What’s New in this Edition?Chapter 19 is slightly updated from the sixth edition, featuring updated data for 2013 throughout the chapter.
Where We AreChapter 19 introduces the AS-AD model and then ex-plains the influences on both aggregate supply and aggregate demand. It uses aggregate demand and aggregate supply to explain how fluctuations in them create the business cycle.
Where We’ve BeenThis chapter moves away from long-run economic growth, covered in Chapter 17 to concentrate on economic fluctuations, the business cycle, and the AS-AD model.
Where We’re GoingThe next chapter focuses on fiscal policy and mone-tary policy. It starts by describing the federal budget process and the supply-side effects of fiscal policy on employment and potential GDP as well as the de-mand-side effects of fiscal policy on employment and real GDP. Then it explores monetary policy and stud-ies how it affects the economy and different mone-tary policy rules.
IN THE CLASSROOM
Class Time NeededAlthough it might be possible to cover the material in this chapter in two class sessions, it is sufficiently important and challenging that spending at least three class periods is a good investment. Depending on the current state of the economy, you can spend upwards of three or more class periods on it!
An estimate of the time per checklist topic is:
19.1 Aggregate Supply—40 to 50 minutes
19.2 Aggregate Demand—40 to 50 minutes
19.3 Explaining Economic Trends and Fluctuations—50 to 70 min-utes
Classroom Activity: You might spend some time talking about the latest business cycle movements and the impact on real GDP, unemployment, and inflation. This is a good place to remind students of these three main economic aggregates on
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which we focus and how they fluctuate through time. You might visit the webpage of the NBER for any updates from the Business Cycle Dating Committee (http://www.nber.org/cycles/main.html). Show students that this is where the news media are likely to get their information regarding recessions and expansions in the economy. Then explain that the AS-AD model can be used to explain the business cycle fluctuations in real GDP and the price level.
19.1 Aggregate SupplyThe purpose of the AS-AD model is to explain how the price level and real GDP are determined. Real GDP depends on labor, capital, technology, land, and entrepre-neurial talent. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP. When the quantity of labor demanded equals the quantity of labor supplied, there is full employment in the labor market and real GDP equals potential GDP.
Aggregate Supply Basics The aggregate supply is the
relationship between the quan-tity of real GDP supplied and the price level when all other in-fluences on production plans (the money wage rate, the prices of other resources, and potential GDP) remain constant.
As illustrated in the figure, the AS curve is upward sloping.
This slope reflects that a higher price level combined with a fixed money wage rate lowers the real wage rate, thereby increasing the quantity of labor employed and hence increasing real GDP.
The potential GDP line is vertical because moving along it both the price level and money wage rate and money prices of other resources change by the same percentage.
Why the AS Curve Slopes Upward
Lecture Launcher: Remind your students that the AS curve used in this chapter is a short-run aggregate supply curve because it assumes product prices and re-sources prices do not move in lock step with one another. That is to say wages, materials prices, energy prices and the like move with a lag behind product prices. To launch your lecture, walk through this thought experiment with your students. Ask your class if firms are likely to be motivated to step up production if product prices rise. They will have no trouble responding in the affirmative. Now tell your students that the higher price is actually the result of an increase in the general price level. Ask them how quickly workers are likely to respond by asking for wage increases. The answer is that it will take time for workers to see the general price level has risen and their real wages are now lower. Eventually they will demand higher wages. Firms are forced to grant the wage hikes be-cause the labor market is tight and if they did not raise wages, they would lose
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workers. But until workers realize their real wage has fallen, firms are in the po-sition of receiving higher prices with no change in money wages, so they in-crease their production. And with this result, you have demonstrated the up-ward-sloping aggregate supply curve!
When the price level changes, three reactions create the positive relationship between the price level and quantity of real GDP supplied: Changes in output rate: When the price level rises and the money wage
rate doesn’t change, the quantity of labor demanded increases and pro-duction increases.
