24729 33 c33 p737-776 - cengage · can public policy do to prevent periods of falling incomes and...

12Short-Run Economic Fluctuations

Aggregate Demand and Aggregate Supply

Economic activity fluctuates from year to year. In most years, the productionof goods and services rises. Because of increases in the labor force, increases inthe capital stock, and advances in technological knowledge, the economy canproduce more and more over time. This growth allows everyone to enjoy ahigher standard of living. On average over the past 50 years, the production ofthe U.S. economy as measured by real GDP has grown by about 3 percent peryear.

In some years, however, this normal growth does not occur. Firms find them-selves unable to sell all of the goods and services they have to offer, so they cutback on production. Workers are laid off, unemployment rises, and factories areleft idle. With the economy producing fewer goods and services, real GDP andother measures of income fall. Such a period of falling incomes and rising unem-ployment is called a recession if it is relatively mild and a depression if it ismore severe.

What causes short-run fluctuations in economic activity? What, if anything,can public policy do to prevent periods of falling incomes and rising unemploy-ment? When recessions and depressions occur, how can policymakers reducetheir length and severity? These are the questions that we take up now.

The variables that we study are largely those we have already seen in previ-ous chapters. They include GDP, unemployment, interest rates, and the price

33

739

recessiona period of decliningreal incomes and risingunemployment

depressiona severe recession

level. Also familiar are the policy instruments of government spending, taxes,and the money supply. What differs from our earlier analysis is the time hori-zon. So far, our focus has been on the behavior of the economy in the long run.Our focus now is on the economy’s short-run fluctuations around its long-runtrend.

Although there remains some debate among economists about how to ana-lyze short-run fluctuations, most economists use the model of aggregate demandand aggregate supply. Learning how to use this model for analyzing the short-runeffects of various events and policies is the primary task ahead. This chapter intro-duces the model’s two pieces: the aggregate-demand curve and the aggregate-supply curve. But before turning to the model, let’s look at some of the key factsthat describe the ups and downs in the economy.

740 PART 12 SHORT-RUN ECONOMIC FLUCTUATIONS

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONSShort-run fluctuations in economic activity occur in all countries and haveoccurred throughout history. As a starting point for understanding these year-to-year fluctuations, let’s discuss some of their most important properties.

Fact 1: Economic Fluctuations Are Irregular and Unpredictable

Fluctuations in the economy are often called the business cycle. As this term sug-gests, economic fluctuations correspond to changes in business conditions.When real GDP grows rapidly, business is good. During such periods of eco-nomic expansion, most firms find that customers are plentiful and that profitsare growing. When real GDP falls during recessions, businesses have trouble.During such periods of economic contraction, most firms experience decliningsales and dwindling profits.

The term business cycle is somewhat misleading because it suggests that eco-nomic fluctuations follow a regular, predictable pattern. In fact, economic fluctu-ations are not at all regular, and they are almost impossible to predict with muchaccuracy. Panel (a) of Figure 1 shows the real GDP of the U.S. economy since1965. The shaded areas represent times of recession. As the figure shows, reces-sions do not come at regular intervals. Sometimes recessions are close together,such as the recessions of 1980 and 1982. Sometimes the economy goes manyyears without a recession. The longest period in U.S. history without a recessionwas the economic expansion from 1991 to 2001.

Fact 2: Most Macroeconomic Quantities Fluctuate Together

Real GDP is the variable that is most commonly used to monitor short-runchanges in the economy because it is the most comprehensive measure of eco-nomic activity. Real GDP measures the value of all final goods and services pro-duced within a given period of time. It also measures the total income (adjustedfor inflation) of everyone in the economy.

It turns out, however, that for monitoring short-run fluctuations, it does notreally matter which measure of economic activity one looks at. Most macroeco-nomic variables that measure some type of income, spending, or productionfluctuate closely together. When real GDP falls in a recession, so do personalincome, corporate profits, consumer spending, investment spending, industrial“YOU’RE FIRED. PASS IT ON.” C

AR

TOO

N:©

2002

TH

E N

EW

YO

RK

ER

CO

LLE

CT

ION

FR

OM

CA

RTO

ON

BA

NK

.CO

M.A

LL R

IGH

TS

RE

SE

RV

ED

.

11F I G U R E

A Look at Short-RunEconomic FluctuationsThis figure shows real GDP inpanel (a), investment spend-ing in panel (b), and unem-ployment in panel (c) for theU.S. economy using quarterlydata since 1965. Recessionsare shown as the shadedareas. Notice that real GDPand investment spendingdecline during recessions,while unemployment rises.

Source: U.S. Department ofCommerce; U.S. Department of Labor.

(a) Real GDP

(b) Investment Spending

(c) Unemployment Rate

Billions of2000 Dollars

1965 1970 1975 1980 1985 1990 1995 2000 20052,000

4,000

6,000

8,000

$10,000

3,000

5,000

7,000

9,000

1965 1970 1975 1980 1985 1990 1995 2000 2005

Billions of2000 Dollars

0

500

1,000

$1,500

1965 1970 1975 1980 1985 1990 1995 2000 2005

Percent ofLabor Force

2

4

6

8

10

12%

Real GDP

InvestmentSpending

UnemploymentRate

production, retail sales, home sales, auto sales, and so on. Because recessions areeconomy-wide phenomena, they show up in many sources of macroeconomicdata.

Although many macroeconomic variables fluctuate together, they fluctuate bydifferent amounts. In particular, as panel (b) of Figure 1 shows, investmentspending varies greatly over the business cycle. Even though investment aver-ages about one-seventh of GDP, declines in investment account for about two-thirds of the declines in GDP during recessions. In other words, when economicconditions deteriorate, much of the decline is attributable to reductions inspending on new factories, housing, and inventories.

Fact 3: As Output Falls, Unemployment Rises

Changes in the economy’s output of goods and services are strongly correlatedwith changes in the economy’s utilization of its labor force. In other words,when real GDP declines, the rate of unemployment rises. This fact is hardly sur-prising: When firms choose to produce a smaller quantity of goods and services,they lay off workers, expanding the pool of unemployed.

Panel (c) of Figure 1 shows the unemployment rate in the U.S. economy since1965. Once again, recessions are shown as the shaded areas in the figure. The fig-ure shows clearly the impact of recessions on unemployment. In each of therecessions, the unemployment rate rises substantially. When the recession endsand real GDP starts to expand, the unemployment rate gradually declines. Theunemployment rate never approaches zero; instead, it fluctuates around its natu-ral rate of about 5 or 6 percent.

List and discuss three key facts about economic fluctuations.


EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONSDescribing what happens to economies as they fluctuate over time is easy.Explaining what causes these fluctuations is more difficult. Indeed, compared tothe topics we have studied in previous chapters, the theory of economic fluctua-tions remains controversial. In this and the next two chapters, we develop themodel that most economists use to explain short-run fluctuations in economicactivity.

The Assumptions of Classical Economics

In previous chapters, we developed theories to explain what determines mostimportant macroeconomic variables in the long run. Chapter 25 explained thelevel and growth of productivity and real GDP. Chapters 26 and 27 explainedhow the financial system works and how the real interest rate adjusts to balancesaving and investment. Chapter 28 explained why there is always some unem-ployment in the economy. Chapters 29 and 30 explained the monetary systemand how changes in the money supply affect the price level, the inflation rate,and the nominal interest rate. Chapters 31 and 32 extended this analysis to openeconomies to explain the trade balance and the exchange rate.

All of this previous analysis was based on two related ideas: the classicaldichotomy and monetary neutrality. Recall that the classical dichotomy is theseparation of variables into real variables (those that measure quantities or rela-tive prices) and nominal variables (those measured in terms of money). Accord-ing to classical macroeconomic theory, changes in the money supply affect nom-inal variables but not real variables. As a result of this monetary neutrality,Chapters 25 through 28 were able to examine the determinants of real variables

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 743

In The NewsOffbeat IndicatorsWhen the economy goes into a recession, many economic vari-ables are affected. This article, written during the recession of2001, gives some examples.

Economic NumbersBefuddle Even the BestBy George Hager

Economists pore over scores of numbersevery week, trying to sense when the re-cession is over. But quirky indicators andgut instinct might be almost as help-ful—maybe even more so.

Is your dentist busy? Dentists saypeople put off appointments when timesturn tough, then reschedule when theeconomy improves.

How far away do you have to parkwhen you go to the mall? Fewer shop-pers equal more parking spaces.

If you drive to work, has your com-mute time gotten shorter or longer?

Economist Michael Evans says a col-league with a pipeline into the garbagebusiness swears by his own homegrownChicago Trash index. Collections plungedafter the Sept. 11 terror attacks, re-bounded in October but then fell offagain in mid-November. “Trash is apretty good indicator of what people are

Source: USA Today, December 26, 2001. Reprinted with permission.

buying,” says Evans, an economist withEvans Carrol & Associates. “They’ve gotto throw out the wrappings.” . . .

What’s actually happening is oftenclear only in hindsight. That’s one reasonthe National Bureau of Economic Re-search waited until November to declarethat a recession began last March—andwhy it took them until December 1992to declare that the last recession hadended more than a year earlier, in March1991.

“The data can fail you,” says AllenSinai, chief economist for Decision Eco-nomics. Sinai cautions that if numbersappear to be going up (or down), it’sbest to wait to see what happens overtwo or three months before drawing aconclusion—something hair-trigger fi-nancial markets routinely don’t do.

“We have lots of false predictions ofrecoveries by (stock) markets that don’thappen,” he says.

Like a lot of economists, Sinai leav-ens the numbers with informal observa-tions. These days, he’s paying particular

attention to what business executivessay at meetings and cocktail partiesbecause their mood—and their plansfor investing and hiring—are key to acomeback.

Even the Federal Reserve, whosemore than 200 economists monitor aboutevery piece of the economy that can bemeasured, make room for anecdotes. Twoweeks before every policy meeting, theFed publishes its “beige book,” a surveybased on off-the-record conversations be-tween officials at the Fed’s 12 regionalbanks and local businesses.

The reports are peppered withquotes from unnamed business people(“Everybody’s decided to go shoppingagain,” someone told the Richmond FedBank last month) and the occasionalodd detail that reveals just how fardown the Fed inquisitors sometimesdrill. Last March, the Dallas Fed Bank re-ported “healthy sales of singing goril-las” for Valentine’s Day.

(real GDP, the real interest rate, and unemployment) without introducing nomi-nal variables (the money supply and the price level).

In a sense, money does not matter in a classical world. If the quantity ofmoney in the economy were to double, everything would cost twice as much,and everyone’s income would be twice as high. But so what? The change wouldbe nominal (by the standard meaning of “nearly insignificant”). The things thatpeople really care about—whether they have a job, how many goods and ser-vices they can afford, and so on—would be exactly the same.

This classical view is sometimes described by the saying, “Money is a veil.”That is, nominal variables may be the first things we see when we observe aneconomy because economic variables are often expressed in units of money. Butwhat’s important are the real variables and the economic forces that determinethem. According to classical theory, to understand these real variables, we needto look beneath the veil.

