Paul Krugman argues the contrary here. But let’s say there was a supply slowdown starting in 1999 or so, as reflected in wage and jobs data, masked a bit by the real estate bubble of 2004-2006 and with some of the productivity figures inflated for domestic purposes due to outsourcing.
If there is less produced, there are eventually perceived negative wealth effects. What happens to demand? It goes down, in this case with a lag because of credit. Yes, it is a big mistake to assume Say’s Law always holds but it is an even bigger mistake to think it never holds. Supply slowdowns are bad for demand, and they likely are bad for credit creation too, which hurts demand further yet.
There is no contradiction in a model where both aggregate demand and aggregate supply curves shift in unfavorable directions! And in the medium run, each of these shifts pushes the other curve around too.
Let’s not forget that economies have real wage and price stickiness in addition to nominal stickiness. That is another channel through which negative supply shocks can hurt aggregate demand and throw people out of work.
Krugman is worried about policy implications:
If labor force growth and productivity growth are falling, the indicated response is (a) see if there are ways to increase efficiency and (b) if there aren’t, live within your reduced means. A growth slowdown from the supply side is, roughly speaking, a reason to look favorably on structural reform and austerity.
But if we have a persistent shortfall in demand, what we need is measures to boost spending — higher inflation, maybe sustained spending on public works (and less concern about debt because interest rates will be low for a long time).
It’s not either/or. Circa 2008-2009, we should have had a higher inflation or ngdp target. We could do structural reform too, whatever you might think that means, obviously opinions will differ. We could build productive infrastructure, boosting both supply and demand, and with little risk of default on the debt. And yes, we might wish to cut some other government expenditures in the process (farm subsidies anyone?), with looser money to pick up the slack. What we shouldn’t do is all that Keynesian ditch digging. Even if you agree with the argument for it (and I don’t), it so hurts the reputation of legitimate government investment that we shouldn’t be going near it. There are many, many other better things to do, including giving our government a reputation for careful project selection looking forward.
Simple textbook economics indicates that the AD-AS distinction makes the most sense in the short run. Of course hysteresis is a mechanism by which low AD can over time translate into low AS as well, but the causation runs both ways, don’t forget that.