Economists have used the basic framework of aggregate demand and supply analysis to explain recessions. Recessions can occur either when there is sharp decreases in aggregate demand a leftward shift in the aggregate demand curve or a decrease in aggregate supply an upward shift in the short-run aggregate supply curve. But this just puts the question back one level: During particular historical episodes, what actually shifted the curves?
Figuring out what caused a recession in any particular episode is very challenging. Here is one complication. Policymakers typically respond to shocks that hit the economy. So, for example, when worldwide oil prices rose in 1973 causing U.S. prices to increase, policymakers also reduced aggregate demand to prevent further price increases. Was the recession that resulted due to (1) the increase in oil prices that shifted the short-run aggregate supply curve or (2) the decrease in aggregate demand engineered by policymakers? It is very difficult to know.
One approach is to use economic models to address this question. Economists James Fackler and Douglas McMillin built a small model of the economy to address this issue. To distinguish between demand and supply shocks, they used an idea that we discuss in this chapter. Shocks to aggregate demand only affect prices in the long run but do not affect output. On the other hand, shocks to aggregate supply can affect potential output in the long run. Using this approach, they find that a mixture of demand and supply shocks were responsible for fluctuations in output in the United States.