Topic 11: Aggregate Demand

and Aggregate Supply

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Fluctuations
Economic activity
Over the long run, rises with increases in land, labor,
capital, technological advancement
Fluctuates from year to year, cycles of ups and downs;
the business cycle

Periods of Recession
Economic contraction; firms unable to sell what they can
produce; cut down on production
Period of declining real incomes and rising
unemployment

Depression
A deep and prolonged recession
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fluctuations in Economic Activity

What causes them?

Can public policy prevent it?
Or at least reduce its severity and
duration?

Short-run Fluctuations

Variables we need to look at: GDP,

unemployment, price level
Policy instruments: monetary and fiscal
Time horizon: short run
Model: aggregate demand and aggregate
supply

Economic Fluctuations
Three key facts about economic
fluctuations
1. Economic fluctuations are irregular and
unpredictable
2. Most macroeconomic quantities fluctuate
together: income, profits, investment,
sales, production
3. As output falls, unemployment rises and
as output rises, unemployment falls
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1
A Look at Short-Run Economic Fluctuations (a)

This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel (c)
for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas.
Notice that real GDP and investment spending decline during recessions, while unemployment rises.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1
A Look at Short-Run Economic Fluctuations (b)

This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel
(c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the shaded areas.
Notice that real GDP and investment spending decline during recessions, while unemployment rises.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1
A Look at Short-Run Economic Fluctuations (c)

This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in
panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the
shaded areas. Notice that real GDP and investment spending decline during recessions, while
unemployment rises.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Short-Run Economic Fluctuations

Classical dichotomy
Separation of variables into
Real variables
Nominal variables

Monetary neutrality
Changes in the money supply
Affect nominal variables
Do not affect real variables

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Short-Run Economic Fluctuations

Classical theory holds in the long-run
Changes in money supply
Affect prices, and other nominal variables
Do not affect real GDP, unemployment, or

other real variables

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10

Short-Run Economic Fluctuations

Short-run
Assumption of monetary neutrality - no
longer appropriate
Real and nominal variables are highly
intertwined
Changes in the money supply
Can temporarily push real GDP away from its

long-run trend

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11

Short-Run Economic Fluctuations

AD-AS model
Model of aggregate demand (AD) &
aggregate supply (AS)
Most economists use it to explain shortrun fluctuations in economic activity
around its long-run trend
Shows the relationship between output
(real variable; horizontal axis) and prices
(nominal variable; vertical axis)
Departure from the classical dichotomy
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12

Short-Run Economic Fluctuations

Aggregate-demand curve
Shows the quantity of goods and
services
That households, firms, the government,
and customers abroad
Want to buy at each price level
Downward sloping

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13

Short-Run Economic Fluctuations

Aggregate-supply curve
Shows the quantity of goods and services
That firms choose to produce and sell
At each price level
Upward sloping

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14

Figure 2
Aggregate Demand and Aggregate Supply
Price
Level

Aggregate supply

Equilibrium
price level

Aggregate demand
Equilibrium
output

Quantity of
Output

Economists use the model of aggregate demand and aggregate supply to analyze
economic fluctuations. On the vertical axis is the overall level of prices. On the
horizontal axis is the economys total output of goods and services. Output and the
price level adjust to the point at which the aggregate-supply and aggregate-demand
curves intersect.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15

AD-AS Curve
Not the same as the demand and supply curve in
microeconomics
Demand curve in microeconomics slopes
downwards because of the income and
substitution effect; no substitution effect in the AD
curve; AD refers to demand for all goods and
services
Supply curve is upward sloping because firms
produce more of a good whose price is rising and
less of a good whose price is falling; AS refers to
supply of all goods and services
Need for an alternative theory
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16

Aggregate-Demand Curve
Y = C + I + G + NX
Three effects explain why AD curve
slopes downward:
Wealth effect (C )
Interest-rate effect (I)
Exchange-rate effect (NX)

Assumption: government spending (G)

Fixed by policy
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17

Price level & consumption (C):

wealth effect
Decrease in price level
Increase real value of money
Consumers wealthier
Increase in consumer spending
Increase in quantity demanded of goods &

services

Increase in price level

Decrease real value of money
Consumers poorer
Decrease in consumer spending
Decrease in quantity demanded of goods &

services
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18

Price level & investment (I):

interest-rate effect
Decrease in price level
Households hold less money; buy bonds, make

deposits in interest bearing assets

Decrease interest rates
Increase spending on investment goods
Increase in quantity demanded of goods & services