The Reality of Short-Run Fluctuations

Do these assumptions of classical macroeconomic theory apply to the world inwhich we live? The answer to this question is of central importance to under-standing how the economy works. Most economists believe that classical theorydescribes the world in the long run but not in the short run.

Consider again the impact of money on the economy. Most economistsbelieve that, beyond a period of several years, changes in the money supplyaffect prices and other nominal variables but do not affect real GDP, unemploy-ment, or other real variables—just as classical theory says. When studying year-to-year changes in the economy, however, the assumption of monetary neutralityis no longer appropriate. In the short run, real and nominal variables are highlyintertwined, and changes in the money supply can temporarily push real GDPaway from its long-run trend.

Even the classical economists themselves, such as David Hume, realized thatclassical economic theory did not hold in the short run. From his vantage pointin 18th-century England, Hume observed that when the money supplyexpanded after gold discoveries, it took some time for prices to rise, and in themeantime, the economy enjoyed higher employment and production.

To understand how the economy works in the short run, we need a newmodel. This new model can be built using many of the tools we developed inprevious chapters, but it must abandon the classical dichotomy and the neutral-ity of money. We can no longer separate our analysis of real variables such asoutput and employment from our analysis of nominal variable such as moneyand the price level. Our new model focuses on how real and nominal variablesinteract.

The Model of Aggregate Demand and Aggregate Supply

Our model of short-run economic fluctuations focuses on the behavior of twovariables. The first variable is the economy’s output of goods and services, asmeasured by real GDP. The second is the average level of prices, as measured bythe CPI or the GDP deflator. Notice that output is a real variable, whereas theprice level is a nominal variable. By focusing on the relationship between thesetwo variables, we are departing from the classical assumption that real and nom-inal variables can be studied separately.


We analyze fluctuations in the economy as a whole with the model of aggre-gate demand and aggregate supply, which is illustrated in Figure 2. On the ver-tical axis is the overall price level in the economy. On the horizontal axis is theoverall quantity of goods and services produced in the economy. The 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. Theaggregate-supply curve shows the quantity of goods and services that firmsproduce and sell at each price level. According to this model, the price level andthe quantity of output adjust to bring aggregate demand and aggregate supplyinto balance.

It is tempting to view the model of aggregate demand and aggregate supplyas nothing more than a large version of the model of market demand and mar-ket supply introduced in Chapter 4. In fact, this model is quite different. Whenwe consider demand and supply in a particular market—ice cream, forinstance—the behavior of buyers and sellers depends on the ability of resourcesto move from one market to another. When the price of ice cream rises, thequantity demanded falls because buyers will use their incomes to buy productsother than ice cream. Similarly, a higher price of ice cream raises the quantitysupplied because firms that produce ice cream can increase production by hiringworkers away from other parts of the economy. This microeconomic substitutionfrom one market to another is impossible for the economy as a whole. After all,the quantity that our model is trying to explain—real GDP—measures the totalquantity of goods and services produced in all markets. To understand why theaggregate-demand curve is downward sloping and why the aggregate-supplycurve is upward sloping, we need a macroeconomic theory that explains the totalquantity of goods and services demanded and the total quantity of goods andservices supplied. Developing such a theory is our next task.


model of aggregatedemand and aggregatesupplythe model that mosteconomists use toexplain short-run fluctua-tions in economic activ-ity around its long-runtrend

aggregate-demandcurvea curve that shows thequantity of goods andservices that households,firms, the government,and customers abroadwant to buy at eachprice level

aggregate-supply curvea curve that shows thequantity of goods andservices that firmschoose to produce andsell at each price level

22F I G U R E

Aggregate Demand andAggregate SupplyEconomists use the model ofaggregate demand and aggregatesupply to analyze economic fluc-tuations. On the vertical axis is the overall level of prices. On thehorizontal axis is the economy’stotal output of goods and ser-vices. Output and the price level adjust to the point at which theaggregate-supply and aggregate-demand curves intersect.

Equilibriumoutput

Quantity ofOutput

PriceLevel

0

Equilibriumprice level

Aggregatesupply

Aggregatedemand

33The Aggregate-DemandCurveA fall in the price level from P1to P2 increases the quantity ofgoods and services demandedfrom Y1 to Y2. There are threereasons for this negative rela-tionship. As the price level falls,real wealth rises, interest ratesfall, and the exchange rate de-preciates. These effects stimu-late spending on consumption,investment, and net exports.Increased spending on any orall of these components of out-put means a larger quantity ofgoods and services demanded.

F I G U R E

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1 Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

How does the economy’s behavior in the short run differ from itsbehavior in the long run? • Draw the model of aggregate demand and aggregatesupply. What variables are on the two axes?


THE AGGREGATE-DEMAND CURVEThe aggregate-demand curve tells us the quantity of all goods and servicesdemanded in the economy at any given price level. As Figure 3 illustrates, theaggregate-demand curve is downward sloping. This means that, other thingsequal, a decrease in the economy’s overall level of prices (from, say, P1 to P2)raises the quantity of goods and services demanded (from Y1 to Y2). Conversely,an increase in the price level reduces the quantity of goods and servicesdemanded.

Why the Aggregate-Demand Curve Slopes Downward

Why does a change in the price level move the quantity of goods and servicesdemanded in the opposite direction? To answer this question, it is useful torecall that an economy’s GDP (which we denote as Y) is the sum of its consump-tion (C), investment (I), government purchases (G), and net exports (NX):

Y � C � I � G � NX.

Each of these four components contributes to the aggregate demand for goodsand services. For now, we assume that government spending is fixed by policy.

The other three components of spending—consumption, investment, and netexports—depend on economic conditions and, in particular, on the price level.To understand the downward slope of the aggregate-demand curve, therefore,we must examine how the price level affects the quantity of goods and servicesdemanded for consumption, investment, and net exports.

The Price Level and Consumption: The Wealth Effect Consider themoney that you hold in your wallet and your bank account. The nominal valueof this money is fixed: One dollar is always worth one dollar. Yet the real value ofa dollar is not fixed. If a candy bar costs 1 dollar, then a dollar is worth one candybar. If the price of a candy bar falls to 50 cents, then 1 dollar is worth two candybars. Thus, when the price level falls, the dollars you are holding rise in value,which increases your real wealth and your ability to buy goods and services.

This logic gives us the first reason the aggregate demand curve is downwardsloping. A decrease in the price level raises the real value of money and makes con-sumers wealthier, which in turn encourages them to spend more. The increase in con-sumer spending means a larger quantity of goods and services demanded. Conversely, anincrease in the price level reduces the real value of money, in turn reducing wealth, con-sumer spending, and the quantity of goods and services demanded.

The Price Level and Investment: The Interest-Rate Effect The pricelevel is one determinant of the quantity of money demanded. The lower theprice level, the less money households need to hold to buy the goods and ser-vices they want. Therefore, when the price level falls, households try to reducetheir holdings of money by lending some of it out. For instance, a householdmight use its excess money to buy interest-bearing bonds. Or it might deposit itsexcess money in an interest-bearing savings account, and the bank would usethese funds to make more loans. In either case, as households try to convertsome of their money into interest-bearing assets, they drive down interest rates.(The next chapter analyzes this in more detail.)

Interest rates, in turn, affect spending on goods and services. Because a lowerinterest rate makes borrowing less expensive, it encourages firms to borrowmore to invest in new plants and equipment, and it encourages households toborrow more to invest in new housing. (A lower interest rate might also stimu-late consumer spending, especially large durable purchases such as cars, whichare often bought on credit.) Thus, a lower interest rate increases the quantity ofgoods and services demanded.

This gives us a second reason the aggregate demand curve is downward slop-ing. A lower price level reduces the interest rate, encourages greater spending on invest-ment goods, and thereby increases the quantity of goods and services demanded. Con-versely, a higher price level raises the interest rate, reducing investment spending andthe quantity of goods and services demanded.

The Price Level and Net Exports: The Exchange-Rate Effect As wehave just discussed, a lower price level in the United States lowers the U.S. inter-est rate. In response to the lower interest rate, some U.S. investors will seekhigher returns by investing abroad. For instance, as the interest rate on U.S. gov-ernment bonds falls, a mutual fund might sell U.S. government bonds to buyGerman government bonds. As the mutual fund tries to convert its dollars intoeuros to buy the German bonds, it increases the supply of dollars in the marketfor foreign-currency exchange.


The increased supply of dollars to be turned into euros causes the dollar todepreciate relative to the euro. This leads to a change in the real exchange rate—the relative price of domestic and foreign goods. Because each dollar buys fewerunits of foreign currencies, foreign goods become more expensive relative todomestic goods.

The change in relative prices affects spending, both at home and abroad.Because foreign goods are now more expensive, Americans buy less from othercountries, causing U.S. imports of goods and services to decrease. At the sametime, because U.S. goods are now cheaper, foreigners buy more from the UnitedStates, so U.S. exports increase. Net exports equal exports minus imports, soboth of these changes cause U.S. net exports to increase. Thus, the fall in the realexchange value of the dollar leads to an increase in the quantity of goods andservices demanded.

This gives us a third reason the aggregate demand curve is downward slop-ing. When a fall in the U.S. price level causes U.S. interest rates to fall, the real value ofthe dollar declines in foreign exchange markets, and this depreciation stimulates U.S. netexports and thereby increases the quantity of goods and services demanded. Conversely,when the U.S. price level rises and causes U.S interest rates to rise, the real value of thedollar increases, and this appreciation reduces U.S. net exports and the quantity of goodsand services demanded.

Summary There are three distinct but related reasons a fall in the price levelincreases the quantity of goods and services demanded:

1. Consumers are wealthier, which stimulates the demand for consumptiongoods.

2. Interest rates fall, which stimulates the demand for investment goods.3. The currency depreciates, which stimulates the demand for net exports.

The same three effects work in reverse: When the price level rises, decreasedwealth depresses consumer spending, higher interest rates depress investmentspending, and a currency appreciation depresses net exports.

Here is a thought experiment to hone your intuition about these effects. Imag-ine that one day you wake up and notice that, for some mysterious reason, theprices of all goods and services have fallen by half, so the dollars you are hold-ing are worth twice as much. In real terms, you now have twice as much moneyas you had when you went to bed the night before. What would you do with theextra money? You could spend it at your favorite restaurant, increasing con-sumer spending. You could lend it out (by buying a bond or depositing it inyour bank), reducing interest rates and increasing investment spending. Or youcould invest it overseas (by buying shares in an international mutual fund),reducing the real exchange value of the dollar and increasing net exports.Whichever of these three responses you choose, the fall in the price level leads toan increase in the quantity of goods and services demanded. This is what thedownward slope of the aggregate-demand curve represents.

It is important to keep in mind that the aggregate-demand curve (like alldemand curves) is drawn holding “other things equal.” In particular, our threeexplanations of the downward-sloping aggregate-demand curve assume that themoney supply is fixed. That is, we have been considering how a change in theprice level affects the demand for goods and services, holding the amount ofmoney in the economy constant. As we will see, a change in the quantity of


money shifts the aggregate-demand curve. At this point, just keep in mind thatthe aggregate-demand curve is drawn for a given quantity of money.