Temporary shutdowns and restarts: The price level relative to costs is an influence on temporary shutdown decisions. If the price level rises rel-ative to costs, fewer firms will decide to shut down, so more firms operate and the quantity of real GDP supplied increases.
Business failure and startup: Real GDP changes when the number of firms in business changes. If the price level rises relative to costs, profits increase, the number of firms in business increases, and the quantity of real GDP supplied increases.
Changes in Aggregate Supply When the price level changes and the money wage rate and other resource
prices remain constant, real GDP departs from potential GDP and there is a movement along the AS curve. The AS curve, however, does not shift.
When potential GDP increases, aggregate supply increases and AS curve shifts rightward. The potential GDP line also shifts rightward.
Short-run aggregate supply changes and the AS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the AS curve leftward. In this case, the potential GDP line does not shift.
19.2 Aggregate DemandThe quantity of real GDP demanded is the sum of consumption expenditure (C ), investment (I ), government expenditures (G ), and net exports (X M ), or Y = C + I + G + (X M ).
Aggregate Demand Basics The relationship between the
quantity of real GDP demanded and the price level is called ag-gregate demand. Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded.
As the figure shows, the AD curve is downward sloping. Moving
along the aggregate demand curve the only thing that changes is the price level.
Why the AD Curve Slopes Downward The negative relationship between the price level and the quantity of real
GDP demanded, that is, the negative slope of the AD curve, reflects three fac-tors: The buying power of money: When the price level rises, the buying of
money decreases and so people decrease consumption expenditure. The real interest rate: When the price level rises, the demand for
money increases, which raises the nominal interest rate. Because the in-flation rate does not immediately change, the real interest rate also rises so that people decrease their consumption expenditure and firms de-crease their investment.
The real price of exports and imports: When the price level rises, do-mestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded.
Changes in Aggregate Demand Any factor that influences expenditure plans other than the price level
changes aggregate demand and shifts the aggregate demand curve. Factors that change aggregate demand are: Expectations: Expectations of higher future income, expectations of
higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward.
Fiscal policy and monetary policy: The government influences the economy by setting and changing taxes, making transfer payments, and purchasing goods and services, which is called fiscal policy. Tax cuts, in-creased transfer payments, or increased government purchases increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand.
The world economy: Exchange rates and foreign income affect net ex-ports (X M ) and, therefore, aggregate demand. A decrease in the ex-change rate or an increase in foreign income increases aggregate de-mand.
The Aggregate Demand Multiplier An initial change in expenditure is magnified by the aggregate demand
multiplier so that aggregate demand changes by a multiple of the initial change.
Land Mine: Some of the same issues regarding change in de-mand versus change in the quantity demanded and change in supply versus change in the quantity supplied apply to the aggre-gate supply and aggregate demand curves as well as the microe-conomic supply and demand model. Remind your students that a change in the price level does not shift the aggregate supply curve or aggregate demand curve. A change in the price level re-sults in movements along the curves.
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You can involve your students in the material and help solve the land mine above by asking them a few hypothetical questions. Ask your class what will happen to the ag-gregate demand curve in each of the following cases:
a. A cut in taxes.b. An increase in expected future profit.c. A cut in government expenditure.d. An increase in foreign income.e. A rise in the price level abroad.
Each of these examples give students practice shifting the aggregate demand curve rightward and leftward as well as understanding why it shifts in the direction it does. You should do a similar exercise that practices shifting the aggregate supply curve in isolation before putting the AD and AS curves together in equilibrium.
19.3 Explaining Economic Trends and Fluctuations
Macroeconomic Equilibrium Macroeconomic equilibrium occurs when the quantity of real GDP de-
manded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the AS curve.
If the quantity of real GDP supplied exceeds the quantity demanded, in-ventories pile up so that firms will cut production and prices.