Increase in price level

Households hold more money; sell bonds, withdraw

deposits
Increase interest rates
Decrease spending on investment goods
Decrease in quantity demanded of goods & services
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19

Price level & net exports (NX): exchangerate effect

Decrease in price level
Decreases domestic interest rates
NCO increases; domestic currency depreciates
Increases net exports
Increase in quantity demanded of goods & services

Increase in price level

Increases domestic interest rates
NCO decreases; domestic currency appreciates
Decreases net exports
Decrease in quantity demanded of goods & services

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20

Aggregate-Demand Curve Slopes

Downwards

A fall in price level

Increases quantity of goods and services
demanded
Because:
1. Consumers are wealthier - stimulates the

demand for consumption goods

2. Interest rates fall - stimulates the demand
for investment goods
3. Currency depreciates - stimulates the
demand for net exports
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21

The Aggregate-Demand Curve Slopes

Downwards

A rise in price level

Decreases the quantity of goods and
services demanded
Because:
1. Consumers are poorer depresses

consumer spending
2. Higher interest rates rise - depresses
investment spending
3. Currency appreciates depresses net
exports
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22

Figure 3
The Aggregate-Demand Curve
Price
Level

1. A decrease in
the price level . . .

P1
2. . . . increases the quantity of
goods and services demanded

P2

Aggregate demand
Y1

Y2

Quantity of Output

A fall in the price level from P1 to P2 increases the quantity of goods and services
demanded from Y1 to Y2. There are three reasons for this negative relationship. As the
price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates.
These effects stimulate spending on consumption, investment, and net exports.
Increased spending on any or all of these components of output means a larger
quantity of goods and services demanded.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23

Shifts in Aggregate-Demand Curve

The AD curve might shift:
Changes in consumption
Changes in investment
Changes in government purchases
Changes in net exports

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24

Shifts in Aggregate-Demand Curve

Changes in consumption, C
Events that change how much people want to
consume at a given price level
Changes in taxes, wealth, propensity to
consume, changes in stock market prices
Increase in consumer spending: tax cut; stock
market boom
Aggregate demand - shift right
Decrease in consumer spending: tax increase,
stock market crash
Aggregate demand - shift left
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25

Shifts in Aggregate-Demand Curve

Changes in investment, I
Events that change how much firms want to
invest at a given price level
Better technology reduce cost, new products
Tax policy: tax credits and rebates
Money supply which affects interest rates
Optimism and pessimism

Increase in investment
Aggregate demand - shift right

Decrease in investment
Aggregate demand - shift left
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26

Shifts in Aggregate-Demand Curve

Changes in government purchases, G
Policy makers change government
spending at a given price level
Build new roads, schools, national defense

Increase in government purchases

Aggregate demand - shift right

Decrease in government purchases

Aggregate demand - shift left

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27

Shifts in Aggregate-Demand Curve

Changes in net exports, NX
Events that change net exports for a given
price level
Recession or booms in trading partners
International speculators move in or out of a

country change in exchange rate

Increase in net exports

Aggregate demand - shift right

Decrease in net exports

Aggregate demand - shift left
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28

Table 1
The Aggregate-Demand Curve: Summary

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29

Table 1
The Aggregate-Demand Curve: Summary

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30

Aggregate Supply Curve

Shows the total quantity of goods and
services that firms are willing to produce
and sell at any given aggregate price level
The shape of the aggregate supply curve
depends crucially on the time horizon
Vertical in the long run; upward sloping in
the short run

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31

Aggregate Supply Curve

Long run aggregate-supply curve, LRAS
Aggregate-supply curve is vertical
Price level does not affect the long-run

determinants of GDP:
Supplies of labor, capital, and natural
resources
Available technology
Price level does not affect the long run
determinants of real GDP
LRAS curve is graphical representation of
classical dichotomy and monetary neutrality
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32

Figure 4
The Long-Run Aggregate-Supply Curve
Price
Level

Long-run
aggregate
supply

P1
1. A change
in the price
level . . .