Why the Aggregate-Demand Curve Might Shift

The downward slope of the aggregate-demand curve shows that a fall in theprice level raises the overall quantity of goods and services demanded. Manyother factors, however, affect the quantity of goods and services demanded at agiven price level. When one of these other factors changes, the aggregate-demand curve shifts.

Let’s consider some examples of events that shift aggregate demand. We cancategorize them according to which component of spending is most directlyaffected.

Shifts Arising from Changes in Consumption Suppose Americans sud-denly become more concerned about saving for retirement and, as a result,reduce their current consumption. Because the quantity of goods and servicesdemanded at any price level is lower, the aggregate-demand curve shifts to theleft. Conversely, imagine that a stock-market boom makes people wealthier andless concerned about saving. The resulting increase in consumer spendingmeans a greater quantity of goods and services demanded at any given pricelevel, so the aggregate-demand curve shifts to the right.

Thus, any event that changes how much people want to consume at a givenprice level shifts the aggregate-demand curve. One policy variable that has thiseffect is the level of taxation. When the government cuts taxes, it encourages peo-ple to spend more, so the aggregate-demand curve shifts to the right. When thegovernment raises taxes, people cut back on their spending, and the aggregate-demand curve shifts to the left.

Shifts Arising from Changes in Investment Any event that changes howmuch firms want to invest at a given price level also shifts the aggregate-demand curve. For instance, imagine that the computer industry introduces afaster line of computers, and many firms decide to invest in new computer sys-tems. Because the quantity of goods and services demanded at any price level ishigher, the aggregate-demand curve shifts to the right. Conversely, if firmsbecome pessimistic about future business conditions, they may cut back oninvestment spending, shifting the aggregate-demand curve to the left.

Tax policy can also influence aggregate demand through investment. As wesaw in Chapter 26, an investment tax credit (a tax rebate tied to a firm’s invest-ment spending) increases the quantity of investment goods that firms demand atany given interest rate. It therefore shifts the aggregate-demand curve to theright. The repeal of an investment tax credit reduces investment and shifts theaggregate-demand curve to the left.

Another policy variable that can influence investment and aggregate demand isthe money supply. As we discuss more fully in the next chapter, an increase in themoney supply lowers the interest rate in the short run. This makes borrowing lesscostly, which stimulates investment spending and thereby shifts the aggregate-demand curve to the right. Conversely, a decrease in the money supply raises theinterest rate, discourages investment spending, and thereby shifts the aggregate-demand curve to the left. Many economists believe that throughout U.S. history,


changes in monetary policy have been an important source of shifts in aggregatedemand.

Shifts Arising from Changes in Government Purchases The most directway that policymakers shift the aggregate-demand curve is through governmentpurchases. For example, suppose Congress decides to reduce purchases of newweapons systems. Because the quantity of goods and services demanded at anyprice level is lower, the aggregate-demand curve shifts to the left. Conversely, ifstate governments start building more highways, the result is a greater quantityof goods and services demanded at any price level, so the aggregate-demandcurve shifts to the right.

Shifts Arising from Changes in Net Exports Any event that changes netexports for a given price level also shifts aggregate demand. For instance, whenEurope experiences a recession, it buys fewer goods from the United States. Thisreduces U.S. net exports at every price level and shifts the aggregate-demandcurve for the U.S. economy to the left. When Europe recovers from its recession,it starts buying U.S. goods again, and the aggregate-demand curve shifts to theright.

Net exports sometimes change because international speculators cause move-ments in the exchange rate. Suppose, for instance, that these speculators loseconfidence in foreign economies and want to move some of their wealth into theU.S. economy. In doing so, they bid up the value of the U.S. dollar in the foreignexchange market. This appreciation of the dollar makes U.S. goods more expen-sive compared to foreign goods, which depresses net exports and shifts theaggregate-demand curve to the left. Conversely, speculation that causes a depre-ciation of the dollar stimulates net exports and shifts the aggregate-demandcurve to the right.

Summary In the next chapter, we analyze the aggregate-demand curve inmore detail. There we examine more precisely how the tools of monetary andfiscal policy can shift aggregate demand and whether policymakers should usethese tools for that purpose. At this point, however, you should have some ideaabout why the aggregate-demand curve slopes downward and what kinds ofevents and policies can shift this curve. Table 1 summarizes what we havelearned so far.

Explain the three reasons the aggregate-demand curve slopesdownward. • Give an example of an event that would shift the aggregate-demandcurve. Which way would this event shift the curve?


THE AGGREGATE-SUPPLY CURVEThe aggregate-supply curve tells us the total quantity of goods and services thatfirms produce and sell at any given price level. Unlike the aggregate-demandcurve, which is always downward sloping, the aggregate-supply curve shows arelationship that depends crucially on the time horizon examined. In the long run,the aggregate-supply curve is vertical, whereas in the short run, the aggregate-supply

curve is upward sloping. To understand short-run economic fluctuations, and howthe short-run behavior of the economy deviates from its long-run behavior, weneed to examine both the long-run aggregate-supply curve and the short-runaggregate-supply curve.

Why the Aggregate-Supply Curve Is Vertical in the Long Run

What determines the quantity of goods and services supplied in the long run?We implicitly answered this question earlier in the book when we analyzed theprocess of economic growth. In the long run, an economy’s production of goods andservices (its real GDP) depends on its supplies of labor, capital, and natural resourcesand on the available technology used to turn these factors of production into goods andservices.

When we analyzed these forces that govern long-run growth, we did not needto make any reference to the overall level of prices. We examined the price levelin a separate chapter, where we saw that it was determined by the quantity ofmoney. We learned that if two economies were identical except that one hadtwice as much money in circulation as the other, the price level would be twiceas high in the economy with more money, but the output of goods and serviceswould be the same.


11T A B L E

The Aggregate-Demand Curve:Summary

Why Does the Aggregate-Demand Curve Slope Downward?1. The Wealth Effect: A lower price level increases real wealth, which encourages spending on

consumption.2. The Interest-Rate Effect: A lower price level reduces the interest rate, which encourages

spending on investment.3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate,

which encourages spending on net exports.

Why Might the Aggregate-Demand Curve Shift?1. Shifts Arising from Consumption: An event that makes consumers spend more at a given price

level (a tax cut, a stock-market boom) shifts the aggregate-demand curve to the right. An eventthat makes consumers spend less at a given price level (a tax hike, a stock-market decline) shiftsthe aggregate-demand curve to the left.

2. Shifts Arising from Investment: An event that makes firms invest more at a given price level(optimism about the future, a fall in interest rates due to an increase in the money supply) shiftsthe aggregate-demand curve to the right. An event that makes firms invest less at a given pricelevel (pessimism about the future, a rise in interest rates due to a decrease in the money supply)shifts the aggregate-demand curve to the left.

3. Shifts Arising from Government Purchases: An increase in government purchases of goods andservices (greater spending on defense or highway construction) shifts the aggregate-demandcurve to the right. A decrease in government purchases on goods and services (a cutback indefense or highway spending) shifts the aggregate-demand curve to the left.

4. Shifts Arising from Net Exports: An event that raises spending on net exports at a given pricelevel (a boom overseas, speculation that causes an exchange-rate depreciation) shifts theaggregate-demand curve to the right. An event that reduces spending on net exports at a givenprice level (a recession overseas, speculation that causes an exchange-rate appreciation) shiftsthe aggregate-demand curve to the left.


44The Long-RunAggregate-Supply CurveIn the long run, the quantityof output supplied dependson the economy’s quantitiesof labor, capital, and naturalresources and on the tech-nology for turning theseinputs into output. Becausethe quantity supplied doesnot depend on the overallprice level, the long-runaggregate-supply curve isvertical at the natural rateof output.

F I G U R E

Quantity ofOutput

Natural rateof output

PriceLevel

0

Long-runaggregate

supply

P2

1. A changein the pricelevel . . .

2. . . . does not affect the quantity of goods and services supplied in the long run.

P1

Because the price level does not affect the long-run determinants of real GDP,the long-run aggregate-supply curve is vertical, as in Figure 4. In other words, inthe long run, the economy’s labor, capital, natural resources, and technologydetermine the total quantity of goods and services supplied, and this quantitysupplied is the same regardless of what the price level happens to be.

The vertical long-run aggregate-supply curve is a graphical representation ofthe classical dichotomy and monetary neutrality. As we have already discussed,classical macroeconomic theory is based on the assumption that real variables donot depend on nominal variables. The long-run aggregate-supply curve is con-sistent with this idea because it implies that the quantity of output (a real vari-able) does not depend on the level of prices (a nominal variable). As noted ear-lier, most economists believe that this principle works well when studying theeconomy over a period of many years but not when studying year-to-yearchanges. Thus, the aggregate-supply curve is vertical only in the long run.

Why the Long-Run Aggregate-Supply Curve Might Shift

Because classical macroeconomic theory predicts the quantity of goods and ser-vices produced by an economy in the long run, it also explains the position ofthe long-run aggregate-supply curve. The long-run level of production is some-times called potential output or full-employment output. To be more precise, we callit the natural rate of output because it shows what the economy produces whenunemployment is at its natural, or normal, rate. The natural rate of output is thelevel of production toward which the economy gravitates in the long run.

Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. Because output in the classical model depends onlabor, capital, natural resources, and technological knowledge, we can categorizeshifts in the long-run aggregate-supply curve as arising from these four sources.

Shifts Arising from Changes in Labor Imagine that an economy experi-ences an increase in immigration. Because there would be a greater number of

natural rate of outputthe production of goodsand services that aneconomy achieves in thelong run when unem-ployment is at its normalrate

workers, the quantity of goods and services supplied would increase. As aresult, the long-run aggregate-supply curve would shift to the right. Conversely,if many workers left the economy to go abroad, the long-run aggregate-supplycurve would shift to the left.

The position of the long-run aggregate-supply curve also depends on the natu-ral rate of unemployment, so any change in the natural rate of unemploymentshifts the long-run aggregate-supply curve. For example, if Congress were to raisethe minimum wage substantially, the natural rate of unemployment would rise,and the economy would produce a smaller quantity of goods and services. As aresult, the long-run aggregate-supply curve would shift to the left. Conversely, if areform of the unemployment insurance system were to encourage unemployedworkers to search harder for new jobs, the natural rate of unemployment wouldfall, and the long-run aggregate-supply curve would shift to the right.

Shifts Arising from Changes in Capital An increase in the economy’s cap-ital stock increases productivity and, thereby, the quantity of goods and servicessupplied. As a result, the long-run aggregate-supply curve shifts to the right.Conversely, a decrease in the economy’s capital stock decreases productivity andthe quantity of goods and services supplied, shifting the long-run aggregate-supply curve to the left.

Notice that the same logic applies regardless of whether we are discussingphysical capital such as machines and factories or human capital such as collegedegrees. An increase in either type of capital will raise the economy’s ability toproduce goods and services and, thus, shift the long-run aggregate-supply curveto the right.

Shifts Arising from Changes in Natural Resources An economy’s pro-duction depends on its natural resources, including its land, minerals, andweather. A discovery of a new mineral deposit shifts the long-run aggregate-supply curve to the right. A change in weather patterns that makes farmingmore difficult shifts the long-run aggregate-supply curve to the left.

