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Chapter 19
Aggregate Demand and
Aggregate Supply
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Economic Principles
The phases of the business cycle
Gross Domestic Product (GDP)
The CPI and GDP deflator
Nominal and real GDP
Aggregate demand and
aggregate supply
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Economic Principles
Macroeconomic equilibrium
Demand-pull and cost-push
inflation
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Why Recession? Why Prosperity?
Recession
• A phase in the business cycle in which the
decline in the economy’s real GDP persists
for at least a half-year. A recession is
marked by relatively high unemployment.
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Why Recession? Why Prosperity?
Depression
• Severe recession.
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Why Recession? Why Prosperity?
Prosperity
• A phase in the business cycle marked by
a relatively high level of real GDP, full
employment, and inflation.
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Why Recession? Why Prosperity?
Inflation
• An increase in the price level.
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Why Recession? Why Prosperity?
Business cycle
• Alternating periods of growth and decline
in an economy’s GDP.
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Why Recession? Why Prosperity?
Business cycle
• No two business cycles are identical. The
number of months in any given phase of
the cycle varies from cycle to cycle.
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Why Recession? Why Prosperity?
Trough
• The bottom of a business cycle.
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Why Recession? Why Prosperity?
Trough
• This is the time period when the
economy’s unemployment rate is greatest
and output declines to the cycle’s minimum
level.
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Why Recession? Why Prosperity?
Recovery
• A phase in the business cycle, following a
recession, in which real GDP increases and
unemployment declines.
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Why Recession? Why Prosperity?
Peak
• The top of a business cycle.
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Why Recession? Why Prosperity?
Peak
• This is the time period when output
reaches its maximum level, the labor force
is fully employed, and increasing pressure
on prices is likely to generate inflation.
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Why Recession? Why Prosperity?
Downturn
• A phase in the business cycle in which
real GDP declines, inflation moderates,
and unemployment emerges.
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Why Recession? Why Prosperity?
Trend lines trace the economy’s
output performance over the
course of a business cycle,
measured either from recession to
recession or from prosperity to
prosperity.
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Why Recession? Why Prosperity?
• Upward-sloping trend lines signify
economic growth.
• The steeper the trend line, the higher
the economy’s rate of growth.
• When no growth occurs, the trend
line is horizontal.
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EXHIBIT 1
THE BUSINESS CYCLE
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Exhibit 1: The Business Cycle
What does the trend line in
Exhibit 1 tell us about the
economy’s output performance?
• The trend line shows that the economy is
growing.
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Measuring the
National Economy
Gross Domestic Product (GDP)
• Total value of all final goods and services,
measured in current market prices,
produced in the economy during a year.
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Measuring the
National Economy
Gross Domestic Product (GDP)
• “Final goods and services” refers to
everything produced that is not itself used
to produce other goods and services.
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Measuring the
National Economy
Gross Domestic Product (GDP)
• “During a given year” refers to a specific
calendar year.
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Measuring the
National Economy
Gross Domestic Product (GDP)
• “Produced in the economy” refers to any
good or service produced in the United
States, regardless of whether a US-owned
or a foreign-owned company produced the
good.
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Measuring the
National Economy
Gross Domestic Product (GDP)
• Conversely, goods produced by US-owned
firms in foreign countries are not included
in GDP.
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Measuring the
National Economy
To compare GDP across years, we
must devise some way of
eliminating the effect of inflation.
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Measuring the
National Economy
Nominal GDP
• GDP measured in terms of current market
prices—that is, the price level at the time of
measurement. (It is not adjusted for
inflation.)
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Measuring the
National Economy
Real GDP
• GDP adjusted for changes in the price
level.
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Measuring the
National Economy
• Price indices are designed to
remove the effect of price changes.
• The consumer price index and
the GDP deflator are the two
indices most commonly used.
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Measuring the
National Economy
Consumer Price Index (CPI)
• A measure comparing the prices of
consumer goods and services that a
household typically purchases to the prices
of those goods and services purchased in a
base year.
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Measuring the
National Economy
Base year
• The reference year with which prices in
other years are compared in a price index.
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Measuring the
National Economy
Price level
• A measure of prices in one year expressed
in relation to prices in a base year.
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Measuring the
National Economy
Example: Suppose in 1998 (the
base year) a basket of goods
including such things as food,
clothing, and fuel cost $350. The
$350 converts to a price level
index of 100, P = 100.
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Measuring the
National Economy
Example: Suppose in the next
year, 1999, the same basket of
goods cost $385. The 1999 CPI,
measured against the 1998 base
year of 100, is 110. P = ($385/$350)
× 100 = 110.
