Confidence collapses

The chain in words

1. Step 1

   Before the scare

   The economy produces at its potential output, the most it can sustain with its workers and machines. The horizontal axis is real GDP, total output. The vertical axis is the price level, the average price of everything. AD and SRAS cross on the vertical LRAS at E₀.

2. Step 2

   Aggregate demand shifts left

   Frightened households spend less at every price level, so aggregate demand shifts left. Firms sell less and cut prices and output. In the short run the economy moves to E₁: a lower price level and output below potential. The distance from E₁ back to LRAS is a recessionary gap.

3. Step 3

   The gap does not close on its own right away

   Output below potential means unemployed workers and idle machines. The gap does not close quickly, because wages and many prices are slow to adjust.

4. Step 4

   Wages fall, SRAS shifts right

   Over time, unemployed workers accept lower wages and input costs fall. Producing any output gets cheaper, so SRAS shifts right. The economy slides down the new AD curve to E₂, back on LRAS.

5. Step 5

   Back at potential, lower prices

   The economy is back at potential output with a lower price level. Self-correction worked, but through a recession and falling wages, which is why governments often act before it finishes.

Takeaway. A negative demand shock cuts output and the price level in the short run, and in the long run SRAS shifts right until output returns to potential at a lower price level.

Draw it yourself

More on the aggregate demand and aggregate supply graph