In many countries, important natural resources are imported. A change in theavailability of these resources can also shift the aggregate-supply curve. As wediscuss later in this chapter, events occurring in the world oil market have his-torically been an important source of shifts in aggregate supply for the UnitedStates and other oil-importing nations.

Shifts Arising from Changes in Technological Knowledge Perhaps themost important reason that the economy today produces more than it did a gen-eration ago is that our technological knowledge has advanced. The invention ofthe computer, for instance, has allowed us to produce more goods and servicesfrom any given amounts of labor, capital, and natural resources. As computeruse has spread throughout the economy, it has shifted the long-run aggregate-supply curve to the right.

Although not literally technological, there are many other events that act likechanges in technology. For instance, opening up international trade has effectssimilar to inventing new production processes because it allows a country to spe-cialize in higher-productivity industries, so it also shifts the long-run aggregate-supply curve to the right. Conversely, if the government passed new regulationspreventing firms from using some production methods, perhaps to addressworker safety or environmental concerns, the result would be a leftward shift inthe long-run aggregate-supply curve.



55Long-Run Growth andInflation in the Modelof Aggregate Demandand Aggregate Supply

F I G U R E

Quantity ofOutput

Y1980

AD1980

Y1990

AD1990

Y2000

Aggregate Demand, AD2000

PriceLevel

0

Long-runaggregatesupply,

LRAS1980 LRAS1990 LRAS2000

P1980

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

4. . . . andongoing inflation.

3. . . . leading to growthin output . . .

P1990

P2000

2. . . . and growth in the money supply shifts aggregate demand . . .

As the economy becomes better able to produce goods and services over time,primarily because of technological progress, the long-run aggregate-supply curveshifts to the right. At the same time, as the Fed increases the money supply, theaggregate-demand curve also shifts to the right. In this figure, output grows fromY1980 to Y1990 and then to Y2000, and the price level rises from P1980 to P1990 andthen to P2000. Thus, the model of aggregate demand and aggregate supply offersa new way to describe the classical analysis of growth and inflation.

Summary Because the long-run aggregate-supply curve reflects the classicalmodel of the economy we developed in previous chapters, it provides a newway to describe our earlier analysis. Any policy or event that raised real GDP inprevious chapters can now be described as increasing the quantity of goods andservices supplied and shifting the long-run aggregate-supply curve to the right.Any policy or event that lowered real GDP in previous chapters can now bedescribed as decreasing the quantity of goods and services supplied and shiftingthe long-run aggregate-supply curve to the left.

Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation

Having introduced the economy’s aggregate-demand curve and the long-runaggregate-supply curve, we now have a new way to describe the economy’slong-run trends. Figure 5 illustrates the changes that occur in an economy from

decade to decade. Notice that both curves are shifting. Although there are manyforces that govern the economy in the long run and can in theory cause suchshifts, the two most important in the real world are technology and monetarypolicy. Technological progress enhances an economy’s ability to produce goodsand services, and this increase in output is reflected in the continual shifts of thelong-run aggregate-supply curve to the right. At the same time, because the Fedincreases the money supply over time, the aggregate-demand curve also shifts tothe right. As the figure illustrates, the result is trend growth in output (as shownby increasing Y) and continuing inflation (as shown by increasing P). This is justanother way of representing the classical analysis of growth and inflation weconducted in earlier chapters.

The purpose of developing the model of aggregate demand and aggregatesupply, however, is not to dress our previous long-run conclusions in new cloth-ing. Instead, it is to provide a framework for short-run analysis, as we will see ina moment. As we develop the short-run model, we keep the analysis simple bynot showing the continuing growth and inflation depicted by the shifts in Figure5. But always remember that long-run trends provide the background for short-run fluctuations. Short-run fluctuations in output and the price level should be viewedas deviations from the continuing long-run trends of output growth and inflation.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

The key difference between the economy in the short run and in the long run isthe behavior of aggregate supply. The long-run aggregate-supply curve is verti-cal because, in the long run, the overall level of prices does not affect the econ-omy’s ability to produce goods and services. By contrast, in the short run, theprice level does affect the economy’s output. That is, over a period of a year ortwo, an increase in the overall level of prices in the economy tends to raise thequantity of goods and services supplied, and a decrease in the level of pricestends to reduce the quantity of goods and services supplied. As a result, theshort-run aggregate-supply curve is upward sloping, as shown in Figure 6.

Why do changes in the price level affect output in the short run? Macro-economists have proposed three theories for the upward slope of the short-runaggregate-supply curve. In each theory, a specific market imperfection causesthe supply side of the economy to behave differently in the short run than itdoes in the long run. Although the following theories differ in their details, theyshare a common theme: The quantity of output supplied deviates from its long-run, or“natural,” level when the actual price level in the economy deviates from the price levelthat people expected to prevail. When the price level rises above the level that peo-ple expected, output rises above its natural rate, and when the price level fallsbelow the expected level, output falls below its natural rate.

The Sticky-Wage Theory The first explanation of the upward slope of theshort-run aggregate-supply curve is the sticky-wage theory. Because this theoryis the simplest of the three approaches to aggregate supply, it is the one weemphasize in this book.

According to this theory, the short-run aggregate-supply curve slopes upwardbecause nominal wages are slow to adjust to changing economic conditions. Inother words, wages are “sticky” in the short run. To some extent, the slowadjustment of nominal wages is attributable to long-term contracts betweenworkers and firms that fix nominal wages, sometimes for as long as three years.


In addition, this slow adjustment may be attributable to social norms andnotions of fairness that influence wage setting and that change only slowly overtime.

An example helps explain how sticky nominal wages can result in a short-runaggregate-supply curve that slopes upward. Imagine that a year ago a firmexpected the price level to be 100, and based on this expectation, it signed a con-tract with its workers agreeing to pay them, say, $20 an hour. In fact, the pricelevel, P, turns out to be only 95. Because prices have fallen below expectations,the firm gets 5 percent less than expected for each unit of its product that it sells.The cost of labor used to make the output, however, is stuck at $20 per hour.Production is now less profitable, so the firm hires fewer workers and reducesthe quantity of output supplied. Over time, the labor contract will expire, andthe firm can renegotiate with its workers for a lower wage (which they mayaccept because prices are lower), but in the meantime, employment and produc-tion will remain below their long-run levels.

The same logic works in reverse. Suppose the price level turns out to be 105,and the wage remains stuck at $20. The firm sees that the amount it is paid foreach unit sold is up by 5 percent, while its labor costs are not. In response, ithires more workers and increases the quantity supplied. Eventually, the workerswill demand higher nominal wages to compensate for the higher price level, butfor a while, the firm can take advantage of the profit opportunity by increasingemployment and the quantity of output supplied above their long-run levels.

In short, according to the sticky-wage theory, the short-run aggregate-supplycurve is upward sloping because nominal wages are based on the expectedprices and do not respond immediately when the actual price level turns out tobe different from what was expected. This stickiness of wages gives firms anincentive to produce less than the natural rate of output when the price levelturns out lower than expected and to produce more when the price level turnsout higher than expected.


66The Short-Run Aggregate-Supply CurveIn the short run, a fall in theprice level from P1 to P2reduces the quantity of out-put supplied from Y1 to Y2.This positive relationshipcould be due to sticky wages,sticky prices, or mispercep-tions. Over time, wages,prices, and perceptions ad-just, so this positive relation-ship is only temporary.

F I G U R E

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Y2 Y1

1. A decreasein the pricelevel . . .

2. . . . reduces the quantityof goods and servicessupplied in the short run.

P1

P2

The Sticky-Price Theory Some economists have advocated another approachto explaining the upward slope of the short-run aggregate-supply curve, calledthe sticky-price theory. As we just discussed, the sticky-wage theory emphasizesthat nominal wages adjust slowly over time. The sticky-price theory emphasizesthat the prices of some goods and services also adjust sluggishly in response tochanging economic conditions. This slow adjustment of prices occurs in partbecause there are costs to adjusting prices, called menu costs. These menu costsinclude the cost of printing and distributing catalogs and the time required tochange price tags. As a result of these costs, prices as well as wages may besticky in the short run.

To see how sticky prices explain the aggregate-supply curve’s upward slope,suppose that each firm in the economy announces its prices in advance based onthe economic conditions it expects to prevail over the coming year. Suppose fur-ther that after prices are announced, the economy experiences an unexpectedcontraction in the money supply, which (as we have learned) will reduce theoverall price level in the long run. Although some firms can reduce their pricesimmediately in response to an unexpected change in economic conditions, otherfirms may not want to incur additional menu costs. As a result, they may tem-porarily lag behind in reducing their prices. Because these lagging firms haveprices that are too high, their sales decline. Declining sales, in turn, cause thesefirms to cut back on production and employment. In other words, because notall prices adjust instantly to changing economic conditions, an unexpected fall inthe price level leaves some firms with higher-than-desired prices, and thesehigher-than-desired prices depress sales and induce firms to reduce the quantityof goods and services they produce.

The same reasoning applies when the money supply and price level turn outto be above what firms expected when they originally set their prices. Whilesome firms raise their prices immediately in response to the new economic envi-ronment, other firms lag behind, keeping their prices at the lower-than-desiredlevels. These low prices attract customers, which induces these firms to increaseemployment and production. Thus, during the time these lagging firms areoperating with outdated prices, there is a positive association between the over-all price level and the quantity of output. This positive association is representedby the upward slope of the short-run aggregate-supply curve.

The Misperceptions Theory A third approach to explaining the upwardslope of the short-run aggregate-supply curve is the misperceptions theory.According to this theory, changes in the overall price level can temporarily mis-lead suppliers about what is happening in the individual markets in which theysell their output. As a result of these short-run misperceptions, suppliersrespond to changes in the level of prices, and this response leads to an upward-sloping aggregate-supply curve.

To see how this might work, suppose the overall price level falls below thelevel that suppliers expected. When suppliers see the prices of their productsfall, they may mistakenly believe that their relative prices have fallen; that is,they may believe that their prices have fallen compared to other prices in theeconomy. For example, wheat farmers may notice a fall in the price of wheatbefore they notice a fall in the prices of the many items they buy as consumers.They may infer from this observation that the reward to producing wheat istemporarily low, and they may respond by reducing the quantity of wheat theysupply. Similarly, workers may notice a fall in their nominal wages before theynotice that the prices of the goods they buy are also falling. They may infer that


the reward for working is temporarily low and respond by reducing the quan-tity of labor they supply. In both cases, a lower price level causes mispercep-tions about relative prices, and these misperceptions induce suppliers torespond to the lower price level by decreasing the quantity of goods and ser-vices supplied.

Similar misperceptions arise when the price level is above what was expected.Suppliers of goods and services may notice the price of their output rising andinfer, mistakenly, that their relative prices are rising. They would conclude that itis a good time to produce. Until their misperceptions are corrected, they respondto the higher price level by increasing the quantity of goods and services sup-plied. This behavior results in a short-run aggregate-supply curve that slopesupward.