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Measuring the
National Economy
Example: A 1999 P = 110 indicates
that from 1998 to 1999 the cost of
goods and services that consumers
typically buy increased by 10
percent.
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Measuring the
National Economy
GDP deflator
• A measure comparing the prices of all
goods and services produced in the
economy during a given year to the prices
of those goods and services purchased in a
base year.
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Measuring the
National Economy
GDP deflator
• This price index includes not only
consumer goods and services, but also
producer goods, investment goods, exports
and imports, and goods and services
purchased by government.
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Measuring the
National Economy
GDP deflator
• This price index is used to convert
nominal GDP to real GDP.
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Measuring the
National Economy
The formula to convert from
nominal GDP to real GDP is:
• Real GDP = (nominal GDP × 100)/
GDP deflator.
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EXHIBIT 2
CONVERTING NOMINAL GDP TO REAL GDP:
1995–2002 ($ BILLIONS, 1996 = 100)
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
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Exhibit 2: Converting Nominal
GDP to Real GDP: 1995-2000
1. What is the nominal difference
between GDP in 1996 and 1997?
• The nominal difference = $8,318.4 billion
- $7,813.2 billion = $505.2 billion.
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Exhibit 2: Converting Nominal
GDP to Real GDP: 1995-2000
2. What is the real difference
between GDP in 1996 and 1997?
• Real GDP in 1996 is = ($7,813.2 billion
× 100)/100.00 = $7,813.2 billion.
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Exhibit 2: Converting Nominal
GDP to Real GDP: 1995-2000
2. What is the real difference
between GDP in 1996 and 1997?
• Real GDP in 1997 = ($8,318.4 billion
× 100)/101.95 = $8,159.5 billion.
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Exhibit 2: Converting Nominal
GDP to Real GDP: 1995-2000
2. What is the real difference
between GDP in 1996 and 1997?
• The real difference = $8,159.5 billion
- $7,813.2 billion = $346.3 billion.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
The aggregate demand and
aggregate supply model is one
model used to explain how GDP is
determined.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
Aggregate supply
• The total quantity of goods and services
that firms in the economy are willing to
supply at varying price levels.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
There are three distinct segments
of the aggregate supply curve:
1. Horizontal segment. Real GDP increases
without affecting the economy’s price level.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
There are three distinct segments
of the aggregate supply curve:
2. Upward-sloping segment. A positive
relationship between real GDP and price
level.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
There are three distinct segments
of the aggregate supply curve:
3. Vertical segment. All resources are fully
employed, so that real GDP cannot
increase.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
Aggregate demand
• The total quantity of goods and services
demanded by households, firms, foreigners,
and government at varying price levels.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
Increases in the price level affect
people’s real wealth, their lending
and borrowing activity, and the
nation’s trade with other nations.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
The quantity of goods and services
demanded in the economy declines
when price levels increase.
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EXHIBIT 3
AGGREGATE SUPPLY AND AGGREGATE
DEMAND
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Exhibit 3: Aggregate Supply and
Aggregate Demand
At what real GDP value is fullemployment of resources realized
in Exhibit 3?
• Full-employment real GDP is $9.5 trillion.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
• The aggregate demand curve shifts
when there is a change in the quantity of
goods and services demanded at a
particular price level.
• Government spending, income levels,
and expectations about the future are all
factors that can cause the curve to shift.
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Deriving Equilibrium GDP in the
Aggregate Demand and Supply Model
The aggregate supply curve shifts
due to factors such as changes in
resource availability and resource
prices.
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EXHIBIT 4
SHIFTS IN AGGREGATE DEMAND AND
AGGREGATE SUPPLY
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Exhibit 4: Shifts in Aggregate Demand
and Aggregate Supply
What might cause the aggregate
demand curve in panel a of
Exhibit 4 to shift to the right?
• Increases in government spending,
increases in incomes, and optimistic
expectations could all cause the aggregate
demand curve to shift to the right.
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Macroeconomic Equilibrium
Macroequilibrium
• The level of real GDP and the price level
that equate the aggregate quantity
demanded and the aggregate quantity
supplied.
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EXHIBIT 5
ACHIEVING MACROECONOMIC
EQUILIBRIUM
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Exhibit 5: Achieving
Macroeconomic Equilibrium
1. At what price level and real GDP
is macroequilibrium achieved in
Exhibit 5?
• Macroequilibrium is achieved at P = 101.95
and real GDP = $8.1595 trillion.
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Exhibit 5: Achieving
Macroeconomic Equilibrium
2. What happens when the price
level increases to P = 110?
