In macroeconomic theory, the aggregate supply curve is usually unaffected by business cycles because production capacity is not altered. Recessions do shift the aggregate demand curve; therefore, what matters in determining the equilibrium level of price and output is where along the aggregate supply curve aggregate demand intersects. However, there are situations where the supply curve shifts, depending on the cause of the recession.
The Aggregate Supply Curve
Aggregate supply represents the production capacity available to produce goods and services for the whole economy. It is an upward sloping curve. As the price level increases, more supply (output of goods and services) is offered. A flat area exists at very low levels of output where changes in output do not affect the price level because there is a lot of excess capacity in the economy. A corresponding vertical section of the aggregate supply curve appears at higher output levels where, no matter the price level, no more goods and services can be produced because the economy has neared its maximum capacity.
The Aggregate Demand Curve
Aggregate demand represents gross domestic product, or the sum of consumption, investment and government spending. The aggregate demand curve is downward sloping. As prices rise, consumers want fewer goods and services. Recessions are more likely to shift the aggregate demand curve to the left. As workers lose jobs, they can afford to purchase fewer items. For every price level, the demand for goods and services pulls back, which again results in excess production capacity in the economy as a whole.
Effects of a Recession
The aggregate supply curve will remain unaffected if the cause of the recession does not affect capacity. Instead, a recession causes aggregate demand to shift lower (to the left) until equilibrium occurs at a lower level of both price and output. High levels of unemployment generally do not cause a reduction in capacity because firms can easily hire back workers. As additional potential workers graduate from high school or university, the maximum capacity may even increase as the total pool of workers grows larger.
If the recession is caused by high energy prices, the supply curve can shift upwards (to the right). At every level of output, the equilibrium price is higher due to the increased cost of a major input. If interest rates drop significantly, the aggregate supply curve may shift downwards as lower cost of investment encourages capital spending and increases the economy's capacity level.
Because aggregate supply is not closely tied to business cycles, government policy in the past favored programs to shift the demand curve upwards, so consumers can afford more goods and services. Policies that affect aggregate supply serve to increase the capacity of the economy, which may result in lower price and output levels unless demand is also stimulated. Differences between political parties underscore the difficulties in crafting effective policies to help the economy out of a recession.