If the quantity of real demanded exceeds the quantity supplied, invento-ries are depleted so that firms will increase production and prices.
Point out to the students that to simplify analysis of the business cycle, economists typically abstract from growth in potential GDP. By fixing potential GDP when con-sidering business cycle fluctuations, economists are looking at short-term move-ments around a slower moving long-run potential GDP level of output. Explain to the students that one reason to abstract from these long-term growth movements is sim-ply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones. A second reason is the standard view that short-term movements around potential GDP are driven by different economic forces than those that lead to growth in potential GDP. So abstracting from growth in potential GDP in order to focus on business cycle fluctuations simplifies matters without any loss of relevant details.
Three Types of Macroeconomic Equilibrium A full employment equilibrium occurs when equilibrium real GDP equals
potential GDP. When real GDP is below or above potential GDP, the money wage rate gradually changes to bring full employment.
A recessionary gap (or below full employment equilibrium) occurs when real GDP is less than potential GDP and that brings a falling price level.
A recessionary gap occurs when the AS curve and the AD curve intersect to the left of the potential GDP line, as illustrated in the figure to the left below. In the figure, potential GDP is $16 trillion but the actual real GDP is $15 trillion. In a recessionary gap, there is a surplus of labor and firms can hire new workers at a lower wage rate.
As the money wage rate falls, the AS curve shifts rightward and the price level falls and real GDP rises. The money wage rate falls until real GDP equals potential GDP.
An inflationary gap (or above full employment equilibrium) occurs when real GDP exceeds potential GDP and that brings a rising price level.
An inflationary gap occurs when the AS curve and the AD curve intersect to the right of the potential GDP line, as illustrated in the figure above to the right. In the figure, potential GDP is $16 trillion but the actual real GDP is $17 trillion. In an inflationary gap, there is a shortage of labor and firms must offer higher wage rates to hire the labor they demand. As the money wage rate rises, the AS curve shifts leftward and the price level rises and real GDP falls. The money wage rate rises until real GDP equals potential GDP.
Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilib-rium occurs where the new AD curve intersects the AS curve is not difficult. But the notion that the AS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the AS curve so that the students realize that wages and other input prices remain constant along an AS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of prices, the AS curve shifts leftward.
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Land Mine: The AS-AD model predicts a fall in the price level as the economy adjusts to an inflationary gap and a decrease in real GDP as the economy adjusts to a recessionary gap. But some students object by pointing out that the price level rarely, if ever, falls and real GDP infrequently decreases. These students are bothered by this apparent mismatch between the predictions of the model and the observed economy. The best way to handle this issue is to emphasize that in our actual economy, aggregate sup-ply and aggregate demand almost always are increasing. When we use the model, we’re studying what happens relative to the trends in real GDP and the price level. Since a certain amount of inflation is to be expected in the U.S. economy, a fall in the price level in the model translates into a lower price level than would otherwise have occurred and a slowing of inflation (often referred to as “disinflation”). The story is similar for real GDP.
Economic Growth and Inflation Trends Economic growth results from a growing labor force and increasing labor productiv-ity, which together make potential GDP grow. Inflation results when the quantity of money grows at a rate that outpaces the growth of potential GDP.
Using the AS-AD model, when the AD curve shifts rightward at a faster rate than the potential GDP curve, inflation occurs.
The Business Cycle The business cycle results from fluctuations in aggregate supply and aggregate de-mand.
Aggregate supply fluctuates because labor productivity grows at a variable pace, which brings fluctuations in the growth of potential GDP. A real busi-ness cycle results from fluctuations in the pace of growth of labor productiv-ity and potential GDP.
Aggregate demand fluctuations are the main source of the business cycle, since swings in aggregate demand occur more quickly than changes in the money wage rate that change aggregate supply.
Inflation Cycles Demand-pull inflation is inflation that starts because aggregate demand in-
creases. Demand-pull inflation can be started by any of the factors that in-crease aggregate demand, but can only be sustained by growth in the quan-tity of money.
