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CHAPTER 12
MACROECONOMIC INSTABILITY: AGGREGATE
DEMAND AND AGGREGATE SUPPLY
CHAPTER GOALS
This chapter deals with aggregate demand and aggregate supply. After reading this chapter, students
should be able to:
• Explain why the classical economists felt that the market economy would automatically move to full
employment and why John Maynard Keynes argued that the market economy is inherently unstable.
• Develop the macroeconomic model of aggregate supply and aggregate demand.
• Use the model of aggregate supply and aggregate demand to analyze the origins of recession and
inflation.
• Distinguish between demand-pull inflation and cost-push inflation.
• Identify the policies that the government might use to counteract a recession or inflation.
LECTURE HINTS AND IDEAS
This chapter presents the classical and Keynesian macroeconomic views. The shapes and determinants of
the aggregate demand and aggregate supply curves are explained, and they are related to equilibrium and
the multiplier effect. The model is then used to demonstrate demand-pull and cost-push inflation (or
stagflation), concepts that were first defined in Chapter 11.
This chapter develops the only macroeconomic model that is used throughout the text, so it is very
important that students become comfortable with it. Although the reasons for their shapes are different, the
aggregate demand and aggregate supply curves should be somewhat familiar to students because of the
concepts covered in Chapter 2. Students can be reminded of the need to distinguish between movements
along a curve and shifts in a curve that result in a change in equilibrium. In class, you may wish to use this
model to illustrate the beginning and ending of the Great Depression through changes in the aggregate
demand curve, taking time to discuss the reasons for the shifts.
BREAK-THE-ICE DISCUSSION STARTERS
1. “Do economy-wide productivity increases, such as those of the current “Information Technology
Revolution,” affect aggregate demand or aggregate supply?” The effect will primarily be on
aggregate supply through fundamental long-run improvements in the way resources are utilized.
However, the development of new technology can also encourage consumers and businesses to buy
new products, so it can boost aggregate demand somewhat as well in the short run.
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2. “Could the U.S. ever experience another Great Depression?” With the contributions of Keynes and
others, we know much more about the economy now, so this is unlikely. Automatic stabilizers also
cushion the economy and help to prevent recessions from becoming depressions.
3. “If the U.S. government closed half its military bases, would there be a multiplier effect?” Talk the
students through the process by which spending initially falls, and then all the spending that those
parties would have done falls, and so on.
4. “Why does the multiplier work best when there are idle resources in an economy?” This means that
an increase in aggregate demand will not result in price-level increases when the aggregate supply
curve is horizontal. There is a maximum effect on output. Thus, government intervention to boost
aggregate demand, as Keynes suggested, works best when the economy is in a severe recession or
depression.
5. “How would a recession in Canada affect aggregate demand in the U.S.?” Canadians would not be
able to afford as many U.S. goods, so U.S. exports to Canada would decline. This would put a
damper on U.S. aggregate demand. The recession could become contagious if the decline were large
enough.
BRIEF ANSWERS TO STUDY QUESTIONS AND PROBLEMS
1. According to the classical economists, if workers became unemployed during an economic downturn,
they would make themselves attractive to their employers by offering their services at lower wages.
As wages fell, firms would find it more profitable to hire workers. Moreover, flexible prices would
also help eliminate an economic downturn. During a recession, firms might realize a decrease in the
demand for their goods. To clear the market of any excess supply, they would be willing to accept
price reductions. However, John Maynard Keynes questioned the extent to which prices and wages
were flexible. According to Keynes, powerful labor unions and large businesses would resist wage
and price reductions during an economic downturn and therefore output and employment would
decline.
2. The aggregate demand curve is downward sloping for three reasons. First, as the price level
decreases, the purchasing power of currency and checking account balances increases; therefore,
households feel less need to save and are likely to buy a greater quantity of goods and services.
Second, a lower price level decreases interest rates, which results in additional spending on
investment goods and so increases the aggregate quantity of goods and services demanded. Third, a
lower price level in the home country relative to the price level abroad increases the foreign demand
for domestic exports and reduces the domestic demand for imports. The decrease in the domestic
price level thus increases net exports, a component of aggregate demand.
3. The aggregate supply curve has three segments. Along the horizontal segment of the aggregate
supply curve, the economy is assumed to be in a recession and experiencing excess capacity.
Because excess capacity places no upward pressure on prices and wages, changes in aggregate
demand cause changes in real output, but no change in the price level along the horizontal segment of
the aggregate supply curve. As the economy approaches full employment, the aggregate supply
curve becomes upward sloping. Throughout the upward-sloping region of the aggregate supply
curve, higher price levels provide an incentive for firms to produce and sell real output, while lower
price levels decrease real output. However, there is a physical limit to the amount of output that can
be produced in a given period of time. When the economy reaches its full-employment output level,
the aggregate supply curve becomes vertical.
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4. a.
b.
c.
d.
e.
f.
g.
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No change in aggregate demand.
Aggregate demand curve increases.
Aggregate demand curve decreases.
No change in aggregate demand.
Aggregate demand curve decreases.
Aggregate demand curve increases.
Aggregate demand curve decreases.
5. With the economy’s marginal propensity to consume equal to 0.75, the multiplier is 4. A $50 million
increase in investment spending would thus cause real GDP to increase by $200 million.
6. With the economy marginal propensity to save equal to 0.1, the multiplier is 10. A $20 million
decrease in net exports would cause real GDP to decrease by $200 million.
7. a.
b.
c.
d.
e.
Aggregate supply curve decreases.
Aggregate supply curve increases.
Aggregate supply curve increases.
Aggregate supply curve decreases.
Aggregate supply curve increases.
8. a.
b.
Equilibrium price level = 100, equilibrium output = $12,000 billion
The full-employment segment of the aggregate supply schedule is associated with $16,000
billion of output.
Output and employment would increase, while the price level remains constant.
Equilibrium price level = 90, equilibrium output level = $14,000 billion
c.
d.
9. Given an upward-sloping aggregate supply curve, an increase in aggregate supply results in increased
output and lower prices. However, a decrease in aggregate supply results in decreased output and
higher prices.
10. Demand-pull inflation occurs when aggregate demand increases cause the price level to rise. The
price level increase that is associated with the rise in aggregate demand comprises demand-pull
inflation because the increase in aggregate demand pulls up the price level. Cost-push inflation arises
from events that increase the cost of production at each price level. Therefore, the aggregate supply
curve shifts to the left, which pushes up the average price level.