• At P = 110, the aggregate quantity
demanded falls to $5 trillion and the
aggregate quantity supplied increases
to $9 trillion.
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Equilibrium, Inflation, and
Unemployment
• The Depression of the 1930s
produced one of the poorest GDP
performance records in our
economic history.
• Real GDP fell by 30 percent in the
first four years of the decade.
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Time Line on Equilibrium,
Inflation, and Unemployment
The U.S. commitment to support
England during World War II
changed the pace and direction of
our national economy
significantly.
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Time Line on Equilibrium,
Inflation, and Unemployment
• Government war-related spending
shifted the aggregate demand curve to
the right.
• With millions of men and women
joining the armed forces, the size of the
civilian labor pool declined and the
aggregate supply curve shifted to
the left.
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Time Line on Equilibrium,
Inflation, and Unemployment
• The same basic shifts in aggregate
demand and supply occurred during
the Vietnam War.
• Unlike the poor economic condition
prior to WWII, however, the economy
was already relatively vigorous prior
to the Vietnam war. Inflation resulted.
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Time Line on Equilibrium,
Inflation, and Unemployment
Demand-pull inflation
• Inflation caused primarily by an increase
in aggregate demand.
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Equilibrium, Inflation, and
Unemployment
Stagflation
• A period of stagnating real GDP, rapid
inflation, and relatively high levels of
unemployment.
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Time Line on Equilibrium,
Inflation, and Unemployment
The oil price increases imposed by
OPEC during the 1970s caused the
cost of producing nearly everything
in the economy to increase. The
aggregate supply curve shifted to
the left. GDP declined while the
price level increased.
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Time Line on Equilibrium,
Inflation, and Unemployment
Cost-push inflation
• Inflation caused primarily by a decrease
in aggregate supply.
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EXHIBIT 6 AGGREGATE DEMAND AND AGGREGATE
SUPPLY DURING THE DEPRESSION AND WAR
PERIOD AND THE OIL PRICE INCREASES
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Exhibit 6: Aggregate Demand and
Aggregate Supply During the
Depression and War Period and the
Oil Price Increases
How does macroeconomic
equilibrium change before and
after OPEC in panel b of Exhibit 6?
• The aggregate supply curve shifts to the
left after OPEC.
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Exhibit 6: Aggregate Demand and
Aggregate Supply During the
Depression and War Period and the
Oil Price Increases
How does macroeconomic
equilibrium change before and
after OPEC in panel b of Exhibit 6?
• A new equilibrium is obtained at a lower
level of real GDP and at a higher price
level.
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Time Line on Equilibrium,
Inflation, and Unemployment
• During the second half of the 1980s,
the economy was performing about as
well as it ever had in the last quarter
century.
• Tax reforms, ready credit, leveraged
buyouts, a commercial real estate boom,
and optimistic expectations contributed
to the already strong aggregate demand.
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Time Line on Equilibrium,
Inflation, and Unemployment
Leveraged buyout
• A primarily debt-financed purchase of all
the stock or assets of a company.
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Time Line on Equilibrium,
Inflation, and Unemployment
The recession of 1990-91 was caused
by an inward shift in aggregate
demand. Reduced federal revenue
sharing with states, downsized
government budgets, cuts in
demand for military goods, and
high levels of debt acquired during
the 1980s are all to blame.
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The Longest Prosperity Phase:
1992-2000
Economists attribute the boom to
supply-side factors:
• A rise in the nation’s productivity caused
by the diffusion of computer technology
throughout the economy.
• The absence of rising inflation.
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The 2001-02 Recession and 9/11
• The 1992-2000 buying spree left
consumers without the means to
keep the spree alive.
• Terrorist attacks created a
heightened sense of economic
uncertainty.
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Can We Avoid Unemployment
and Inflation?
Although the desired
macroequilibrium outcome would
occur at a real GDP level consistent
with full employment and no
inflation, this level is not always
achieved.
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Can We Avoid Unemployment
and Inflation?
Some economists believe
government should act in ways to
help shift macroequilibrium to this
position.
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Can We Avoid Unemployment
and Inflation?
Increasing or decreasing
government spending and income
taxes are two methods government
can use to attempt to shift the
aggregate demand curve.
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EXHIBIT 7 OBTAINING FULL-EMPLOYMENT GDP
WITHOUT INFLATION
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Exhibit 7: Obtaining Full-Employment
GDP Without Inflation
How might government shift the
aggregate demand curve from AD
to AD′ in Exhibit 7?
• Government could increase spending and
reduce income taxes in order to shift the
demand curve to the right.
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