Starting at full employment, an increase in AD increases the price level and real GDP and creates an inflationary gap. The shortage of labor in-creases the money wage rate, which decreases AS and thereby increases the price level and decreases GDP back to potential GDP. If the quantity of money increases, AD will increase again, creating an inflationary gap. This process repeating itself results in an ongoing demand-pull inflation spiral.
Cost-push inflation is an inflation that begins with an increase in cost. The two main sources of cost increases are increases in the money wage rate and
increases in the money prices of raw materials such as oil. Cost-push infla-tion can be started by an increase in costs, but can only be sustained by growth in the quantity of money.
Starting at full employment, an increase oil prices decreases the AS which increases the price level, decreases real GDP, and creates a reces-sionary gap. When the unemployment rate rises above the natural rate, the Fed increases the quantity of money to restore full employment. AD increases and returns real GDP back to potential GDP, but the price level rises further. Oil producers now see the price of everything else rising so they raise the price oil still higher and this process repeats in a cost-push inflation spiral.
The combination of recession (decreasing real GDP) and inflation (rising price level) is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks. Stagflation poses a dilemma for the Fed, because if they fail to increase the quantity of money the econ-omy remains below full employment but if they increase the quantity of money it can create a cost-push inflation spiral.
Class activity: Use the AS-AD model to apply the theory students are learning to current events in the economy. For example, oil prices have increased due to Asian demand and every summer there is concern about hurricanes. Encourage students to think about the impact of these factors in the AS-AD model. How will higher oil prices affect the nation’s GDP and price level? Alternatively, if there have recently been significant changes to taxes, government spending, interest rates, exchange rates, events that may alter consumer or business confidence, etc. make sure you bring them into your discussion and use this opportunity to get practice applying the AS-AD model interpret the macroeconomic conse-quences of current events. This not only helps students master how to work with the model, but also demonstrates to them the practical applicability of this new tool. Also, be sure to remind your students that the upcoming chapters will be building on top of this model, so grasping the upcoming material will require un-derstanding how to work with this important tool.
Deflation and Great Depression In the Great Depression from 1929 to 1933, the price level fell by 22 percent
and real GDP fell by 31 percent. In the 2008-2009 recession, the price level rose at a slow pace and real GDP fell by less than 4 percent. The 2008-2009 recession was much milder than the Great Depression for various reasons: During the Great Depression, bank failures, a 25 percent contraction in
the quantity of money, and inaction by the Fed resulted in a collapse of aggregate demand. Money wage rates and the price level were slow to adjust, resulting in huge decreases in real GDP and employment.
During the 2008 financial crisis, the Fed bailed out troubled financial in-stitutions and doubled the monetary basis, which kept the quantity of money growing. Combined with increased government expenditure, the growing quantity of money limited the fall in aggregate demand, thus re-sulting in smaller decreases in employment and real GDP.
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USING EYE ON THE U.S. ECONOMY
U.S. Economic Growth, Inflation, and the Business Cycle
If you have young students in your class, most of them will have little or no knowledge of how our economy has evolved since the 1970s. This knowledge is vital because our experiences with economic growth, inflation, and the business cycle help shape policymakers’ de-cisions about what policies to pursue today. For instance, for those who lived through them, the 1970s and early 1980s with their high and volatile inflation rates are times that bring bad memories. So, pol-icymakers today take actions to help avoid the roaring inflation that the U.S. economy experienced then. Indeed, some observers credit the Fed’s decisions in 2005 to continue raising interest rates in the face of oil price hikes as an attempt to avoid reliving the 1970s/early 1980s when the Fed eased in the face of oil price hikes and inflation skyrocketed. Use this Eye to help your students gain a more balanced, historical perspective because this view might well help them under-stand policymakers’ decisions today!
