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337
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
box on “What Have We Learned?”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ three key facts about short-run economic fluctuations.
➢ how the economy in the short run differs from the economy in the long run.
➢ how to use the model of aggregate demand and aggregate supply to explain economic fluctuations.
➢ how shifts in either aggregate demand or aggregate supply can cause booms and recessions.
CONTEXT AND PURPOSE:
To this point, our study of macroeconomic theory has concentrated on the behavior of the economy in
the long run. Chapters 20 through 22 now focus on short-run fluctuations in the economy around its
long-term trend. Chapter 20 introduces aggregate demand and aggregate supply and shows how shifts in
these curves can cause recessions. Chapter 21 focuses on how policymakers use the tools of monetary
and fiscal policy to influence aggregate demand. Chapter 22 addresses the relationship between inflation
and unemployment.
20
AGGREGATE DEMAND AND
AGGREGATE SUPPLY
338 ❖ Chapter 20/Aggregate Demand and Aggregate Supply
KEY POINTS:
• All societies experience short-run economic fluctuations around long-run trends. These fluctuations
are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of
income, spending, and production fall, and unemployment rises.
• The aggregate-demand curve slopes downward for three reasons. The first is the wealth effect: A
lower price level raises the real value of households’ money holdings, which stimulates consumer
spending. The second is the interest-rate effect: A lower price level reduces the quantity of money
households demand; as households try to convert money into interest-bearing assets, interest rates
fall, which stimulates investment spending. The third is the exchange-rate effect: As a lower price
level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange,
which stimulates net exports.
• Any event or policy that raises consumption, investment, government purchases, or net exports at a
given price level increases aggregate demand. Any event or policy that reduces consumption,
investment, government purchases, or net exports at a given price level decreases aggregate
demand.
• The long-run aggregate-supply curve is vertical. In the long run, the quantity of goods and services
supplied depends on the economy’s labor, capital, natural resources, and technology, but not on the
overall level of prices.
• Three theories have been proposed to explain the upward slope of the short-run aggregate-supply
curve. According to the sticky-wage theory, an unexpected fall in the price level temporarily raises
• Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural
resources, or technology, shift the short-run aggregate-supply curve (and may shift the long-run
aggregate-supply curve as well). In addition, the position of the short-run aggregate-supply curve
depends on the expected price level.
• One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate-
demand curve shifts to the left, output and prices fall in the short run. Over time, as a change in the
expected price level causes perceptions, wages, and prices to adjust, the short-run aggregate-supply
curve shifts to the right. This shift returns the economy to its natural level of output at a new, lower
price level.
Chapter 20/Aggregate Demand and Aggregate Supply ❖ 339
CHAPTER OUTLINE:
I. Economic activity fluctuates from year to year.
A. Definition of recession: a period of declining real incomes and rising unemployment.
II. Three Key Facts about Economic Fluctuations
A. Fact 1: Economic Fluctuations Are Irregular and Unpredictable
1. Fluctuations in the economy are often called the business cycle.
2. Economic fluctuations correspond to changes in business conditions.
3. These fluctuations are not at all regular and are almost impossible to predict.
4. Panel (a) of Figure 1 shows real GDP since 1965. The shaded areas represent recessions.
B. Fact 2: Most Macroeconomic Quantities Fluctuate Together
1. Real GDP is the variable that is most often used to examine short-run changes in the
economy.
2. However, most macroeconomic variables that measure some type of income, spending, or
production fluctuate closely together.
3. Panel (b) of Figure 1 shows how investment spending changes over the business cycle. Note
that investment spending falls during recessions just as real GDP does.
C. Fact 3: As Output Falls, Unemployment Rises
1. Changes in the economy’s output level will have an effect on the economy’s utilization of its
labor force.
D.