Summary There are three alternative explanations for the upward slope of theshort-run aggregate-supply curve: (1) sticky wages, (2) sticky prices, and (3) mis-perceptions about relative prices. Economists debate which of these theories iscorrect, and it is very possible each contains an element of truth. For our pur-poses in this book, the similarities of the theories are more important than thedifferences. All three theories suggest that output deviates in the short run fromits long-run level (the natural rate) when the actual price level deviates from theprice level that people had expected to prevail. We can express this mathemati-cally as follows:

Quantity Natural Actual Expectedof output � rate of � a price � pricesupplied output level level

where a is a number that determines how much output responds to unexpectedchanges in the price level.

Notice that each of the three theories of short-run aggregate supply empha-sizes a problem that is likely to be temporary. Whether the upward slope of theaggregate-supply curve is attributable to sticky wages, sticky prices, or misper-ceptions, these conditions will not persist forever. Over time, nominal wages willbecome unstuck, prices will become unstuck, and misperceptions about relativeprices will be corrected. In the long run, it is reasonable to assume that wagesand prices are flexible rather than sticky and that people are not confused aboutrelative prices. Thus, while we have several good theories to explain why theshort-run aggregate-supply curve is upward sloping, they are all consistent witha long-run aggregate-supply curve that is vertical.

Why the Short-Run Aggregate-Supply Curve Might Shift

The short-run aggregate-supply curve tells us the quantity of goods and servicessupplied in the short run for any given level of prices. This curve is similar tothe long-run aggregate-supply curve, but it is upward sloping rather than verti-cal because of sticky wages, sticky prices, and misperceptions. Thus, whenthinking about what shifts the short-run aggregate-supply curve, we have toconsider all those variables that shift the long-run aggregate-supply curve plus anew variable—the expected price level—that influences the wages that are stuck,the prices that are stuck, and the perceptions about relative prices.


q r

Let’s start with what we know about the long-run aggregate-supply curve. Aswe discussed earlier, shifts in the long-run aggregate-supply curve normallyarise from changes in labor, capital, natural resources, or technological knowl-edge. These same variables shift the short-run aggregate-supply curve. Forexample, when an increase in the economy’s capital stock increases productivity,the economy is able to produce more output, so both the long-run and short-runaggregate-supply curves shift to the right. When an increase in the minimumwage raises the natural rate of unemployment, the economy has fewer employedworkers and thus produces less output, so both the long-run and short-runaggregate-supply curves shift to the left.

The important new variable that affects the position of the short-run aggregate-supply curve is the price level that people expected to prevail. As we have dis-cussed, the quantity of goods and services supplied depends, in the short run, onsticky wages, sticky prices, and misperceptions. Yet wages, prices, and perceptionsare set on the basis of the expected price level. So when people change their expec-tations of the price level, the short-run aggregate-supply curve shifts.

To make this idea more concrete, let’s consider a specific theory of aggregatesupply—the sticky-wage theory. According to this theory, when workers and firmsexpect the price level to be high, they are more likely to reach a bargain with ahigh level of nominal wages. High wages raise firms’ costs, and for any givenactual price level, higher costs reduce the quantity of goods and services that firmssupply. Thus, when the expected price level rises, wages are higher, costs increase,and firms supply a smaller quantity of goods and services at any given actualprice level. Thus, the short-run aggregate-supply curve shifts to the left. Con-versely, when the expected price level falls, wages are lower, costs decline, firmsincrease output at any given price level, and the short-run aggregate-supply curveshifts to the right.

A similar logic applies in each theory of aggregate supply. The general lessonis the following: An increase in the expected price level reduces the quantity of goodsand services supplied and shifts the short-run aggregate-supply curve to the left. Adecrease in the expected price level raises the quantity of goods and services supplied andshifts the short-run aggregate-supply curve to the right. As we will see in the nextsection, this influence of expectations on the position of the short-run aggregate-supply curve plays a key role in explaining how the economy makes the transi-tion from the short run to the long run. In the short run, expectations are fixed,and the economy finds itself at the intersection of the aggregate-demand curveand the short-run aggregate-supply curve. In the long run, if people observe thatthe price level is different from what they expected, their expectations adjust,and the short-run aggregate-supply curve shifts. This shift ensures that the econ-omy eventually finds itself at the intersection of the aggregate-demand curveand the long-run aggregate-supply curve.

You should now have some understanding about why the short-run aggregate-supply curve slopes upward and what events and policies can cause this curve toshift. Table 2 summarizes our discussion.

Explain why the long-run aggregate-supply curve is vertical. •Explain three theories for why the short-run aggregate-supply curve is upward slop-ing. • What variables shift both the long-run and short-run aggregate-supplycurves? • What variable shifts the short-run aggregate-supply curve but not thelong-run aggregate-supply curve?



22The Short-RunAggregate-SupplyCurve: Summary

T A B L E Why Does the Short-Run Aggregate-Supply Curve Slope Upward?1. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, which

causes firms to hire fewer workers and produce a smaller quantity of goods and services.2. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher-

than-desired prices, which depresses their sales and leads them to cut back production.3. The Misperceptions Theory: An unexpectedly low price level leads some suppliers to think

their relative prices have fallen, which induces a fall in production.

Why Might the Short-Run Aggregate-Supply Curve Shift?1. Shifts Arising from Labor: An increase in the quantity of labor available (perhaps due to a

fall in the natural rate of unemployment) shifts the aggregate-supply curve to the right. Adecrease in the quantity of labor available (perhaps due to a rise in the natural rate ofunemployment) shifts the aggregate-supply curve to the left.

2. Shifts Arising from Capital: An increase in physical or human capital shifts the aggregate-supply curve to the right. A decrease in physical or human capital shifts the aggregate-supply curve to the left.

3. Shifts Arising from Natural Resources: An increase in the availability of natural resourcesshifts the aggregate-supply curve to the right. A decrease in the availability of naturalresources shifts the aggregate-supply curve to the left.

4. Shifts Arising from Technology: An advance in technological knowledge shifts theaggregate-supply curve to the right. A decrease in the available technology (perhaps due to government regulation) shifts the aggregate-supply curve to the left.

5. Shifts Arising from the Expected Price Level: A decrease in the expected price level shiftsthe short-run aggregate-supply curve to the right. An increase in the expected price levelshifts the short-run aggregate-supply curve to the left.

TWO CAUSES OF ECONOMIC FLUCTUATIONSNow that we have introduced the model of aggregate demand and aggregatesupply, we have the basic tools we need to analyze fluctuations in economicactivity. In particular, we can use what we have learned about aggregatedemand and aggregate supply to examine the two basic causes of short-run fluc-tuations: shifts in aggregate demand and shifts in aggregate supply.

To keep things simple, we assume the economy begins in long-run equilib-rium, as shown in Figure 7. Output and the price level are determined in thelong run by the intersection of the aggregate-demand curve and the long-runaggregate-supply curve, shown as point A in the figure. At this point, output isat its natural rate. Because the economy is always in a short-run equilibrium, theshort-run aggregate-supply curve passes through this point as well, indicatingthat the expected price level has adjusted to this long-run equilibrium. That is,when an economy is in its long-run equilibrium, the expected price level mustequal the actual price level so that the intersection of aggregate demand withshort-run aggregate supply is the same as the intersection of aggregate demandwith long-run aggregate supply.

The Effects of a Shift in Aggregate Demand

Suppose that a wave of pessimism suddenly overtakes the economy. The causemight be a scandal in the White House, a crash in the stock market, or the out-break of war overseas. Because of this event, many people lose confidence in thefuture and alter their plans. Households cut back on their spending and delaymajor purchases, and firms put off buying new equipment.

What is the macroeconomic impact of such a wave of pessimism? In answer-ing this question, we can follow the three steps we used in Chapter 4 when ana-lyzing supply and demand in specific markets. First, we determine whether theevent affects aggregate demand or aggregate supply. Second, we decide whichdirection the curve shifts. Third, we use the diagram of aggregate demand andaggregate supply to compare the initial and the new equilibrium. The new wrin-kle is that we need to add a fourth step: We have to keep track of a new short-run equilibrium, a new long-run equilibrium, and the transition between them.Table 3 summarizes the four steps to analyzing economic fluctuations.

The first two steps are easy. First, because the wave of pessimism affects spend-ing plans, it affects the aggregate-demand curve. Second, because households and


77F I G U R E

The Long-Run EquilibriumThe long-run equilibrium of theeconomy is found where theaggregate-demand curve crossesthe long-run aggregate-supplycurve (point A). When the econ-omy reaches this long-run equi-librium, the expected price levelwill have adjusted to equal theactual price level. As a result, theshort-run aggregate-supply curvecrosses this point as well.


Quantity ofOutput

PriceLevel

0

Equilibriumprice

Short-runaggregate

supply

Long-runaggregate

supply

Aggregatedemand

A

33T A B L E

Four Steps for AnalyzingMacroeconomic Fluctuations

1. Decide whether the event shifts the aggregate demand curve or the aggregatesupply curve (or perhaps both).

2. Decide in which direction the curve shifts.3. Use the diagram of aggregate demand and aggregate supply to see how the

shift changes output and the price level in the short run.4. Use the diagram of aggregate demand and aggregate supply to analyze how the

economy moves from its new short-run equilibrium to its long-run equilibrium.


88A Contraction in AggregateDemandA fall in aggregate demand is rep-resented with a leftward shift inthe aggregate-demand curve fromAD1 to AD2. In the short run, theeconomy moves from point A topoint B. Output falls from Y1 to Y2,and the price level falls from P1 toP2. Over time, as the expectedprice level adjusts, the short-runaggregate-supply curve shifts tothe right from AS1 to AS2, and theeconomy reaches point C, wherethe new aggregate-demand curvecrosses the long-run aggregate-supply curve. In the long run, theprice level falls to P3, and outputreturns to its natural rate, Y1.

F I G U R E

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS1

Long-runaggregate

supply

Aggregatedemand, AD1

A

B

C

P1

P2

P3

Y1Y2

AD2

AS2

1. A decrease inaggregate demand . . .

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

3. . . . but over time, the short-runaggregate-supplycurve shifts . . .

4. . . . and output returnsto its natural rate.

firms now want to buy a smaller quantity of goods and services for any givenprice level, the event reduces aggregate demand. As Figure 8 shows, the aggre-gate-demand curve shifts to the left from AD1 to AD2.

With this figure, we can perform step three: By comparing the initial and newequilibrium, we can see the effects of the fall in aggregate demand. In the shortrun, the economy moves along the initial short-run aggregate-supply curve, AS1,going from point A to point B. As the economy moves between these two points,output falls from Y1 to Y2, and the price level falls from P1 to P2. The falling levelof output indicates that the economy is in a recession. Although not shown inthe figure, firms respond to lower sales and production by reducing employ-ment. Thus, the pessimism that caused the shift in aggregate demand is, to someextent, self-fulfilling: Pessimism about the future leads to falling incomes andrising unemployment.

