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Chapter 12 Economic Fluctuations
Aggregate Demand
Aggregate Demand is the relationship between the ______________________
and ________________________ in the economy.
Total spending in an economy, adjusted for changes in the general price level,
is referred to as real expenditures, and is calculated using the GDP price
deflator.
Real Expenditures: --------------------------------Recall:
Total spending on an economy’s goods and services is the sum of four
components: _______________________, _______________________,
_______________________, _______________________ by the
four groups: _______________________, _______________________,
_______________________, _______________________.
The relationship between the general price level and total spending in the
economy expressed in a table is known as the __________________________.
The relationship between the general price level and total spending in the
economy expressed on a graph is known as the _________________________.
Inverse relationship
$, output bought,
Price Level/
GDP deflator
vice versa
AD
Real GDP
Factors affect the amount spent in the economy: wealth, foreign trade
Wealth can be in the form of _____________ or _________ assets. Nominal
values of these stay the same their real values change.
Real value of financial assets = --------------------------------------------
Changes in Aggregate Demand
Aggregate demand factors are variables that cause changes in
____________________ at all _______________________.
Price Level/
GDP deflator
Real GDP
Increase in aggregate demand: AD curve shift to the __________
Decrease in aggregate demand: AD curve shift to the __________
The 4 components of spending: Consumption
Government purchases
Investment
Net Exports
Consumption
1. Disposable Income (DI)

Most significant determinant of consumer spending

Economy’s total DI change because of changes in ______________ or DI
per ______________

DI and spending have a _________ relationship:  DI,  Spending,  Total
expenditures, AD Curve shifts to the right
2. Wealth

Made up of _______________ assets (stocks, bonds) and _________
assets (houses, appliances)

 Wealth, Spending,  Total expenditures, AD Curve shifts to the right
3. Consumer Expectations

Affect aggregate demand by changing general ______________________

Expect prices to rise (war) or an increase in income, consumers will
spend more now and save less

 Spending,  Total expenditures, AD Curve shifts to the right
4. Interest Rates

Households borrow to purchase ____________ goods (cars, furniture)

 Real Interest Rates,  Borrow rates,  Spending, AD Curve shifts to
the right
Investment

Limited to planned investment, which excludes unintended changes in
inventories

Businesses decide to invest by calculating the ____________________ and
_______ of the project in constant dollars

Then, businesses consider the _________________________________, the
constant-dollar extra profit provided by a project each year stated as a
percentage of the project’s initial cost

If real rate of return ≥ real interest rates, businesses will invest

The relationship between interest rates and investment is known as the
__________________________.

The relationship between interest rates and investment expressed in a
table is called the ________________________________________.

The relationship between interest rates and investment expressed on a
graph is the ___________________________________________.
1. Interest Rates

Real interest rates and investment have an _________ relationship.

 Real interest rates,  AD, AD Curve shifts to the left
2. Business Expectations

When businesses anticipate profits to increase, investment demand rises,
 AD, AD Curve shifts to the right
3. Production Costs

Production costs influence the ________________ of investment projects

 Business costs ( higher corporate taxes),  Real rates of return, 
Investment spending, AD Curve shifts to the left
Government Purchases

 Government purchases (highway construction),  AD, AD Curve shifts
to the right

Exclude government transfer payments
Net Exports
1. Foreign Incomes

 Income in a foreign country,  Purchases on other countries,  Net
Exports, AD, AD Curve shifts to the right
2. Exchange Rates

Exchange rate is the __________ of one nation’s currency in terms of
another currency

 Canada Dollar (exports from Canada become more expensive),  Net
Exports,  AD, AD Curve shifts to the left
*When consider each in turn, assume other factors and price level constant.
Aggregate Supply
Aggregate supply is the relationship between the ________________________
and ____________________________________ in the economy.
The relationship between the general price level and real output expressed in
a table is known as the __________________________.
The relationship between the general price level and real output expressed
on a graph is known as the ____________________________.
AS
Potential output
Direct Relationship
Price Level/
GDP deflator
$,  output production,
vice versa
Real GDP
Pt A: Real output level is __________ than its potential. Businesses
produce significantly ___________ capacity and the AS Curve is
relatively _________.
Pt C: Output increases above the potential output level, businesses
produce above their ________________________________.
Pt D: AS Curve become very ___________. Businesses are producing
_____________ their normal capacity, which is possible in the
short run only if businesses employ overtime labor and
temporarily rent new machinery.
Changes in Aggregate Supply
Aggregate supply factors are variables that cause changes in
_____________________ at all _______________________.
Input Prices

Changes in input prices- which can occur frequently over brief
periods of time- alter _____________________________.

____________ in the price oh an input pushes up production costs,
businesses ___________ their real output and the AS Curve shifts
to the __________.

Changes in input prices only apply to short run and take place
within a short period; the economy’s ________________________
stays the same.

Short-run increase in aggregate supply is an increase in total
output at all price levels, with no change in potential output.