In the News: The Social Influences of Economic Downturns
Figure 1
340 ❖ Chapter 20/Aggregate Demand and Aggregate Supply
1. The U.S. economy suffered a severe economic downturn in 2008 and 2009.
2. This article from
The New York Times
examines how an event like this affects society as a
whole.
III. Explaining Short-Run Economic Fluctuations
A. The Assumptions of Classical Economics
1. The classical dichotomy is the separation of variables into real variables and nominal
variables.
2. According to classical theory, changes in the money supply only affect nominal variables.
B. The Reality of Short-Run Fluctuations
1. Most economists believe that the classical theory describes the world in the long run but not
in the short run.
C. The Model of Aggregate Demand and Aggregate Supply
2. We can show this model using a graph.
a. The variable on the vertical axis is the average level of prices in the economy, as
measured by the CPI or the GDP deflator.
b. The variable on the horizontal axis is the economy’s output of goods and services, as
measured by real GDP.
Figure 2
Begin by reviewing demand, supply, and equilibrium. Make it clear that the
microeconomic variables of price and quantity can be aggregated into a price level
(measured by either the GDP deflator or the Consumer Price Index) and total output
(real GDP).
Chapter 20/Aggregate Demand and Aggregate Supply ❖ 341
3. In this model, the price level and the quantity of output adjust to bring aggregate demand
and aggregate supply into balance.
IV. The Aggregate-Demand Curve
A. Why the Aggregate-Demand Curve Slopes Downward
1. Recall that GDP (
Y
) is made up of four components: consumption (
C
), investment (
I
),
government purchases (
G
), and net exports (
NX
).
2. Each of the four components is a part of aggregate demand.
a. Government purchases are assumed to be fixed by policy.
3. The Price Level and Consumption: The Wealth Effect
Y C I G NX
= + + +
Figure 3
Highlight the fact that all three of these effects begin with a decrease (or increase) in
the price level and end with an increase (decrease) in aggregate quantity demanded.
You will likely need to remind students of the difference between changes in quantity
demanded (movements along the demand curve) and changes in demand (shifts in
the demand curve).
342 ❖ Chapter 20/Aggregate Demand and Aggregate Supply
a. A decrease in the price level raises the real value of money and makes consumers feel
wealthier, which in turn encourages them to spend more.
b. The increase in consumer spending means a larger quantity of goods and services
demanded.
4. The Price Level and Investment: The Interest-Rate Effect
a. The lower the price level, the less money households need to buy goods and services.
b. When the price level falls, households try to reduce their holdings of money by lending
some out (either in financial markets or through financial intermediaries).
5. The Price Level and Net Exports: The Exchange-Rate Effect
a. A lower price level in the United States lowers the U.S. interest rate.
b. Some U.S. investors will seek higher returns by investing abroad, increasing U.S. net
capital outflow.
c. The increase in net capital outflow raises the supply of dollars, lowering the real
exchange rate.
6. All three of these effects imply that, all else being equal, there is an inverse relationship
between the price level and the quantity of goods and services demanded.
B. Why the Aggregate-Demand Curve Might Shift
Get the students involved in suggesting factors that might shift the aggregate-
demand curve. Relate changes in aggregate demand to changes in consumption,
Remind students that the aggregate-demand curve (like all demand curves) is drawn
assuming that everything else is held constant.
Chapter 20/Aggregate Demand and Aggregate Supply ❖ 343
1. Shifts Arising from Changes in Consumption
a. If Americans become more concerned with saving for retirement and reduce current
consumption, aggregate demand will shift to the left.
2. Shifts Arising from Changes in Investment
a. Suppose that the computer industry introduces a faster line of computers and many firms
decide to invest in new computer systems. This will cause aggregate demand to shift to
the right.
3. Shifts Arising from Changes in Government Purchases
a. If Congress decides to reduce purchases of new weapon systems, aggregate demand will
shift to the left.
b. If state governments decide to build more highways, aggregate demand will shift to the
right.