P2

2. . . . does not affect the

quantity of goods and services
supplied in the long run
Natural rate
of output

Quantity of Output

In the long run, the quantity of output supplied depends on the economys quantities
of labor, capital, and natural resources and on the technology for turning these inputs
into output. Because the quantity supplied does not depend on the overall price level,
the long-run aggregate-supply curve is vertical at the natural rate of output.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33

Aggregate Supply Curve

Natural rate of output
Production of goods and services
That an economy achieves in the long run
When unemployment is at its normal rate

Potential output
Full-employment output

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34

Aggregate Supply Curve

The LRAS curve might shift
Any change in natural rate of output
Changes in labor
Changes in capital
Changes in natural resources
Changes in technological knowledge

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35

Aggregate Supply Curve

Changes in labor
Quantity of labor increases
Aggregate supply shifts right

Natural rate of unemployment increases

Aggregate supply shifts left

Changes in capital
Capital stock increases
Aggregate supply shifts right

Physical and human capital

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36

Aggregate Supply Curve

Changes in natural resources
discovery of new natural resources
Aggregate supply shifts right

Weather disturbances
Availability and prices of natural resources
through imports

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37

Aggregate Supply Curve

Changes in technology
New technology, raises output for any
given labor, capital and natural resources
Aggregate supply shifts right

International trade allows specialization

and productivity increases
Government regulation restricting harmful
production processes

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38

Long-Run Growth and Inflation

In long run both AD and LRAS curve shift
Continual shifts of LRAS curve to right
Technological progress, etc.

AD curve shifts to right

Monetary policy
The Fed increases money supply over time

Result:
Continuing growth in output
Continuing inflation
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39

Figure 5
Long-Run Growth and Inflation in the Model of Aggregate
Demand and Aggregate Supply
Price
Level

LRAS1990

LRAS2000 LRAS2010
1. In the long run,
technological progress shifts
long-run aggregate supply

2. . . . and growth in the

money supply shifts
aggregate demand . . .
P2010

3. . . . leading to
growth in output . . .

P2000
P1990

AD2010

4. . . . and
ongoing inflation

AD1990
Y1990

Y2000

AD2000
Y2010

Quantity of Output

As the economy becomes better able to produce goods and services over time, primarily
because of technological progress, the long-run aggregate-supply curve shifts to the right. At
the same time, as the Fed increases the money supply, the aggregate-demand curve also
shifts to the right. In this figure, output grows from Y1990 to Y2000 and then to Y2010, and the price
level rises from P1990 to P2000 and then to P2010. Thus, the model of aggregate demand and
aggregate supply offers a new way to describe the classical analysis of growth and inflation.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40

Aggregate Supply Curve

In the short-run:
Increase in overall level of prices in
economy
Tends to raise the quantity of goods and

services supplied

Decrease in level of prices

Tends to reduce quantity of goods and

services supplied

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

41

Figure 6
The Short-Run Aggregate-Supply Curve
Price
Level

Short-run
aggregate
supply

1. A decrease in
the price level . . .

P1
P2

2. . . . reduces the quantity of

goods and services supplied
in the short run
Y2

Y1

Quantity of Output

In the short run, a fall in the price level from P1 to P2 reduces the quantity of output
supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky
prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this
positive relationship is only temporary.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42

Aggregate Supply Curve

Theories explain why the AS curve
slopes upward in short-run:
Sticky-wage theory
Sticky-price theory
Misperceptions theory
In the long run wages, prices, and
perceptions adjust so that the upward slope
of the AS curve is only temporary

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

43

Aggregate Supply Curve

Sticky-wage theory
Nominal wages slow to adjust to changing
economic conditions
Long-term contracts: workers and firms
Slowly changing social norms
Notions of fairness - influence wage setting

Nominal wages based on expected prices

Dont respond immediately when actual price

level is different from what was expected

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

44

Aggregate Supply Curve

Sticky-wage theory
If price level < expected
Firms incentive is to produce less output

If price level > expected

Firms incentive is to produce more output

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

45

Aggregate Supply Curve

Sticky-price theory
Prices of some goods & services slow to adjust
to changing economic conditions
Menu costs
Prices are announced beforehand: if lower than
expected some firms cannot adjust immediately
and will suffer a fall in demand; these firms
decrease output
if higher than expected, some firms cannot
adjust immediately and will experience an
increase in demand; these firms increase output
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

46

Aggregate Supply Curve

Misperceptions theory
Changes in the overall price level
Can temporarily mislead suppliers
About changes in individual markets
Changes in relative prices
Suppliers - respond to changes in level of

prices
Change quantity supplied of goods and services

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

47

Aggregate Supply Curve

Quantity of output supplied =
= Natural rate of output + a (Actual price level
Expected price level)
Where a - number that determines how much output

responds to unexpected changes in the price level

The quantity of output supplied deviates

from its long run or natural level when the
actual price level deviates from the expected
level