Short-run decrease in aggregate supply is a decrease in total
output at all price levels, with no change in potential output.
AS0
Potential output
AS1
Price Level/
GDP deflator
Real GDP
Resource Supplies

Over the long term, resources in an economy- especially ____________
and _______________ resources tend to _________.

More (less) inputs over the long-run __________ (___________) aggregate
supply, as well as the economy’s _______________________________.

Long-run increase in aggregate supply is an increase in total and
potential output at all price levels.

Long-run decrease in aggregate supply is a decrease in total and
potential output at all price levels.
AS0
AS1
Price Level/
GDP deflator
Potential output
Real GDP
Productivity

Productivity is the ________________________________ per unit of input
over a given period of time.

Labor productivity = real output ÷ total hours worked

 Productivity due largely to _______________________________, which
raises productivity with the _________ amount of economic resources.

As a result, there would be a _____________ increase in aggregate supply.
Government Policies

Government policies influence aggregate supply through their effects on
the __________________________ in an economy.

More (less) regulations rise (lower) per unit costs; businesses produce
________ (______) real output at every price level.

As a result, there will be a _________ change in the aggregate supply.
Equilibrium
An economy’s equilibrium price level and real output occur at the
________________ of the AD and AS curve.
Surplus
Price Level/
GDP deflator
Shortage
AS
AD
Real GDP
Inventories Changes
Unintended changes in inventories cause _____________________ and
_____________________ to reach equilibrium.
Inventory Increase

General price level above equilibrium price, real output exceeds real
expenditures = More is ___________ than is ____________ in the economy

Positive unplanned investment is an unintended increase in inventories;
a surplus

 general price level: buyers  spending, businesses  real output
Inventory Decrease

General price level below equilibrium price, real output falls behind real
expenditures = More is ___________ than is ____________ in the economy

Negative unplanned investment is an unintended decrease in inventories;
a shortage

 general price level: buyers  spending, businesses  real output
*Unplanned investment plays a central role in stabilizing the economy.
Injections and Withdrawals
Injections are the ______________ to an economy’s income spending stream.
There are 3 flows: Investment (I), Government Purchases (G) and Exports (X)
Withdrawals are the ______________ from an economy’s income-spending
stream. They are: Saving (S), Taxes (T) and Imports (M)
Investment and Saving

The amount invested and the amount saved in an economy are not equal
for 3 reasons:
1.
Companies keep a portion of their profits to reinvest
2.
Governments also borrow money
3.
Foreign lending usually exceeds foreign borrowing, foreign funds add to
Canadian savings available for investment
Government Purchases and Taxes

Transfer payments and business subsidies are negative taxes

Government purchases usually exceed taxes and they borrow funds in
financial markets to make up for the discrepancy

If taxes exceed government purchases, governments use the excess
revenues to pay off debt
Exports and Imports

Foreign lending tends to be greater than foreign borrowing and thus
surplus of foreign lending makes up for the shortfall in net exports.
Figure 12.10
Equilibrium vs. Potential Output
Economy’s equilibrium point can occur at its potential output, unemployment
at equilibrium ________________ the natural unemployment rate.
Recessionary Gaps - the amount by which equilibrium output falls short of
potential output

Equilibrium output is ____________ its potential level, unemployment is
_____________ the natural unemployment rate
Inflationary Gaps – the amount by which equilibrium output exceeds
potential output

Equilibrium output _____________ potential output, unemployment is
temporarily ______________ natural unemployment rate
Business Cycles
A sustained rise in real output, known as a period of expansion or recovery, is
followed by an extended period of falling real output, known as a contraction.
These rises and falls in real output constitute a pattern known as the
business cycle.
CONTRACTION
Peak
Long-run Trend of
Potential Output
Real GDP
Recessionary
gap
Inflationary
gap
Trough
EXPANSION
Time
Inflationary gap: real output falls below its potential level
Recessionary gap: real output falls short of its potential
Contraction
Economy has reached its peak and is said to be experiencing a boom, which
occurs when real GDP is at its highest value in the business cycle. The
economy must contract because

Inflationary gap reached its maximum width

Unemployment is at its lowest possible level
Real output can grow no larger in the short run.

Causes of a contraction

Originate with events occur in the previous boom

Higher demand pushes up the prices for inputs

 Production costs,  Real rates of return for investment projects,
 Investment spending, AD Curve shifts to the left
The Role of Expectations

Expectations are often made simply by extending current trends,
households and businesses will then react to their expectations

Pessimism and optimism can affect the reaction; if the economy is
experiencing a reductions in real output and spending, households and
businesses will likely to decrease their spending in 3 ways:
1. Consumption
2. Investment
3. Exports
Effects of a Contraction

AD Curve shifts to the left,  equilibrium output

Unemployment rises above its natural unemployment rate

Downward pressure on prices causing deflation
Recessions and Depressions

The longer period of declining real output, the more serious its effects.

A decline in real output that lasts for six months or more is ____________.

