2006. Central banks were
successfully managing aggregate demand
to keep it close to full capacity.
Of the three countries, Germany is the most
dependent on manufacturing exports. China
led the global economy into a boom in the
first decade of the twenty-first century,
and commodity prices were rising sharply
by 2007 /08. It should be no surprise that
German exporters enjoyed this boom in
the world economy. German demand and
output were above their long-run sustainable
level. This was true to a lesser extent in both
the UK and US.
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
-4.0
-5.0
-6.0
-7.0
Output gaps, 1998-2010 (%)
9 2010
- Germany
- UK
- us
When the financial crisis hit, some economists
thought that Germany would be
relatively well insulated, since its regulation of banks had been more stringent than in the UK and US. Yet, the
diagram shows that Germany, experienced nearly as dramatic a slump in aggregate demand as its Anglo­
Saxon competitors. Sub-prime mortgages had found their way even into Stuttgart and Frankfurt. Even China
did not escape. When aggregate demand in China fell in 2009, German exports were hard hit. Thus different
countries experienced the crash through different channels. It originated in the US, and UK banks were then
very exposed, but Germany suffered because all its export markets suffered.
The diagram shows how the upturn is slowly starting to take effect. It also confirms that for the next few years
all major economies will have substantial spare capacity - the underlying assumption of the Keynesian
perspective.
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