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

48

The Aggregate Supply Curve

The short-run AS curve might shift:
Changes in labor, capital, natural
resources, or technological knowledge
Expected price level increases
Aggregate-supply curve shifts left

Expected price level decreases

Aggregate-supply curve shifts right

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

49

Table 2
The Short-Run Aggregate-Supply Curve: Summary

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

50

Table 2
The Short-Run Aggregate-Supply Curve: Summary

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

51

2 Causes of Economic Fluctuations

Assumption
Economy begins in long-run equilibrium

Long-run equilibrium:
Intersection of AD, SRAS and LRAS
curves:
Output is at natural rate
Actual price level is equilibrium price
Expected price level = Actual price level

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

52

Exhibit 7
The Long-Run Equilibrium
Price
Level

Equilibrium
price

Long-run
aggregate
supply

Short-run
aggregate
supply

Natural rate
of output

Aggregate
demand
Quantity of Output

The long-run equilibrium of the economy is found where the aggregate-demand curve
crosses the long-run aggregate-supply curve (point A). When the economy reaches
this long-run equilibrium, the expected price level will have adjusted to equal the
actual price level. As a result, the short-run aggregate-supply curve crosses this point
as well.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

53

(1) A Shift in Aggregate Demand

Wave of pessimism; stock market crash,
possibility of war; political instability
firms delay investments, consumers
postpone purchases

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

54

Table 3
Four Steps for Analyzing Macroeconomic Fluctuations

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

55

(1) A Shift in Aggregate Demand

Aggregate demand decreases; aggregate
demand curve shifts left; AD1 to AD2
Short-run; pessimism becomes selffulfilling
Output falls
Price level falls; below what people expected

Long-run; prices expected to be low

Short-run aggregate supply curve shifts right
Output natural rate (C)
Price level falls
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

56

Exhibit 8
A Contraction in Aggregate Demand
Price
Level

P1
P2

Long-run
Short-run aggregate
aggregate supply
supply, AS1

P3

AS2

3. . . . but over time, the

short-run aggregate-supply
curve shifts . . .

4. . . . and output returns to its

natural rate.
1. A decrease in aggregate
demand . . .
AD2

Y2

Aggregate demand, AD1

Y1

Quantity of Output

2. . . . causes output to fall in the short run . . .

A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1
to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the
short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches
point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. In
the long run, the price level falls to P3, and output returns to its natural rate, Y1.

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

57

Government Action
Government may decide to take action to
reduce the length and severity of the
recession
Increase aggregate demand by
Increasing government spending or
Central Bank will increase money supply
so that interest rates will fall and
investment spending will increase
Or both
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

58

Two Big Shifts in Aggregate Demand: The

Great Depression and World War II

Early 1930s: large drop in real GDP

The Great Depression
Largest economic downturn in U.S.
history
From 1929 to 1933
Real GDP fell by 27%
Unemployment rose from 3 to 25%
Price level fell by 22%

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

59

The Great Depression

Cause: decrease in aggregate demand
Bank run; decrease in deposits (reserves), increase
in excess reserves (reserve ratio)
Decline in money supply (by 28%)
Decreasing: C and I

Fed failed to act by increasing money supply

Other causes of the decrease in aggregate
demand
Stock prices fell by 90 percent depressing household
wealth
Reducing household consumption
Bank run made banks reduce loans causing
investment spending by firms to fall
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

60

World War II

Early 1940s: large increase in real GDP

Economic boom
World War II
More resources to the military
Government purchases increased
Aggregate demand increased 1939 - 1944
Doubled the economys production of goods
and services
20% increase in the price level
Unemployment fell from 17 to 1%
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

61

Figure 9
U.S. Real GDP Growth since 1900

Over the course of U.S. economic history, two fluctuations stand out as especially large. During
the early 1930s, the economy went through the Great Depression, when the production of goods
and services plummeted. During the early 1940s, the United States entered World War II, and the
economy experienced rapidly rising production. Both of these events are usually explained by
large shifts in aggregate demand.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

62

The Recession of 20082009

2008-2009, financial crisis, severe

downturn in economic activity
Worst macroeconomic event in more
than half a century

A few years earlier - substantial boom in

the housing market
Fueled by low interest rates Feds
response to the recession of 2001
Rise in housing prices

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

63

The Recession of 20082009

Developments in the mortgage market

Easier for subprime borrowers to get
loans
Borrowers with a higher risk of default
(income and credit history)

Securitization
Process by which a financial institution
(mortgage originator) makes loan
Then (investment bank) bundles them
together as mortgage-backed securities
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

