Chapter 33: Aggregate Demand and Aggregate
Supply
Three Key Facts About Economic Fluctuations
Fact 1: Economic Fluctuations are Irregular and Unpredictable
Economic Fluctuations correspond to changes in business conditions. When real GDP
grows rapidly, business is good. On the other hand, when real GDP falls, many firms
experience declining sales and dwindling profits.
Fact 2: Most Macroeconomic Quantities Fluctuate Together
Real GDP is the variable that is most commonly used to monitor short-run changes in the
economy. Real GDP measures the value of all final goods and services produced in the time
period and it measures total income (adjusted for inflation) of everyone in the economy.
Most macroeconomic variables that measure some type of income, spending or production,
fluctuate closely together. When Real GDP falls in a recession, so do personal income,
corporate profits, consumer spending, investment spending, industrial production, retail
sales, home sales, car sales, and so on. Although many macroeconomic variables fluctuate
together, they fluctuate by different amounts.
Fact 3: As Output Falls, Unemployment Rises
When real GDP declines the rate of unemployment rises. The negative relationship between
unemployment and real GDP is referred to as Okun’s law. Okun noted that in order to keep
the unemployment rate steady, real GDP needs to grow at or close to its potential. To
reduce the unemployment rate by 1 percent in a year, real GDP must rise by 2 percent or
more than potential GDP over the year.
Explaining Short-Run Economic Fluctuations
How the Short Run Differs from the Long Run
We have developed theories to explain what determines the most important macroeconomic
variables in the long-run. We have looked at the level and growth of productivity and real
GDP, why there is always some unemployment in the economy and the analysis to open
economy’s in order to explain the trade balance and the exchange rate. All of these previous
analyses were based on two related ideas - the classical dichotomy and monetary neutrality.
To understand the economy in the short run, we need a new model.
The Basic Model of Economic Fluctuations
Our model of short-run economic fluctuations focuses on the behavior of two variables. The
first being the economy’s output of goods and services, as measured by real GDP. The
second being the overall price level, the average price of all the goods and services in an
economy as measured by the CPI or the GDP deflator. Output is a real variable, whereas
the price level is a nominal variable. We analyze fluctuations in the economy as a whole with
the model of aggregate demand and aggregate supply. The aggregate demand curve shows
the quantity of goods and services that households, firms, and the government want to buy
at each price level. The aggregate supply curve shows the quantity of goods and services
that firms produce and sell at each price level. To understand why the AD curve is downward
sloping and why the AS curve is upward sloping, we need a macroeconomic theory.
, The Aggregate Demand Curve
The AD curve tells us the quantity of all goods and services demanded in the economy at
any given price level. The AD curve is downward sloping reflecting the inverse relationship
between the price level and national income.
Why the Aggregate Demand Curve Slopes Downwards
The level of AD is determined by the sum of consumption, investment, government
purchases, and net exports.
The Price Level and Consumption: The Wealth Effect
A decrease in price levels makes consumer saving more valuable, which in turn encourages
them to spend more. The increase in consumer spending means a larger quantity of goods
and services demanded.
The Price Level and Investment: The Interest Rate Effect
A lower price level reduces the interest rate, encourages greater spending on investment
goods, and thereby increase the quantity of goods and services demanded.
The Price Level and Net Exports: The Exchange Rate Effect
When a fall in the European price level causes European interest rates to fall, the real value
of the euro falls, and this depreciation stimulates European net exports and thereby
increases the quantity of goods and services demanded in the European economy.
Why the Aggregate Demand Curve Might Shift
The downward slope of the AD curve shows that a fall in the price level raises the overall
quantity of goods and services demanded. Many other factors affect the quantity of goods
and services demanded at a given price level. When one of these factors changes, the AD
curve shifts.
Shifts Arising from Consumption
Supply
Three Key Facts About Economic Fluctuations
Fact 1: Economic Fluctuations are Irregular and Unpredictable
Economic Fluctuations correspond to changes in business conditions. When real GDP
grows rapidly, business is good. On the other hand, when real GDP falls, many firms
experience declining sales and dwindling profits.
Fact 2: Most Macroeconomic Quantities Fluctuate Together
Real GDP is the variable that is most commonly used to monitor short-run changes in the
economy. Real GDP measures the value of all final goods and services produced in the time
period and it measures total income (adjusted for inflation) of everyone in the economy.
Most macroeconomic variables that measure some type of income, spending or production,
fluctuate closely together. When Real GDP falls in a recession, so do personal income,
corporate profits, consumer spending, investment spending, industrial production, retail
sales, home sales, car sales, and so on. Although many macroeconomic variables fluctuate
together, they fluctuate by different amounts.
Fact 3: As Output Falls, Unemployment Rises
When real GDP declines the rate of unemployment rises. The negative relationship between
unemployment and real GDP is referred to as Okun’s law. Okun noted that in order to keep
the unemployment rate steady, real GDP needs to grow at or close to its potential. To
reduce the unemployment rate by 1 percent in a year, real GDP must rise by 2 percent or
more than potential GDP over the year.
Explaining Short-Run Economic Fluctuations
How the Short Run Differs from the Long Run
We have developed theories to explain what determines the most important macroeconomic
variables in the long-run. We have looked at the level and growth of productivity and real
GDP, why there is always some unemployment in the economy and the analysis to open
economy’s in order to explain the trade balance and the exchange rate. All of these previous
analyses were based on two related ideas - the classical dichotomy and monetary neutrality.
To understand the economy in the short run, we need a new model.
The Basic Model of Economic Fluctuations
Our model of short-run economic fluctuations focuses on the behavior of two variables. The
first being the economy’s output of goods and services, as measured by real GDP. The
second being the overall price level, the average price of all the goods and services in an
economy as measured by the CPI or the GDP deflator. Output is a real variable, whereas
the price level is a nominal variable. We analyze fluctuations in the economy as a whole with
the model of aggregate demand and aggregate supply. The aggregate demand curve shows
the quantity of goods and services that households, firms, and the government want to buy
at each price level. The aggregate supply curve shows the quantity of goods and services
that firms produce and sell at each price level. To understand why the AD curve is downward
sloping and why the AS curve is upward sloping, we need a macroeconomic theory.
, The Aggregate Demand Curve
The AD curve tells us the quantity of all goods and services demanded in the economy at
any given price level. The AD curve is downward sloping reflecting the inverse relationship
between the price level and national income.
Why the Aggregate Demand Curve Slopes Downwards
The level of AD is determined by the sum of consumption, investment, government
purchases, and net exports.
The Price Level and Consumption: The Wealth Effect
A decrease in price levels makes consumer saving more valuable, which in turn encourages
them to spend more. The increase in consumer spending means a larger quantity of goods
and services demanded.
The Price Level and Investment: The Interest Rate Effect
A lower price level reduces the interest rate, encourages greater spending on investment
goods, and thereby increase the quantity of goods and services demanded.
The Price Level and Net Exports: The Exchange Rate Effect
When a fall in the European price level causes European interest rates to fall, the real value
of the euro falls, and this depreciation stimulates European net exports and thereby
increases the quantity of goods and services demanded in the European economy.
Why the Aggregate Demand Curve Might Shift
The downward slope of the AD curve shows that a fall in the price level raises the overall
quantity of goods and services demanded. Many other factors affect the quantity of goods
and services demanded at a given price level. When one of these factors changes, the AD
curve shifts.
Shifts Arising from Consumption
