Two types of shocks can hit the economy. An is some event other than a policy change that shifts the aggregate aggregate demand shocks demand curve. Examples include changes in foreign demand changing net exports, or a new type of credit card that impacts money demand. A price disturbance is some event that shifts the price adjustment relationship. Disturbances can be temporary or permanent. Since monetary and fiscal policy also shift the aggregate demand curve, in order to determine the effect of a shock we have to know what will be the change in monetary and fiscal policy. Price level shocks. Oil cartel; Firms make a mistake on expectations and increase prices; Union gets an excessive settlement. Economic Shocks. Investment function intercept changes. Change in money demand for a given level of income or interest rate. While most economists agree on the desirability of maintaining aggregate demand, there is disagreement on the means by which this is done. Disagreements center on: The effectiveness of a governmental policy especially in a world of changing expectations, the difficulty at predicting when a policy is needed (recognition lag) and problems in implementing the policy in a timely manner (implementation lag). Monetarists agree that monetary policy has an effect on real variables in the short run. In the long run prices adjust and the effect wears off. The problem is the monetary policy occurs with a long and variable lag. Politics. Monetary policy can lead to inflation, especially when monetary policy decisions are made in a political setting. Assume an upward price shock. Policies that increase the money supply in response to a price shock are called accommodative policies. These put less pressure on prices to fall than nonaccommodative policies that hold the money supply fixed and put maximum pressure on prices to fall. While treating policy variables as exogenous has long been the tradition, another view would treat them as endogenous or the function of some policy rule. There is a controversy over how much cost is incurred by not smoothing out the cycle. Tobin & Okun stress that the costs are larger than Lucas and others. A recession may have the benefit of making firms leaner, however. There is no comparable mechanism for the public sector.
Two types of shocks can hit the economy. An aggregate demand shocks is some event other than a policy change that shifts the aggregate demand curve. Examples include changes in foreign demand changing net exports, or a new type of credit card that impacts money demand. A price disturbance is some event that shifts the price adjustment relationship. Disturbances can be temporary or permanent. Since monetary and fiscal policy also shift the aggregate demand curve, in order to determine the effect of a shock we have to know what will be the change in monetary and fiscal policy. Price level shocks. Oil cartel; Firms make a mistake on expectations and increase prices; Union gets an excessive settlement. Economic Shocks. Investment function intercept changes. Change in money demand for a given level of income or interest rate. While most economists agree on the desirability of maintaining aggregate demand, there is disagreement on the means by which this is done. Disagreements center on: The effectiveness of a governmental policy especially in a world of changing expectations, the difficulty at predicting when a policy is needed (recognition lag) and problems in implementing the policy in a timely manner (implementation lag). Monetarists agree that monetary policy has an effect on real variables in the short run. In the long run prices adjust and the effect wears off. The problem is the monetary policy occurs with a long and variable lag. Politics. Monetary policy can lead to inflation, especially when monetary policy decisions are made in a political setting. Assume an upward price shock. Policies that increase the money supply in response to a price shock are called accommodative policies. These put less pressure on prices to fall than nonaccommodative policies that hold the money supply fixed and put maximum pressure on prices to fall. While treating policy variables as exogenous has long been the tradition, another view would treat them as endogenous or the function of some policy rule. There is a controversy over how much cost is incurred by not smoothing out the cycle. Tobin & Okun stress that the costs are larger than Lucas and others. A recession may have the benefit of making firms leaner, however. There is no comparable mechanism for the public sector.