64

The Recession of 20082009

Developments in the mortgage market

Mortgage-backed securities
Sold to other institutions, which may not
have fully appreciated the risks in these
securities

Other issues
Inadequate regulation for these high-risk
loans
Misguided government policy
Encouraged this high-risk lending
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

65

The Recession of 20082009

1995-2006
Increase in housing demand
Increase in housing prices
More than doubled

2006-2009, housing prices fell 30%

Substantial rise in mortgage defaults and
home foreclosures
Financial institutions that owned
mortgage-backed securities
Huge losses
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

66

The Recession of 20082009

Banks become undercapitalized and

reduce lending
Large contractionary shift in AD
Real GDP fell sharply
By 4% between the fourth quarter of 2007
and the second quarter of 2009

Employment fell sharply

Unemployment rate rose from 4.4% in May
2007 to 10.1% in October 2009

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

67

The Recession of 20082009

Three policy actions - aimed in part at

returning AD to its previous level
The Fed
Cut its target for the federal funds rate
From 5.25% in September 2007 to about zero in
December 2008

Started buying mortgage-backed securities

and other private loans
In open-market operations
Provided banks with additional funds

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

68

The Recession of 20082009

Three policy actions

October 2008, Congress appropriated
$700 billion
For the Treasury to use to rescue the
financial system
To stem the financial crisis on Wall Street
To make loans easier to obtain
Equity injections into banks
U.S. government temporarily became a part
owner of these banks
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

69

The Recession of 20082009

Three policy actions

January 2009, Barack Obama
Large increase in government spending
$787 billion stimulus bill, February 17, 2009

Economy
Starting to recover from the economic
downturn
Real GDP - growing again
Unemployment 9.5% in June 2010
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

70

(2) Shift in Aggregate Supply

Firms experience an increase in
production costs
Aggregate supply curve shifts left

Short-run leads to stagflation

Output falls
Price level rises

May lead to wage-price spiral

People expect prices to rise
SRAS shifts to the left

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

71

Long Run
Long-run, if AD is held constant
Short-run AS shifts back to right as wages fall

due to growing unemployment

Output returns to natural rate
Price level falls

72

Figure 10
An Adverse Shift in Aggregate Supply
Price
Level

Long-run
aggregate
supply
B

P2
3. . . . and
the price
P1
level to rise

AS2

1. An adverse shift in the

short-run aggregatesupply curve . . .

Short-run
aggregate
supply, AS1

Aggregate demand
Y2

Y1

Quantity of Output

2. . . . causes output to fall . . .

When some event increases firms costs, the short-run aggregate-supply curve shifts
to the left from AS1 to AS2. The economy moves from point A to point B. The result is
stagflation: Output falls from Y1 to Y2, and the price level rises from P1 to P2.
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

73

Government Action
Long-run, policymakers shift AD to right
from AD1 to AD2
Output goes back to natural rate
Price level rises
Called an accommodative policy; higher
level of prices to achieve higher level of
output and employment

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

74

Exhibit 11
Accommodating an Adverse Shift in Aggregate Supply
Price
Level

Long-run
aggregate
supply

3. . . .
which
P3
causes the P2
price level P
1
to rise
further . . .

AS2
Short-run
aggregate
supply, AS1

A
AD2

1. When short-run
aggregate supply
falls . . .

2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .

Aggregate demand, AD1

4. . . . but keeps output
at its natural rate.

Y1

Quantity of Output

Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who
can influence aggregate demand might try to shift the aggregate-demand curve to the
right from AD1 to AD2. The economy would move from point A to point C. This policy
would prevent the supply shift from reducing output in the short run, but the price level
would permanently rise from P1 to P3.

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

75

Oil and the Economy

Economic fluctuations in the U.S.

Since 1970, originated in the oil fields of
the Middle East

Some event (OPEC ) reduces the supply

of crude oil flowing from Middle East
Price of oil rises (doubles) around the
world
Aggregate-supply curve shifts left
Stagflation
Mid-1970s and late-1970s
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

76

Oil and the economy

Some event increases the supply of

crude oil from Middle East, 1986
Price of oil decreases by half
Aggregate-supply curve shifts right
Output rapid growth
Unemployment falls
Inflation rate falls

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

77

Oil and the economy

Recent years
World market for oil not an important
source of economic fluctuations
Conservation efforts
Changes in technology

Amount of oil used to produce a unit of

real GDP
Declined 40% since the OPEC shocks of
the 1970s
2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

78