As illustrated by the business cycle, there are times when the economy undergo recessions and high unemployment and does not reach full employment; there are other times when rapid growth triggers inflation. In such cases, the economy is experiencing macro failures, when the economy fails to achieve or maintain full employment.
Recession and Cyclical Unemployment in the AD/AS Model
In the short run, GDP falls and rises in every economy, as the economy dips into recession or expands out of recession. Recessions are illustrated in the AD/AS diagram when the equilibrium level of real GDP is substantially below potential GDP creating a recessionary gap. If current equilibrium GDP is lower than full employment GDP, the unemployment rate will be higher than the natural unemployment rate and the economy will be experiencing cyclical unemployment. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP.
Demand Pull Inflation in the AD/AS Model
Inflation fluctuates in the short run. Higher inflation rates have typically occurred either during or just after economic booms: for example, the biggest spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation generally decline during recessions. As an extreme example, inflation actually became negative—a situation called “deflation”—during the Great Depression. Even during the relatively short recession of 1991–1992, the rate of inflation declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short recession of 2001, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007–2009, the rate of inflation declined from 3.8% in 2008 to –0.4% in 2009. Some countries have experienced bouts of high inflation that lasted for years. In the U.S. economy since the mid–1980s, inflation does not seem to have had any long-term trend to be substantially higher or lower; instead, it has stayed in the range of 1–5% annually.
Demand Pull inflation will occur if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the AS curve.
In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods, because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level. In this situation ‘too many dollars are chasing too few goods’ and an inflationary gap exist in the difference between the current equilibrium GDP and the full employment or potential GDP.
Stagflation, a Combination of Recession and Cost Push Inflation in the AD/AS Model
This macro failure combines the two harmful consequences of the business cycle: inflation and high unemployment. It occurs with a fall of the Aggregate Supply and a equilibrium GDP now below full employment GDP, thereby creating a recessionary gap, cyclical unemployment and inflation. Stagflation is often due to a ‘supply shock’ or sudden and significant rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—which causes the aggregate supply curve to shift back to the left. In effect, the rise in input prices ends up, after the final output is produced and sold, being passed along in the form of a higher price level for outputs called Cost Push inflation.
Growth in the AD/AS Model
So how can we avoid the harmful effects of the instability in the economy? For growth with low inflation and low unemployment, the Aggregate Demand and Supply have to both increase at a similar pace so that the economy experiences increases in output without high inflation.