Now comes step four—the transition from the short-run equilibrium to thelong-run equilibrium. Because of the reduction in aggregate demand, the pricelevel initially falls from P1 to P2. The price level is thus below the level that peo-ple had come to expect (P1) before the sudden fall in aggregate demand.Although people are surprised in the short run, they will not remain surprised.Over time, expectations catch up with this new reality, and the expected pricelevel falls as well. The fall in the expected price level alters wages, prices, andperceptions, which in turn influences the position of the short-run aggregate-supply curve. For example, according to the sticky-wage theory, once workersand firms come to expect a lower level of prices, they start to strike bargains forlower nominal wages; the reduction in labor costs encourages firms to hire moreworkers and expands production at any given level of prices. Thus, the fall inthe expected price level shifts the short-run aggregate-supply curve to the right

from AS1 to AS2 in Figure 8. This shift allows the economy to approach point C,where the new aggregate-demand curve (AD2) crosses the long-run aggregate-supply curve.

In the new long-run equilibrium, point C, output is back to its natural rate.The economy has corrected itself: The decline in output is reversed in the longrun, even without action by policymakers. Although the wave of pessimism hasreduced aggregate demand, the price level has fallen sufficiently (to P3) to offsetthe shift in the aggregate-demand curve, and people have come to expect thisnew lower price level as well. Thus, in the long run, the shift in aggregatedemand is reflected fully in the price level and not at all in the level of output. Inother words, the long-run effect of a shift in aggregate demand is a nominalchange (the price level is lower) but not a real change (output is the same).

What should policymakers do when faced with a sudden fall in aggregatedemand? In this analysis, we assumed they did nothing. Another possibility isthat, as soon as the economy heads into recession (moving from point A to pointB), policymakers could take action to increase aggregate demand. As we notedearlier, an increase in government spending or an increase in the money supplywould increase the quantity of goods and services demanded at any price and,therefore, would shift the aggregate-demand curve to the right. If policymakersact with sufficient speed and precision, they can offset the initial shift in aggre-gate demand, return the aggregate-demand curve back to AD1, and bring theeconomy back to point A. If the policy is successful, the painful period ofdepressed output and employment can be reduced in length and severity. The


FYIMonetary Neutrality Revisited

According to clas-sical economictheory, money is

neutral. That is, changes in the quantity of money affect nominalvariables such as the price level but not real variables such asoutput. Earlier in this chapter, we noted that most economistsaccept this conclusion as a description of how the economyworks in the long run but not in the short run. With the modelof aggregate demand and aggregate supply, we can illustratethis conclusion and explain it more fully.

Suppose that the Federal Reserve reduces the quantity ofmoney in the economy. What effect does this change have? Aswe discussed, the money supply is one determinant of aggre-gate demand. The reduction in the money supply shifts theaggregate-demand curve to the left.

The analysis looks just like Figure 8. Even though the causeof the shift in aggregate demand is different, we would observe

the same effects on output and the price level. In the short run,both output and the price level fall. The economy experiences arecession. But over time, the expected price level falls as well.Firms and workers respond to their new expectations by, forinstance, agreeing to lower nominal wages. As they do so, theshort-run aggregate-supply curve shifts to the right. Eventually,the economy finds itself back on the long-run aggregate-supplycurve.

Figure 8 shows when money matters for real variables andwhen it does not. In the long run, money is neutral, as repre-sented by the movement of the economy from point A to pointC. But in the short run, a change in the money supply has realeffects, as represented by the movement of the economy frompoint A to point B. An old saying summarizes the analysis:“Money is a veil, but when the veil flutters, real output sputters.”

next chapter discusses in more detail the ways in which monetary and fiscal pol-icy influence aggregate demand, as well as some of the practical difficulties inusing these policy instruments.

To sum up, this story about shifts in aggregate demand has three importantlessons:

• In the short run, shifts in aggregate demand cause fluctuations in the econ-omy’s output of goods and services.

• In the long run, shifts in aggregate demand affect the overall price level butdo not affect output.

• Policymakers who influence aggregate demand can potentially mitigate theseverity of economic fluctuations.

TWO BIG SHIFTS IN AGGREGATE DEMAND: THE GREAT DEPRESSION AND WORLD WAR II

At the beginning of this chapter, we established three key facts about economicfluctuations by looking at data since 1965. Let’s now take a longer look at U.S.economic history. Figure 9 shows data since 1900 on the percentage change inreal GDP over the previous 3 years. In an average 3-year period, real GDP growsabout 10 percent—a bit more than 3 percent per year. The business cycle, how-ever, causes fluctuations around this average. Two episodes jump out as beingparticularly significant: the large drop in real GDP in the early 1930s and thelarge increase in real GDP in the early 1940s. Both of these events are attributa-ble to shifts in aggregate demand.


C A S ESTUDY

99U.S. Real GDPGrowth since 1900

Source: U.S. Department ofCommerce.

F I G U R E

Percent Change in Real GDP from

3 Years Earlier

1900 1910 1920 1930 1940 1950 19901960 2000 20101970 1980

8070605040302010

0�10�20�30

The Great Depression

The World War IIBoom

Real GDPGrowth

AverageGrowth

Over the course of U.S. economic history, two fluctuations stand out as espe-cially large. During the early 1930s, the economy went through the GreatDepression, when the production of goods and services plummeted. Duringthe early 1940s, the United States entered World War II, and the economyexperienced rapidly rising production. Both of these events are usuallyexplained by large shifts in aggregate demand.

The economic calamity of the early 1930s is called the Great Depression, and itis by far the largest economic downturn in U.S. history. Real GDP fell by 27 per-cent from 1929 to 1933, and unemployment rose from 3 percent to 25 percent. Atthe same time, the price level fell by 22 percent over these 4 years. Many othercountries experienced similar declines in output and prices during this period.

Economic historians continue to debate the causes of the Great Depression,but most explanations center on a large decline in aggregate demand. Whatcaused aggregate demand to contract? Here is where the disagreement arises.

Many economists place primary blame on the decline in the money supply:From 1929 to 1933, the money supply fell by 28 percent. As you may recall fromour discussion of the monetary system, this decline in the money supply was dueto problems in the banking system. As households withdrew their money fromfinancially shaky banks and bankers became more cautious and started holdinggreater reserves, the process of money creation under fractional-reserve bankingwent into reverse. The Fed, meanwhile, failed to offset this fall in the money mul-tiplier with expansionary open-market operations. As a result, the money supplydeclined. Many economists blame the Fed’s failure to act for the Great Depres-sion’s severity.

Other economists have suggested alternative reasons for the collapse inaggregate demand. For example, stock prices fell about 90 percent during thisperiod, depressing household wealth and thereby consumer spending. In addi-tion, the banking problems may have prevented some firms from obtaining thefinancing they wanted for investment projects, and this would have depressedinvestment spending. Of course, all of these forces may have acted together tocontract aggregate demand during the Great Depression.

The second significant episode in Figure 9—the economic boom of the early1940s—is easier to explain. The obvious cause of this event was World War II. Asthe United States entered the war overseas, the federal government had todevote more resources to the military. Government purchases of goods and ser-vices increased almost fivefold from 1939 to 1944. This huge expansion in aggre-gate demand almost doubled the economy’s production of goods and servicesand led to a 20 percent increase in the price level (although widespread govern-ment price controls limited the rise in prices). Unemployment fell from 17 per-cent in 1939 to about 1 percent in 1944—the lowest level in U.S. history. •

THE RECESSION OF 2001

After the longest economic expansion in history, the U.S. economy experienced arecession in 2001. The unemployment rate rose from 3.9 percent in December2000 to 4.9 percent in August 2001 and to 6.3 percent in June 2003. The unem-ployment rate then began to decline. By January 2005, unemployment had fallenback to 5.2 percent.

What caused the recession, and what ended it? The answer to both questionsis shifts in aggregate demand.

The recession began with the end of the dot-com bubble in the stock market.During the 1990s, many stock-market investors became optimistic about infor-mation technology, and they bid up stock prices, particularly of high-tech com-panies. With hindsight, it is fair to say that this optimism was excessive. Eventu-ally, the optimism faded, and stock prices fell by about 25 percent from August2000 to August 2001. The fall in the stock market reduced household wealth,


THE OUTCOME OF A MASSIVE

DECREASE IN AGGREGATE

DEMAND

©B

ET

TM

AN

N/C

OR

BIS

C A S ESTUDY

which in turn reduced consumer spending. In addition, when the new technolo-gies started to appear less profitable than they had originally seemed, invest-ment spending fell. The aggregate-demand curve shifted to the left.

The second shock to the economy was the terrorist attacks on New York andWashington on September 11, 2001. In the week after the attacks, the stock mar-ket fell another 12 percent, its biggest weekly loss since the Great Depression ofthe 1930s. Moreover, the attacks increased uncertainty about what the futurewould hold. Uncertainty can reduce spending, as households and firms post-pone plans, waiting for the uncertainty to be resolved. Thus, the terrorist attacksalso shifted the aggregate-demand curve further to the left.

The third event that put downward pressure on aggregate demand was aseries of corporate accounting scandals. During 2001 and 2002, several majorcorporations, including Enron and WorldCom, were found to have misled thepublic about their profitability. When the truth became known, the value of theirstock plummeted. Even honest companies experienced stock declines, as stock-market investors became less trustful of all accounting data. This fall in the stockmarket further depressed aggregate demand.


FYIThe Origins of Aggregate Demand and Aggregate Supply

Now that wehave a prelimi-

nary understanding of the model of aggregate demand andaggregate supply, it is worthwhile to step back from itand consider its history. How did this model of short-run fluctuations develop? The answer is that thismodel, to a large extent, is a by-product of the GreatDepression of the 1930s. Economists and policymak-ers at the time were puzzled about what had causedthis calamity and were uncertain about how to dealwith it.

In 1936, economist John Maynard Keynes pub-lished a book titled The General Theory of Employ-ment, Interest, and Money, which attempted toexplain short-run economic fluctuations in generaland the Great Depression in particular. Keynes’s pri-mary message was that recessions and depressionscan occur because of inadequate aggregate demand for goodsand services.

Keynes had long been a critic of classical economic theory—the theory we examined earlier in the book—because it could

explain only the long-run effects of policies. A few years beforeoffering The General Theory, Keynes had written the followingabout classical economics:

The long run is a misleading guide tocurrent affairs. In the long run we areall dead. Economists set themselvestoo easy, too useless a task if in tem-pestuous seasons they can only tell uswhen the storm is long past, the oceanwill be flat.

Keynes’s message was aimed at policymakersas well as economists. As the world’seconomies suffered with high unemploy-ment, Keynes advocated policies to increaseaggregate demand, including governmentspending on public works.

In the next chapter, we examine in detail how policymakerscan use the tools of monetary and fiscal policy to influenceaggregate demand. The analysis in the next chapter, as well asin this one, owes much to the legacy of John Maynard Keynes.

John Maynard Keynes

PH

OTO

:©B

ET

TM

AN

N/C

OR

BIS

Policymakers were quick to respond to these events. As soon as the economicslowdown became apparent, the Federal Reserve pursued expansionary mone-tary policy. Money growth accelerated, and interest rates fell. The federal fundsrate (the interest rate on loans between banks that the Fed uses as its short-termpolicy target) fell from 6.5 percent in December 2000 to 1.0 percent in June 2003.Lower interest rates stimulated spending by reducing the cost of borrowing. Atthe same time, with the president’s urging, Congress passed a tax cut in 2001,including an immediate tax rebate, and another tax cut in 2003. One goal ofthese tax cuts was to stimulate consumer and investment spending. Interest-ratecuts and tax cuts both shifted the aggregate-demand curve to the right, offset-ting the three contractionary shocks the economy had experienced.

