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Chapter 19
AGGREGATE DEMAND,
AGGREGATE SUPPLY AND
GDP
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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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
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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 foreignowned 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 2005 (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,
2006, the same basket of goods cost
$385. The 2006 CPI, measured
against the 2005 base year of 100, is
110. P = ($385/$350) × 100 = 110.
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Measuring the
National Economy
Example: A 2006 P = 110 indicates that
from 2005 to 2006 the cost of goods
and services that consumers typically
buy increased by 10 percent.
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Measuring the
National Economy
GDP deflator
• A measure comparing the prices of all goods
and services produced in the economy during
a given year to the prices of those goods and
services purchased in a base year.
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Measuring the
National Economy
GDP deflator
• This price index includes not only consumer
goods and services, but also producer goods,
investment goods, exports and imports, and
goods and services purchased by
government.
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Measuring the
National Economy
GDP deflator
• This price index is used to convert nominal
GDP to real GDP.
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Measuring the
National Economy
The formula to convert from nominal
GDP to real GDP is:
• Real GDP = (Nominal GDP × 100)/GDP deflator
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EXHIBIT 2
CONVERTING NOMINAL GDP TO REAL GDP:
2005–2010 ($ BILLIONS, 2005 = 100)
Source: Survey of Current Business, U.S. Department of Commerce, Washington, D.C., May, 2011. Unlike the data for nominal GDP, the
data provided by the SCB for real GDP and the GDP deflator are chained-linked. To bring nominal and real into accord, the GDP deflator
data in Exhibit 2 have been adjusted.
.
.
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Exhibit 2: Converting Nominal
GDP to Real GDP: 2005–2010
1. What is the nominal difference
between GDP in 2005 and 2006?
• The nominal difference = $12,638.4 billion
– $13,398.9 billion = –$760.5 billion
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Exhibit 2: Converting Nominal
GDP to Real GDP: 2005–2010
2. What is the real difference between
GDP in 2005 and 2006?
• Real GDP in 2005 is = ($12,638.4 billion
× 100)/100.00 = $12,638.4 billion
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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Exhibit 2: Converting Nominal
GDP to Real GDP: 2005–2010
2. What is the real difference between
GDP in 2005 and 2006?
• Real GDP in 2006 = ($13,398.9 billion
× 100)/106 = $12,640.5 billion
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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Exhibit 2: Converting Nominal
GDP to Real GDP: 2005-2010
2. What is the real difference between
GDP in 2005 and 2006?
• The real difference = $12,638.4 billion
– $12,640.5 billion = –$2.1 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
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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
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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
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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 = 115.9 and
real GDP = $13.3 trillion.
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Exhibit 5: Achieving
Macroeconomic Equilibrium
2. What happens when the price level
increases to P = 125?
• At P = 125, the aggregate quantity demanded
falls to $10 trillion and the aggregate quantity
supplied increases to $15 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 World War II, 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 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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The Extended 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 2001–2002 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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War in Iraq and Afghanistan
War spending can shift the aggregate
demand curve to the right, increasing
both levels of real GDP and employment.
It accomplished exactly that over the
years 2003–2006. The unemployment rate
fell from 5.8 percent in 2003 to 4.6
percent in 2006.
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Financial Meltdown–Induced
Recession: 2008
Was it a slow-down or recession? Two
events answer the question:
1. The oil-price spike in July 2008 shifted
aggregate supply inward to the left shrinking
GDP and employment.
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Financial Meltdown–Induced
Recession: 2008
Was it a slow-down or recession? Two
events answer the question:
2. A weakening housing market produced
massive foreclosures and a housing glut
that depressed the value of all prompting
sharp cuts in consumption spending. This
shifted aggregate demand inward to the
left, further shrinking GDP and
employment. We were in recession.
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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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