A decline in real output that is particularly long and harsh is ___________.
Expansion
The spiral of worsening expectations and declining real output will stop
eventually and the economy reaches a trough where real output is at its
lowest possible value in the business cycle.

Recessionary gap at its widest

Unemployment is at its highest level
Cause of an Expansion

Originate with the latter stages of the precious period of contraction

Lower Demand pushed down prices of resources

Production costs,  Real rates of return for investment projects, 
investment spending, AD Curve shifts to the right
Effects of an Expansion

AD Curve shifts to the right,  equilibrium output

Unemployment rate goes from above to below its natural rate

Rise in the general price level causing inflation
ARTICLE SUMMARY
Economist Extraordinaire- Summary
John Maynard Keynes and the transformation of macroeconomics
Keynes and his Influence



John Maynard Keynes (1883 –1946)
Father was an economist and his mother was a city politician.
Served as a representative at international conferences such as Paris Peace
Conference that ended WWI

During the great depression he supported the government intervention with a
coherent theory. This theory stressed the role played by aggregate demand in
determining output in the macroeconomy.

Keynes ideas dominated macroeconomics from after WWII to the 1970s,
when events brought a new period of questioning and debate.
Neoclassical Theory

Based on two major assumptions: flexible labour markets and Say’s law

This was influenced by Keynes theory. Most economists held the opinion
that economic slow downs (Ex: Great Depression) are self-correcting.
Say’s Law
Neoclassical economists: also assumed that periods of underspending in the economy
are short-lived.
Flexible Labour Markets

Neoclassical economists: demand and supply of labour depend on the real
wage rate (constant base year $) rather than nominal wage rates (current $).

Neoclassical economists:
two types of unemployment  voluntary and involuntary

Voluntary unemployment: workers decide that real wages are not high enough
to make work worth while

Involuntary unemployment: when someone wants to work at current real wage
rates but cannot find a job.

Note: because markets are flexible, involuntary unemployment is no more
than a short-run problem.

Keynesian Theory

Challenge both of the assumption of neoclassical economics. He explained
involuntary unemployment and under spending had become chronic problems
during the depression.

Challenge to Flexible Labour Markets

Keynes believed that workers were influenced by money illusion. Meaning
that workers would respond to changes in nominal wages rather than real
wages.

Challenge to Say’s Law

Keynes agreed that Say’s law seems to be common sense but it is valid only if
income in an economy is spent.

Neoclassical Economist believed that Say’s law occurs since total withdraws
and injections can be equal at any output.
Chapter 12 Economic Fluctuations
Definitions
Aggregate demand: the relationship between the general price level and
total spending in the economy
Real expenditures: total spending in an economy, adjusted for charges in the
general price level
Aggregate demand schedule: the relationship between the general price level
and total spending in the economy expresses in a table
Aggregate demand curve: the relationship between general price level and
total spending in the economy expresses on a
graph
Wealth effect: with changes in the price level, the real value of households’
financial assets changes, causing households to adjust their
spending
Foreign trade effect: with changes in the price level, expenditures on imports
change in the opposite direction change in the same
direction, while expenditures on exports
Aggregate demand factors: variables that cause in total expenditures at all
price level
Increase in aggregate demand: an increase in total expenditures at all price
level
Decrease in aggregate demand: a decrease in total expenditures at all price
level
Real rate of return: constant-dollar extra profit provided by a project each
year stated as a percentage of the project’s initial cost
Investment demand: the relationship between interest rates and investment
expresses in a table
Investment demand curve: the relationship between interest rates and
investment expressed on the graph
Exchange rate: the value of one nation’s currency in terms of another
currency
Aggregate supply: the relationship between the general price level and real
output produced in the economy
Aggregate supply schedule: the relationship between the general price level
and real output expressed in a table
Aggregate supply curve: the relationship between the general price level and
real output expressed on a graph
Aggregate supply factors: variables that change total output at all price
levels
Short-run increase in aggregate supply: an increase in total output at all price
levels, with no change in potential
output
Short-run decrease in aggregate supply: a decrease in total output at all price
level, with no change in potential
output
Long-run increase in aggregate supply: an increase in total and potential
output at all price levels
Long-run decrease in aggregate supply: a decrease in total and potential
output at all price levels
Positive unplanned investment: an unintended increase in inventories; a
surplus
Negative unplanned investment: an unintended decrease in inventories; a
shortage
Injections: additions to an economy’s income spending stream
Withdrawals: deductions from an economy’s income spending stream
Recessionary gap: the amount by which equilibrium output falls short of
potential output
Inflationary gap: the amount by which equilibrium output exceeds potential
output
Expansion: a sustained rise in real output of an economy
Contraction: a sustained falls in real output of economy
Business cycle: the cycle of expansions and contractions in the economy
Peak: the point in the business cycle at which real output is at tis highest
Recession: a decline in real output that lasts for six months or more
Depression: a particularly long and harsh period of reduced real output
Trough: the point in the business cycle at which real output is at its lowest