The recession of 2001 is a reminder of the many kinds of events that can influ-ence aggregate demand and, thus, the direction of the economy. •

The Effects of a Shift in Aggregate Supply

Imagine once again an economy in its long-run equilibrium. Now suppose thatsuddenly some firms experience an increase in their costs of production. Forexample, bad weather in farm states might destroy some crops, driving up thecost of producing food products. Or a war in the Middle East might interruptthe shipping of crude oil, driving up the cost of producing oil products.

To analyze the macroeconomic impact of such an increase in production costs,we follow the same four steps. First, which curve is affected? Because produc-tion costs affect the firms that supply goods and services, changes in productioncosts alter the position of the aggregate-supply curve. Second, which directiondoes the curve shift? Because higher production costs make selling goods andservices less profitable, firms now supply a smaller quantity of output for anygiven price level. Thus, as Figure 10 shows, the short-run aggregate-supplycurve shifts to the left from AS1 to AS2. (Depending on the event, the long-runaggregate-supply curve might also shift. To keep things simple, however, wewill assume that it does not.)

The figure allows us to perform step three of comparing the initial and newequilibrium. In the short run, the economy goes from point A to point B, movingalong the existing aggregate-demand curve. The output of the economy fallsfrom Y1 to Y2, and the price level rises from P1 to P2. Because the economy isexperiencing both stagnation (falling output) and inflation (rising prices), such anevent is sometimes called stagflation.

Now consider step four—the transition from the short-run equilibrium to thelong-run equilibrium. According to the sticky-wage theory, the key issue is howstagflation affects nominal wages. Firms and workers may at first respond tothe higher level of prices by raising their expectations of the price level and set-ting higher nominal wages. In this case, firms’ costs will rise yet again, and theshort-run aggregate-supply curve will shift further to the left, making the prob-lem of stagflation even worse. This phenomenon of higher prices leading tohigher wages, in turn leading to even higher prices, is sometimes called a wage-price spiral.

At some point, this spiral of ever-rising wages and prices will slow. The lowlevel of output and employment will put downward pressure on workers’ wagesbecause workers have less bargaining power when unemployment is high. Asnominal wages fall, producing goods and services becomes more profitable, and


stagflationa period of falling out-put and rising prices

the short-run aggregate-supply curve shifts to the right. As it shifts back towardAS1, the price level falls, and the quantity of output approaches its natural rate. Inthe long run, the economy returns to point A, where the aggregate-demand curvecrosses the long-run aggregate-supply curve.

This transition back to the initial equilibrium assumes, however, that aggre-gate demand is held constant throughout the process. In the real world, thatmay not be the case. Policymakers who control monetary and fiscal policy mightattempt to offset some of the effects of the shift in the short-run aggregate-supply curve by shifting the aggregate-demand curve. This possibility is shownin Figure 11. In this case, changes in policy shift the aggregate-demand curve tothe right from AD1 to AD2—exactly enough to prevent the shift in aggregatesupply from affecting output. The economy moves directly from point A to pointC. Output remains at its natural rate, and the price level rises from P1 to P3. Inthis case, policymakers are said to accommodate the shift in aggregate supply. Anaccommodative policy accepts a permanently higher level of prices to maintain ahigher level of output and employment.

To sum up, this story about shifts in aggregate supply has two importantlessons:

• Shifts in aggregate supply can cause stagflation—a combination of recession(falling output) and inflation (rising prices).

• Policymakers who can influence aggregate demand can potentially mitigatethe adverse impact on output but only at the cost of exacerbating the problemof inflation.


1010An Adverse Shift inAggregate SupplyWhen some event increasesfirms’ costs, the short-runaggregate-supply curve shiftsto the left from AS1 to AS2.The economy moves frompoint A to point B. The resultis stagflation: Output fallsfrom Y1 to Y2, and the pricelevel rises from P1 to P2.

F I G U R E

Quantity ofOutput

PriceLevel

0

Aggregate demand

A

B

Y1Y2

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

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

1. An adverse shift in the short-run aggregate-supply curve . . .

Short-runaggregate

supply, AS1

Long-runaggregate

supply

P2

P1

AS2

OIL AND THE ECONOMY

Some of the largest economic fluctuations in the U.S. economy since 1970 haveoriginated in the oil fields of the Middle East. Crude oil is a key input into theproduction of many goods and services, and much of the world’s oil comes fromSaudi Arabia, Kuwait, and other Middle Eastern countries. When some event(usually political in origin) reduces the supply of crude oil flowing from thisregion, the price of oil rises around the world. U.S. firms that make gasoline,tires, and many other products experience rising costs, and they find it less prof-itable to supply their output of goods and services at any given price level. Theresult is a leftward shift in the aggregate-supply curve, which in turn leads tostagflation.

The first episode of this sort occurred in the mid-1970s. The countries withlarge oil reserves got together as members of OPEC, the Organization of Petro-leum Exporting Countries. OPEC is a cartel—a group of sellers that attempts tothwart competition and reduce production to raise prices. And indeed, oil pricesrose substantially. From 1973 to 1975, oil approximately doubled in price. Oil-importing countries around the world experienced simultaneous inflation andrecession. The U.S. inflation rate as measured by the CPI exceeded 10 percent forthe first time in decades. Unemployment rose from 4.9 percent in 1973 to 8.5 per-cent in 1975.

Almost the same thing happened a few years later. In the late 1970s, theOPEC countries again restricted the supply of oil to raise the price. From 1978 to1981, the price of oil more than doubled. Once again, the result was stagflation.


1111F I G U R E

Accommodating anAdverse Shift inAggregate SupplyFaced with an adverse shiftin aggregate supply fromAS1 to AS2, policymakerswho can influence aggregatedemand might try to shiftthe aggregate-demandcurve to the right from AD1to AD2. The economy wouldmove from point A to pointC. This policy would preventthe supply shift from reduc-ing output in the short run,but the price level wouldpermanently rise from P1to P3.

Quantity ofOutput


PriceLevel

0

Short-runaggregate

supply, AS1

Long-runaggregate

supply

Aggregate demand, AD1

A

C

P2

P3

P1

AS2

3. . . . whichcauses theprice level to rise further . . .

4. . . . but keeps outputat its natural rate.

2. . . . policymakers canaccommodate the shiftby expanding aggregatedemand . . .

1. When short-run aggregatesupply falls . . .

AD2

C A S ESTUDY

Inflation, which had subsided somewhat after the first OPEC event, again roseabove 10 percent per year. But because the Fed was not willing to accommodatesuch a large rise in inflation, a recession was soon to follow. Unemployment rosefrom about 6 percent in 1978 and 1979 to about 10 percent a few years later.

The world market for oil can also be a source of favorable shifts in aggregatesupply. In 1986, squabbling broke out among members of OPEC. Member coun-tries reneged on their agreements to restrict oil production. In the world marketfor crude oil, prices fell by about half. This fall in oil prices reduced costs to U.S.firms, which now found it more profitable to supply goods and services at any


FYIThe Macroeconomic Impact of Hurricane Katrina

In August 2005,as this book was

going to press, the Gulf Coast of the United States was hit byHurricane Katrina, devastating New Orleans and the surround-ing area. While the human toll was the primary focus of policy-makers’ attentions, economists in and out of government imme-diately started analyzing the economic impact. Here are someexcerpts from the analysis of the Congressional Budget Office(CBO), prepared just a few days after the disaster:

Katrina could dampen real gross domestic product (GDP)growth in the second half of the year by 1/2 to 1 percent-age point and reduce employment through the end of thisyear by about 400,000. Most economic forecasters hadexpected 3 percent to 4 percent growth during the sec-ond half, and employment growth of 150,000 to 200,000per month. Economic growth and employment are likelyto rebound during the first half of 2006 as rebuildingaccelerates. . . .

Katrina’s macroeconomic effects will be greater thanthose of previous major hurricanes such as Andrew andHugo, which caused a great deal of devastation butwhich had a small effect on the macroeconomy. Katrina’seffects will be greater because of the greater devasta-tion, the long-term flooding of New Orleans (which willpreclude immediate rebuilding), and the destruction ofenergy and port infrastructure. . . .

The gross state product of Louisiana is about 1.2 per-cent of U.S. GDP, and that for Mississippi is about 0.7 per-cent. If half of that product were lost for three months

(September to November), the level of real GDP would belowered by about 1 percent from what it otherwise wouldbe. . . . It is unlikely that production would be hurt thatmuch for that long, however. Presumably some people inNew Orleans and other parts of the coast will be able toreturn to work in one or two months, and constructionemployment will be picking up during the fourth quarter. . . .

Economic activity in the rest of the United States willbe adversely affected through higher energy prices,which will temporarily reduce other consumption. . . .[This fall in consumption occurs because] the increase ingasoline prices is basically a temporary redistribution ofincome from consumers of gasoline to the stockholdersof refiners. . . . If sustained, that would reduce annualizedGDP growth for the third quarter by 0.4 percent and forthe fourth quarter by 0.9 percent. That effect is tempo-rary: as gasoline prices return to pre-Katrina levels, con-sumption would bounce back, meaning higher GDPgrowth.

In other words, the hurricane was expected to reduce aggre-gate supply by making unavailable some of the productivecapacity of the Gulf area. In addition, it was expected to reduceaggregate demand because consumers might respond to highergasoline prices by cutting back their overall level of spending.The predicted decline in GDP growth from these two shifts wassignificant, but according to CBO, it was not large enough topush the economy into recession.

As you read this book, you should know if this analysisproved correct.

given price level. As a result, the aggregate-supply curve shifted to the right.The U.S. economy experienced the opposite of stagflation: Output grew rapidly,unemployment fell, and the inflation rate reached its lowest level in many years.

In recent years, the world market for oil has not been as important a source ofeconomic fluctuations. Part of the reason is that OPEC has been less effective asa cartel: Adjusted for inflation, the price of oil has never again reached therecord levels set in the early 1980s. In addition, conservation efforts and changesin technology have reduced the economy’s dependence on oil. The amount of oilused to produce a unit of real GDP has declined about 40 percent since theOPEC shocks of the 1970s. As a result, the economic impact of any change in oilprices is smaller today than it was in the past.

Nonetheless, it would be premature to conclude that the United States nolonger needs to worry about oil prices. Political troubles in the Middle East orgreater cooperation among the members of OPEC could always send oil priceshigher. And indeed, during the Iraq war, the price of crude oil did rise signifi-cantly. If the rise in oil prices were ever large enough, the macroeconomic resultwould most likely resemble the stagflation of the 1970s. •

Suppose that the election of a popular presidential candidate sud-denly increases people’s confidence in the future. Use the model of aggregate demandand aggregate supply to analyze the effect on the economy.


CHANGES IN MIDDLE EAST

OIL PRODUCTION ARE ONE

SOURCE OF U.S. ECONOMIC

FLUCTUATIONS.