4. Shifts Arising from Changes in Net Exports
a. When Europe experiences a recession, it buys fewer American goods, which lowers U.S.
net exports at every price level. Aggregate demand for the U.S. economy will shift to the
left.
V. The Aggregate-Supply Curve
A. The relationship between the price level and the quantity of goods and services supplied depends
on the time horizon being examined.
B. Why the Aggregate-Supply Curve Is Vertical in the Long Run
1. In the long run, an economy’s production of goods and services depends on its supplies of
resources along with the available production technology.
Table 1
344 ❖ Chapter 20/Aggregate Demand and Aggregate Supply
2. Because the price level does not affect these determinants of output in the long run, the
long-run aggregate-supply curve is vertical.
C. Why the Long-Run Aggregate-Supply Curve Might Shift
1. The position of the aggregate-supply curve occurs at an output level sometimes referred to
as
potential output
or
full-employment output
.
3. Any change in the economy that alters the natural level of output shifts the long-run
aggregate-supply curve.
4. Shifts Arising from Changes in Labor
a. Increases in immigration increase the number of workers available. The long-run
aggregate-supply curve would shift to the right.
5. Shifts Arising from Changes in Capital
a. An increase in the economy’s capital stock raises productivity and thus shifts long-run
aggregate supply to the right.
6. Shifts Arising from Changes in Natural Resources
Figure 4
Chapter 20/Aggregate Demand and Aggregate Supply ❖ 345
a. A discovery of a new mineral deposit shifts the long-run aggregate-supply curve to the
right.
7. Shifts Arising from Changes in Technological Knowledge
a. The invention of the computer has allowed us to produce more goods and services from
any given level of resources. As a result, it has shifted the long-run aggregate-supply
curve to the right.
b. Opening up international trade has similar effects to inventing new production processes.
Therefore, it also shifts the long-run aggregate-supply curve to the right.
D. Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation
1. Two important forces that govern the economy in the long run are technological progress
and monetary policy.
a. Technological progress shifts the long-run aggregate-supply curve to the right.
b. The Fed increases the money supply over time, which raises aggregate demand.
2. The result is growth in output and continuing inflation (increases in the price level).
3. Although the purpose of developing the model of aggregate demand and aggregate supply is
to describe short-run fluctuations, these short-run fluctuations should be considered
deviations from the long-run trends of output growth and inflation.
Figure 5
346 ❖ Chapter 20/Aggregate Demand and Aggregate Supply
E. Why the Aggregate-Supply Curve Slopes Upward in the Short Run
1. In the short run, the price level does affect the economy's output. An increase in the overall
level of prices tends to raise the quantity of goods and services supplied.
2. The quantity of output supplied deviates from its natural level when the actual price level
deviates from the expected price level.
3. The Sticky-Wage Theory
a. Nominal wages are often slow to adjust to changing economic conditions due to long-
term contracts between workers and firms along with social norms and notions of
fairness that influence wage setting and are slow to change over time.
e. This theory of short-run aggregate supply is emphasized in the text.
4. The Sticky-Price Theory
a. The prices of some goods and services are also sometimes slow to respond to changing
economic conditions. This is often blamed on menu costs.
Figure 6
Chapter 20/Aggregate Demand and Aggregate Supply ❖ 347
b. If the price level falls unexpectedly, and a firm does not change the price of its product
quickly, its relative price will rise and this will lead to a loss in sales.
5. The Misperceptions Theory
a. Changes in the overall price level can temporarily mislead suppliers about what is
happening in the markets in which they sell their output.
b. As a result of these misperceptions, suppliers respond to changes in the level of prices
and thus, the short-run aggregate-supply curve is upward sloping.
quantity of goods and services supplied.
6. Note that each of these theories suggests that output deviates from its natural level when
the price level deviates from the price level that people expected.
7. Note also that the effects of the change in the price level will be temporary. Eventually
people will adjust their price level expectations and output will return to its natural level;
thus, the aggregate-supply curve will be vertical in the long run.