USING EYE ON YOUR LIFE
Using the AS-AD Model
To have students actually use this “Eye on Your Life” in a meaningful way you should probably make this a required assignment. Addition-ally, to get them to pour over the data it might be useful to actually go through the release dates of important statistics so that students are working with “fresh” information. Typically, unemployment data is re-leased the first Friday of the month for the previous month. CPI data are released about halfway through the month for the previous month. GDP is a bit more backward looking and while there is a preliminary update given approximately four weeks after the conclusion of the quarter, that measurement goes through 2 revisions over the follow-ing months until it becomes a final reading. Pinning down the release dates sends a cue to your students that you want the latest informa-tion on the economy. It might even be a good idea to provide your class with specific government websites and the precise information that can be found there. For instance if you want your students to grab the latest CPI and unemployment information you can direct them to www.bls.gov. GDP information can be found at www.bea.gov. You can even create data tables going back as far as you find to be relevant for these data to include in your course syllabus and have students update these tables throughout the semester as data are re-leased. Of course if you believe at this point that students should al-ready know where to look for this information then you can refrain from distributing the actual website addresses in class.
Why Did the U.S. Economy Go into Recession in 2008?
Use this Eye to help reinforce how the aggregate supply—aggregate demand model can be used to organize an analysis of real world macroeconomic fluctuations. Many times the models introduced in economics can seem too disconnected from reality to students to war-rant appreciation. However, the AS-AD model works well to describe the 2008-2009 recession and the mix of a rising price level for the first part of the recession, and then a falling price level for the second part. You can add to the analysis presented in the Eye by presenting what happened when oil prices fell from their peak in July 2008 near $150 to the $30 range in early 2009. Breaking the 2008-2009 reces-sion into two segments, you can demonstrate how the first portion of the recession saw a rising price level and the threat of stagflation as oil prices rose and aggregate supply decreased by more than aggre-gate demand. But then oil prices fell and aggregate demand continued to decrease, so the price level was pulled down and we saw deflation-ary pressure. You can gather data on the CPI from the BLS web site to help illustrate this shift as there is a stark divide in the monthly infla-tion reading before and after July 2008. In fact, while monthly read-ings on the CPI were high through July, the overall CPI saw a 1.5 per-cent decline from August 2008 to August 2009.
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ADDITIONAL EXERCISES FOR ASSIGNMENT
Questions Checkpoint 19.3 Explaining Economic Trends and Fluctuations1. What effect does each of the following combinations have on real
GDP and the price level? 1a. Increase in aggregate demand and a decrease in aggregate sup-
ply.1b. Increase in aggregate demand and an increase in aggregate sup-
ply.1c. Decrease in aggregate demand and a decrease in aggregate sup-
ply.
Answers Checkpoint 19.3 Explaining Economic Trends and Fluctuations1a. An increase in aggregate demand raises the price level and in-
creases real GDP. A decrease in aggregate supply raises the price level and decreases real GDP. Combined, the price level definitely rises. But the effect on real GDP is ambiguous. If the aggregate demand effect is larger than the aggregate supply effect, real GDP increases, while if the aggregate supply effect is larger, real GDP decreases. If the two are the same magnitude, real GDP will not change.
1b. An increase in aggregate demand raises the price level and in-creases real GDP. An increase in aggregate supply lowers the price level and increases real GDP. When both occur simultane-ously, definitely real GDP increases. The effect on the price level is uncertain. If the aggregate demand effect is larger, the price level rises and if the aggregate supply effect is larger, the price level falls. And if the two effects are the same magnitude, the price level does not change.
1c. A decrease in aggregate demand lowers the price level and de-creases real GDP. A decrease in aggregate supply raises the price level and decreases real GDP. When both occur, real GDP defi-nitely decreases. However, the effect on the price level is uncer-tain. If the aggregate demand effect dominates, the price level falls but if the aggregate supply effect dominates, the price level rises. And if the two effects are the same size, the price level does not change.
