Austerity cuts demand

The chain in words

1. Step 1

   Before the cuts

   The economy sits at potential output. Real GDP is on the horizontal axis and the price level on the vertical. E₀ is on LRAS.

2. Step 2

   Aggregate demand shifts left

   Government purchases are part of aggregate demand. When they fall, total spending falls at every price level, so aggregate demand shifts left. Contractors lay off workers, who spend less in turn, so the shift is bigger than the cut itself. The economy moves to E₁: lower output and a lower price level, a recessionary gap.

3. Step 3

   Wages fall, SRAS shifts right

   If nothing else changes, the gap closes slowly. Unemployed workers accept lower wages, costs fall, and SRAS shifts right until output returns to potential at E₂ with a lower price level.

4. Step 4

   The cost of adjustment

   The deficit fell, but so did output for as long as the adjustment took. The pain is largest when the economy is already weak.

Takeaway. A cut in government spending shifts AD left, cutting output and prices in the short run until wages fall enough for SRAS to restore potential output.

Draw it yourself

More on the aggregate demand and aggregate supply graph