Chapter 9 — Business Cycles, AD–AS, and Monetary Policy

Core question

Is output changing because planned spending changed, productive capacity changed, or both—and what can monetary policy influence?

Learning outcomes

You will be able to:

• distinguish actual from potential output;
• classify aggregate-demand and aggregate-supply shocks;
• trace an interest-rate decision through multiple transmission channels;
• explain why monetary policy faces lags, uncertainty, and distributional effects.

1. Actual and potential output

Potential output is the sustainable level of production given labour, capital, technology, and institutions—not the physical maximum under emergency effort.

• negative gap: weak utilisation and usually higher cyclical unemployment;
• positive gap: demand exceeds sustainable capacity and inflation pressure may build.

Potential output is estimated, not observed. Revisions can change the diagnosis.

2. Aggregate demand

Aggregate demand describes planned expenditure on domestic output at different overall price levels, conditional on policy, expectations, wealth, foreign demand, and financial conditions.

The expenditure identity helps organise channels:

But the identity does not prove why spending changed. AD shifts when desired consumption, investment, government demand, or net exports change for reasons other than movement along the price-level relation.

3. Aggregate supply

• SRAS links production and the price level while some wages, prices, expectations, and capacity are slow to adjust.
• LRAS is located at potential output; nominal prices alone do not create permanent productive capacity.

The model is most useful when the shock, horizon, and adjustment rule are stated.

4. Running case: imported energy shock

An energy-importing economy faces a sharp gas-price increase.

1. Firms' marginal costs rise.
2. SRAS shifts left.
3. Output falls while the price level rises.
4. Real household income falls, possibly weakening AD too.
5. Wage and price expectations determine persistence.
6. Exchange-rate depreciation can amplify import costs.

This is harder than a pure demand recession: supporting output may sustain inflation, while reducing demand may deepen the output loss.

5. Monetary transmission

Main channels

6. A policy decision is a forecast under uncertainty

A central bank must estimate:

• current inflation mechanism and persistence;
• output gap and neutral interest rate;
• strength and lag of transmission;
• financial-stability consequences;
• response of expectations and fiscal policy.

Interest-rate changes affect demand with variable lags. They cannot produce gas, repair a port, train workers, or directly allocate losses from a supply shock.

7. Recent evidence: euro-area tightening

ECB analysis of the 2022–24 tightening episode describes pass-through from policy rates to money-market rates, bank funding, lending rates, credit standards, and credit volumes. It also stresses that transmission varies with sector and balance sheet, while the original inflation surge contained major sectoral and energy-supply components (Lane, 2024).

The case supports the transmission chain. It does not identify one invariant lag or effect size for every economy.

8. Policy rules and judgment

A simple reaction rule raises the policy rate when inflation exceeds target or output exceeds potential, and lowers it in the reverse case. Real policy also considers forecasts, risk asymmetry, financial conditions, model uncertainty, and the effective lower bound.

Rules create consistency and accountability; judgment handles information a compact formula omits. Neither removes uncertainty.

Practice: monetary-policy meeting

Inflation is 6%, output is 2% below estimated potential, unemployment is rising, energy prices remain high, and inflation expectations are stable.

1. Diagnose demand and supply components.
2. Draw the initial AD–AS change.
3. Give the case for tightening, holding, and easing.
4. Identify the groups most exposed to each choice.
5. Choose a policy path and state what new evidence would change it.

Quick check

• Potential output is estimated and can be revised.
• C + I + G + NX is an identity, not a shock diagnosis.
• Demand and supply shocks can move inflation and output differently.
• Monetary policy works through rates, credit, assets, exchange rates, and expectations.
• Policy cannot remove a real supply loss; it manages propagation and demand.

Next: compare fiscal stabilisation, distribution, and debt dynamics.