©LA

NG

EV

IN J

AC

QU

ES

/CO

RB

IS S

YG

MA

CONCLUSIONThis chapter has achieved two goals. First, we have discussed some of theimportant facts about short-run fluctuations in economic activity. Second, wehave introduced a basic model to explain those fluctuations, called the model ofaggregate demand and aggregate supply. We continue our study of this modelin the next chapter to understand more fully what causes fluctuations in theeconomy and how policymakers might respond to these fluctuations.

• All societies experience short-run economic fluc-tuations around long-run trends. These fluctua-tions are irregular and largely unpredictable.When recessions do occur, real GDP and othermeasures of income, spending, and productionfall, and unemployment rises.

• Classical economic theory is based on theassumption that nominal variables such as themoney supply and the price level do not influ-ence real variables such as output and employ-ment. Most economists believe that this assump-

tion is accurate in the long run but not in theshort run. Economists analyze short-run eco-nomic fluctuations using the model of aggregatedemand and aggregate supply. According to thismodel, the output of goods and services and theoverall level of prices adjust to balance aggregatedemand and aggregate supply.

• The aggregate-demand curve slopes downwardfor three reasons. The first is the wealth effect:A lower price level raises the real value ofhouseholds’ money holdings, which stimulates

SUMMARY

consumer spending. The second is the interest-rate effect: A lower price level reduces the quan-tity of money households demand; as householdstry to convert money into interest-bearing assets,interest rates fall, which stimulates investmentspending. The third is the exchange-rate effect:As a lower price level reduces interest rates, thedollar depreciates in the market for foreign-cur-rency exchange, which stimulates net exports.

• Any event or policy that raises consumption,investment, government purchases, or net exportsat a given price level increases aggregate demand.Any event or policy that reduces consumption,investment, government purchases, or net exportsat a given price level decreases aggregate demand.

• The long-run aggregate-supply curve is vertical.In the long run, the quantity of goods and ser-vices supplied depends on the economy’s labor,capital, natural resources, and technology but noton the overall level of prices.

• Three theories have been proposed to explain theupward slope of the short-run aggregate-supplycurve. According to the sticky-wage theory, anunexpected fall in the price level temporarilyraises real wages, which induces firms to reduceemployment and production. According to thesticky-price theory, an unexpected fall in the pricelevel leaves some firms with prices that are tem-porarily too high, which reduces their sales andcauses them to cut back production. According to


the misperceptions theory, an unexpected fall inthe price level leads suppliers to mistakenlybelieve that their relative prices have fallen,which induces them to reduce production. Allthree theories imply that output deviates from itsnatural rate when the actual price level deviatesfrom the price level that people expected.

• Events that alter the economy’s ability to produceoutput, such as changes in labor, capital, naturalresources, or technology, shift the short-runaggregate-supply curve (and may shift the long-run aggregate-supply curve as well). In addition,the position of the short-run aggregate-supplycurve depends on the expected price level.

• One possible cause of economic fluctuations is ashift in aggregate demand. When the aggregate-demand curve shifts to the left, for instance, out-put and prices fall in the short run. Over time, asa change in the expected price level causeswages, prices, and perceptions to adjust, theshort-run aggregate-supply curve shifts to theright, and the economy returns to its natural rateof output at a new, lower price level.

• A second possible cause of economic fluctuationsis a shift in aggregate supply. When the aggregate-supply curve shifts to the left, the short-run effectis falling output and rising prices—a combinationcalled stagflation. Over time, as wages, prices,and perceptions adjust, the price level falls backto its original level, and output recovers.

1. Name two macroeconomic variables that declinewhen the economy goes into a recession. Nameone macroeconomic variable that rises during arecession.

2. Draw a diagram with aggregate demand, short-run aggregate supply, and long-run aggregatesupply. Be careful to label the axes correctly.

QUESTIONS FOR REVIEW

recession, p. 739depression, p. 739model of aggregate demand and

aggregate supply, p. 745

natural rate of output, p. 752stagflation, p. 767

KEY CONCEPTS

aggregate-demand curve, p. 745aggregate-supply curve, p. 745


3. List and explain the three reasons the aggregate-demand curve is downward sloping.

4. Explain why the long-run aggregate-supplycurve is vertical.

5. List and explain the three theories for why theshort-run aggregate-supply curve is upwardsloping.

6. What might shift the aggregate-demand curve tothe left? Use the model of aggregate demand and

aggregate supply to trace through the short-runand long-run effects of such a shift on output andthe price level.

7. What might shift the aggregate-supply curve tothe left? Use the model of aggregate demand andaggregate supply to trace through the short-runand long-run effects of such a shift on output andthe price level.

1. Suppose that the economy is in a long-run equi-librium.a. Draw a diagram to illustrate the state of the

economy. Be sure to show aggregate demand,short-run aggregate supply, and long-runaggregate supply.

b. Now suppose that a stock-market crashcauses aggregate demand to fall. Use yourdiagram to show what happens to outputand the price level in the short run. Whathappens to the unemployment rate?

c. Use the sticky-wage theory of aggregate sup-ply to explain what will happen to output andthe price level in the long run (assuming thereis no change in policy). What role does theexpected price level play in this adjustment?Be sure to illustrate your analysis in a graph.

2. Explain whether each of the following eventswill increase, decrease, or have no effect onlong-run aggregate supply.a. The United States experiences a wave of

immigration.b. Congress raises the minimum wage to $10

per hour.c. Intel invents a new and more powerful com-

puter chip.d. A severe hurricane damages factories along

the East Coast.3. Suppose an economy is in long-run equilibrium.

a. Use the model of aggregate demand andaggregate supply to illustrate the initial equi-librium (call it point A). Be sure to includeboth short-run and long-run aggregate supply.

b. The central bank raises the money supply by5 percent. Use your diagram to show what

happens to output and the price level as theeconomy moves from the initial to the newshort-run equilibrium (call it point B).

c. Now show the new long-run equilibrium(call it point C). What causes the economy tomove from point B to point C?

d. According to the sticky-wage theory of aggre-gate supply, how do nominal wages at pointA compare to nominal wages at point B?How do nominal wages at point A compareto nominal wages at point C?

e. According to the sticky-wage theory of aggre-gate supply, how do real wages at point Acompare to real wages at point B? How doreal wages at point A compare to real wagesat point C?

f. Judging by the impact of the money supplyon nominal and real wages, is this analysisconsistent with the proposition that moneyhas real effects in the short run but is neutralin the long run?

4. In 1939, with the U.S. economy not yet fullyrecovered from the Great Depression, PresidentRoosevelt proclaimed that Thanksgiving wouldfall a week earlier than usual so that the shop-ping period before Christmas would be longer.Explain what President Roosevelt might havebeen trying to achieve, using the model ofaggregate demand and aggregate supply.

5. Explain why the following statements are false.a. “The aggregate-demand curve slopes down-

ward because it is the horizontal sum of thedemand curves for individual goods.”

PROBLEMS AND APPLICATIONS

b. “The long-run aggregate-supply curve is ver-tical because economic forces do not affectlong-run aggregate supply.”

c. “If firms adjusted their prices every day, thenthe short-run aggregate-supply curve wouldbe horizontal.”

d. “Whenever the economy enters a recession,its long-run aggregate-supply curve shifts tothe left.”

6. For each of the three theories for the upwardslope of the short-run aggregate-supply curve,carefully explain the following:a. How the economy recovers from a recession

and returns to its long-run equilibrium with-out any policy intervention.

b. What determines the speed of that recovery.7. Suppose the Fed expands the money supply, but

because the public expects this Fed action, itsimultaneously raises its expectation of the pricelevel. What will happen to output and the pricelevel in the short run? Compare this result to theoutcome if the Fed expanded the money supplybut the public didn’t change its expectation ofthe price level.

8. Suppose that the economy is currently in a reces-sion. If policymakers take no action, how willthe economy change over time? Explain in wordsand using an aggregate-demand/aggregate-supply diagram.

9. The economy begins in long-run equilibrium.Then one day, the president appoints a newchairman of the Federal Reserve. This newchairman is well-known for his view that infla-tion is not a major problem for an economy.a. How would this news affect the price level

that people would expect to prevail?b. How would this change in the expected

price level affect the nominal wage thatworkers and firms agree to in their newlabor contracts?

c. How would this change in the nominal wageaffect the profitability of producing goodsand services at any given price level?

d. How does this change in profitability affectthe short-run aggregate-supply curve?

e. If aggregate demand is held constant, howdoes this shift in the aggregate-supply curveaffect the price level and the quantity of out-put produced?


f. Do you think this Fed chairman was a goodappointment?

10. Explain whether each of the following eventsshifts the short-run aggregate-supply curve, theaggregate-demand curve, both, or neither. Foreach event that does shift a curve, draw a dia-gram to illustrate the effect on the economy.a. Households decide to save a larger share of

their income.b. Florida orange groves suffer a prolonged

period of below-freezing temperatures.c. Increased job opportunities overseas cause

many people to leave the country.11. For each of the following events, explain the

short-run and long-run effects on output and theprice level, assuming policymakers take noaction.a. The stock market declines sharply, reducing

consumers’ wealth.b. The federal government increases spending

on national defense.c. A technological improvement raises produc-

tivity.d. A recession overseas causes foreigners to buy

fewer U.S. goods.12. Suppose that firms become very optimistic

about future business conditions and investheavily in new capital equipment.a. Draw an aggregate-demand/aggregate-supply

diagram to show the short-run effect of thisoptimism on the economy. Label the new lev-els of prices and real output. Explain inwords why the aggregate quantity of outputsupplied changes.

b. Now use the diagram from part (a) to showthe new long-run equilibrium of the econ-omy. (For now, assume there is no change inthe long-run aggregate-supply curve.) Explainin words why the aggregate quantity of out-put demanded changes between the short runand the long run.

c. How might the investment boom affect thelong-run aggregate-supply curve? Explain.

13. In economy A, all workers agree in advance onthe nominal wages that their employers will paythem. In economy B, half of all workers havethese nominal wage contracts, while the otherhalf have indexed employment contracts, sotheir wages rise and fall automatically with the


price level. According to the sticky-wage theoryof aggregate supply, which economy has a moresteeply sloped short-run aggregate-supplycurve? In which economy would a 5 percentincrease in the money supply have a largerimpact on output? In which economy would ithave a larger impact on the price level? Explain.

14. The National Bureau of Economic Research is anonprofit economic research group that sets theofficial dates for the beginning and end of reces-sions in the United States. Go to its website,http://www.nber.org, and find informationabout business cycle dating. Notice that the

NBER often uses the term contraction for a reces-sion and the term expansion for the period ofgrowth between recessions.a. What was the U.S. economy’s most recent

turning point? Is the U.S economy now in anexpansion or a contraction?

b. When was the most recent completed con-traction? How long was it? By historical stan-dards, was this contraction short or long?

c. When was the most recent completed expan-sion? How long was it? By historical stan-dards, was this expansion short or long?

For further information on topics in this chapter, additional problems, examples, applications, online quizzes, and more, please visit our website athttp://mankiw.swlearning.com.

24729 33 c33 p737-776 - cengage · can public policy do to prevent periods of falling incomes and...

Documents