8. Because the sticky-wage theory is the simplest of the three theories, it is the one that is
emphasized in the text.
F. Summing Up
( )
levelpriceExpectedlevelpriceActualoutputoflevelNaturaloutputofQuantity −+= a
3. Each of the three theories emphasizes a problem that is likely to be temporary.
a. Over time, nominal wages will become unstuck, prices will become unstuck, and
misperceptions about relative prices will be corrected.
348 ❖ Chapter 20/Aggregate Demand and Aggregate Supply
b. In the long run, it is reasonable to assume that wages and prices are flexible and that
people are not confused about relative prices.
G. Why the Short-Run Aggregate-Supply Curve Might Shift
1. Events that shift the long-run aggregate-supply curve will shift the short-run aggregate-
supply curve as well.
3. An increase in the expected price level decreases the quantity of goods and services supplied
and shifts the short-run aggregate-supply curve to the left. A decrease in the expected price
level increases the quantity of goods and services supplied and shifts the short-run
aggregate-supply curve to the right.
VI. Two Causes of Economic Fluctuations
A. Long-Run Equilibrium
1. Long-run equilibrium is found where the aggregate-demand curve intersects with the long-
run aggregate-supply curve.
2. Output is at its natural level.
3. Also at this point, perceptions, wages, and prices have all adjusted so that the short-run
aggregate-supply curve intersects at this point as well.
B. The Effects of a Shift in Aggregate Demand
Table 2
Figure 7
Table 3
Chapter 20/Aggregate Demand and Aggregate Supply ❖ 349
1. Example: Pessimism causes household spending and investment to decline.
2. This will cause the aggregate-demand curve to shift to the left.
7.
FYI: Monetary Neutrality Revisited
a. According to classical theory, changes in the quantity of money affect nominal variables
such as the price level, but not real variables such as output.
Figure 8
Students will be confused by the graphs showing the adjustment process that occurs
when aggregate demand shifts. Take the time to walk them through step-by-step
several times, summarizing what moves the economy from one point to the next.
Price
Level
Output
Long-Run Aggregate
Supply
AD
1
AD
2
AS
1
AS
2
350 ❖ Chapter 20/Aggregate Demand and Aggregate Supply
b. If the Fed decreases the money supply, aggregate demand shifts to the left. In the short
c. Thus, changes in the money supply have effects on real output in the short run only.
8.
Case Study: Two Big Shifts in Aggregate Demand: The Great Depression and World War II
a. Figure 9 shows real GDP for the United States since 1900.
b. Two time periods of economic fluctuations can be seen dramatically in the picture. These
are the early 1930s (the Great Depression) and the early 1940s (World War II).
9.
Case Study: The Recession of 2008–2009
a. The United States experienced a financial crisis and severe economic downturn in 2008
and 2009.
b. The recession was preceded by a housing boom fueled by low interest rates and various
developments in the mortgage market.
10.
In the News: What have we learned?
a. Following the financial crisis and deep recession of 2008-2009, economists are learning
lessons about macroeconomics.
b. This article from
The Wall Street Journal
describes five important lessons.
C. The Effects of a Shift in Aggregate Supply
1. Example: Firms experience a sudden increase in their costs of production.
Figure 9
Chapter 20/Aggregate Demand and Aggregate Supply ❖ 351
5. The result over time may be a wage-price spiral.
6. Eventually, the low level of output will put downward pressure on wages.
a. Producing goods and services becomes more profitable.
b. Short-run aggregate supply shifts to the right until the economy is again producing at the
natural level of output.
7. If policymakers want to end the stagflation, they can shift the aggregate-demand curve. Note
8.
Case Study: Oil and the Economy
a. Crude oil is a key input in the production of many goods and services.
Figure 10
Figure 11
Price
Level
Long-Run Aggregate
Supply
AS
2
