recovery

By the time most students exit undergrad, they get acquainted with the Aggregate Supply – Aggregate Demand model. I think that this model is so important that my Principles of Macro class spends twice the amount of time on it as on any other topic. The model is nice because it uses the familiar tools of Supply & Demand and throws a macro twist on them. Below is a graph of the short-run AS-AD model.

Quick primer: The AD curve increases to the right and decreases to the left. The Federal Reserve and Federal government can both affect AD by increasing or decreasing total spending in the economy. Economists differ on the circumstances in which one authority is more relevant than another.

The AS curve reflects inflation expectations, short-run productivity (intercept), and nominal rigidity (slope). If inflation expectations rise, then the AS curve shifts up vertically. If there is transitory decline in productivity, then it shifts up vertically and left horizontally.

Nominal rigidity refers to the total spending elasticity of the quantity produced. In laymen’s terms, nominal rigidity describes how production changes when there is a short-run increase in total spending. The figure above displays 3 possible SR-AS’s. AS0 reflects that firms will simply produce more when there is greater spending and they will not raise their prices. AS2 reflects that producers mostly raise prices and increase output only somewhat. AS1 is an intermediate case. One of the things that determines nominal rigidity is how accurate the inflation expectations are. The more accurate the inflation expectations, the more vertical the SR-AS curve appears.*

The AS-AD model has many of the typical S&D features. The initial equilibrium is the intersection between the original AS and AD curves. There is a price and quantity implication when one of the curves move. An increase in AD results in some combination of higher prices and greater output – depending on nominal rigidities. An increase in the SR-AS curve results in some combination of lower prices and higher output – depending on the slope of aggregate demand.

Of course, the real world is complicated – sometimes multiple shocks occur and multiple curves move simultaneously. If that is the case, then we can simply say which curve ‘moved more’. We should also expect that the long-run productive capacity of the economy increased over the past two years, say due to technological improvements, such that the new equilibrium output is several percentage points to the right. We can’t observe the AD and AS curves directly, but we can observe their results.

The big questions are:

What happened during and after the 2020 recession?
Was there more than one shock?
When did any shocks occur?

Below is a graph of real consumption and consumption prices as a percent of the business cycle peak in February prior to the recession (See this post that I did last week exploring the real side only). What can we tell from this figure?

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The financial crisis recession that started in late 2007 was very different from the 2020 pandemic recession. Even now, 15 years later, we don’t all agree on the causes of the 2007 recession. Maybe it was due to the housing crisis, maybe due to the policy of allowing NGDP to fall, or maybe due to financial contagion. I watched Vernon Smith give a lecture in 2012 in which he explained that it was a housing crisis. Scott Sumner believes that a housing sectoral decline would have occurred, and that the economy-wide deep recession and subsequent slow recovery was caused by poor monetary policy.

Everyone agrees, however, that the 2007 recession was fundamentally different from the 2020 recession. The latter, many believe, reflected a supply shock or a technology shock. Performing social activities, including work, in close proximity to others became much less safe. As a result, we traded off productivity for safety.

The policy responses to each of the two were also different. In 2020, monetary policy was far more targeted in its interventions and the fiscal stimulus was much bigger. I’ll save the policy response differences for another post. In this post, I want to display a few graphs that broadly reflect the speed and magnitude of the recoveries. Because the recessions had different causes, I use broad measures that are applicable to both.

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