Recession: Demand or Supply-Side Shock?

Does output decrease because of a lack of demand or a lack of supply? Another way of asking the same question is to ask, does output decrease because people simply don’t want to buy as much or because we don’t want to produce as much? This is a critical macroeconomic question and one which is contentious and highly politicized.

Adherents of supply-side economics, mainly those on the right of the political spectrum, maintain that the 2008 recession began with a supply-side shock. However, this notion can be refuted by looking at the AD-AS model and, more particularly, focusing on prices.

If supply side adherents are correct, the recession began with a negative shock to supply. This would then shift either (or both) the long-run or short-run aggregate supply curves to the left, resulting in an equilibrium which has lower output and higher prices.

If the supply-side theorists were correct, the lower output (supply) resulting from the supply-side shock would bid up prices and we would see a significant increase in inflation. That has clearly not happened, with some exceptions being spikes in the prices of certain commodities. Given the lower inflation, the supply-side explanation of the cause of the recession cannot be correct.

If the recession were triggered by a demand-side shock – a negative shock to demand – the aggregate demand curve in the AD-AS model will shift to the left and the new equilibrium will have lower output and lower prices. This new equilibrium more closely resembles the reality post-2008, particularly with regard to prices, and is therefore a better explanation of the cause of the recession.

If the aggregate demand curve shifts leftwards, what causes it to do so? Keynes offers some insight here. According to Keynes, when savings outruns spending there will be a fall in aggregate demand with a commensurate fall in output. Consumers will be disposed to save rather than spend for a variety of reasons – their confidence may be shaken, the price of assets they own may plummet, etc. In the worst case, this withholding of spending may lead to the liquidity trap of Krugman and Eggertsson, where consumers will hoard money despite extremely low interest rates and readily available money.

If supply-side economics is right, increasing supply should stimulate demand since, according to supply-siders, supply creates its own demand. The evidence, however, is that this premise is flawed. Despite continuing corporate tax cuts, low corporate tax rates (here in Canada, at least), and healthy corporate earnings, firms cannot be encouraged to spend, hire, and increase supply. The reason given by most CEO’s – there is little reason to expand supply when there is a lack of demand!

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