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Understanding Economics
5th edition
by Mark Lovewell
Copyright © 2009 by McGraw-Hill Ryerson
Limited. All rights reserved.
5th edition
by Mark Lovewell
Chapter 10
Economic Fluctuations
Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.
Learning Objectives
After this chapter you will be able to:
1.
2.
3.
4.
5.
identify aggregate demand and the factors that
affect it
distinguish aggregate supply and the factors
that influence it
understand the economy’s equilibrium and how
it differs from its potential
define economic growth, its sources and its
impact
summarize Canada’s historical record of
economic growth
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Aggregate Demand (a)

Aggregate demand (AD):


is the relationship between the general price level and
real expenditures (i.e. total spending) in an economy
is shown as a schedule or curve
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Aggregate Demand (b)
Figure 10.1, Page 260
Aggregate Demand
Schedule
Price Real GDP Point on
Level
Graph
(2002,
$ billions)
200
160
120
650
700
750
a
b
c
Price Level (GDP deflator,
2002 = 100)
Aggregate Demand Curve
200
a
160
b
120
c
80
AD
40
0
650
700
750
Real GDP (2002 $ billions)
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800
The Aggregate Demand Curve

Two factors cause the aggregate demand curve to be
downward sloping:
 The wealth effect means that higher prices decrease the
real value of financial assets and decrease consumption,
since households feel poorer (and vice versa for lower
prices).
 The foreign trade effect means that higher prices
decrease exports and increase imports (and vice versa
for lower prices).
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Changes in Aggregate Demand (a)

Aggregate demand changes are shown by shifts in the
AD curve.
 An increase in spending causes a rightward shift in the
AD curve.
 A decrease in spending causes a leftward shift in the AD
curve.
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Changes in Aggregate Demand (b)
Figure 10.2, Page 262
Aggregate Demand
Schedule
Price
Level
Real GDP
AD0
AD1
(2002 $ billions)
200
160
120
650
700
750
700
750
800
Price Level (GDP deflator,
2002 = 100)
Aggregate Demand Curve
200
160
120
AD0
80
AD1
40
0
650
700
750
Real GDP (2002 $ billions)
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800
Aggregate Demand Factors (a)

AD changes are caused by aggregate demand factors
related to each of the four main spending components:
 consumption (C)




disposable income
wealth (other than wealth changes caused by a varying price
level)
consumer expectations
interest rates
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Aggregate Demand Factors (b)
 investment (I)


interest rates
business expectations
 government purchases (G)
 net exports (X-M)


foreign incomes
exchange rates
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Investment Demand (a)


Investment demand is the relationship between the
interest rate and investment and depends on the real
rate of return and the real interest rate.
Businesses pursue projects whose real rate of return at
least equals the real interest rate, which means the
investment demand curve is downward-sloping, since
more projects are profitable at lower interest rates.
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Investment Demand (b)
Figure 10.3, Page 264
Investment Demand Schedule
Real
Total
Point on Projects
Interest Investment Graph Undertaken
Rate
(%) (2002 $ billions)
12
8
4
0
30
60
a
b
c
-A, B
A, B, C, D
Real Rate of Return and
Real Interest Rate (%)
Investment Demand Curve
12
a
b
8
c
4
A
0
B
C
30
D1
D
60
Investment (2002 $ billions)
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Shifts in the Aggregate Demand Curve
Figure 10.4, Page 266
Aggregate demand increases and the
AD curve shifts to the right, with the
following:
Aggregate demand decreases and the
AD curve shifts to the left, with the
following:
(1) An increase in consumption due to
(a) a rise in disposable income
(b) a rise in wealth unrelated to a
change in price level
(c) an expected rise in prices or
incomes
(d) a fall in interest rates
(2) An increase in investment due to
(a) a fall in interest rates
(b) an expected rise in profits
(3) An increase in government purchases
(4) An increase in net exports due to
(a) a rise in foreign income
(b) a fall in value of the Canadian
dollar
(1) A decrease in consumption due to
(a) a fall in disposable income
(b) a fall in wealth unrelated to a
change in price level
(c) an expected fall in prices or
incomes
(d) a rise in interest rates
(2) A decrease in investment due to
(a) a rise in interest rates
(b) an expected fall in profits
(3) A decrease in government purchases
(4) A decrease in net exports due to
(a) a fall in foreign income
(b) a rise in value of the Canadian
dollar
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Aggregate Supply (a)

Aggregate supply (AS) is:
 the relationship between the general price level and real
output in an economy
 shown as a schedule or curve
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Aggregate Supply (b)
Figure 10.5, Page 268
Aggregate Supply
Schedule
Price Real GDP Point on
Level
Graph
(2002,
$ billions)
120
160
200
240
650
700
725
730
a
b
c
d
Price Level (GDP deflator,
2002 = 100)
Aggregate Supply Curve
240
AS
d
200
c
160
b
120
a
Potential
Output
80
40
0
650
675
700
725 730
Real GDP (2002 $ billions)
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The Aggregate Supply Curve


The AS curve is upward-sloping because higher prices
encourage businesses to produce more, while at lower
prices businesses are forced to reduce output.
The AS curve becomes steep above potential output
because a relatively large increase in the price level is
required if businesses are to increase output in this
range.
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Short-Run Changes in Aggregate
Supply

Short-run AS changes are shown by shifts in the AS
curve and a constant potential output for the economy.
 A short-run increase in AS occurs when the AS curve
shifts rightward while potential output stays constant.
 A short-run decrease in AS occurs when the AS curve
shifts leftward while potential output stays constant.
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A Short-Run Change in Aggregate Supply
Figure 10.6, page 269
Aggregate Supply
Schedule
Price
Level
Real GDP
AS0
AS1
(2002 $ billions)
120
160
200
240
650
700
725
730
700
725
730
731
Price Level (GDP deflator,
2002 = 100)
Aggregate Supply Curve
240
200
160
120
80
AS1
AS0
Potential
Output
40
0
650
675
700
725
Real GDP (2002 $ billions)
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750
Long-Run Changes in Aggregate
Supply

Long-run AS changes are shown by shifts in both the
AS curve and in potential output.
 A long-run increase in AS occurs when the AS curve and
potential output both shift rightward.
 A long-run decrease in AS occurs when the AS curve and
potential output both shift leftward.
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A Long-Run Change in Aggregate Supply
Figure 10.7, Page 269
Aggregate Supply Curve
Aggregate Supply
Schedule
Price
Level
Real GDP
AS0
AS1
(2002 $ billions)
120
160
200
240
650
700
725
730
700
750
775
780
Price Level (GDP deflator,
2002 = 100)
AS0
AS1
240
200
160
120
40
0
New
Potential
Output
Original
Potential
Output
80
650
725
775
Real GDP (2002 $ billions)
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Aggregate Supply Factors

AS changes are caused by aggregate supply factors
related either to short-run or long-run trends.
 Short-run changes in AS are caused by varying input
prices.
 Long-run changes in AS are caused by varying:



resource supplies
productivity
government policies
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Shifts in the Aggregate Supply Curve (a)
Figure 10.8, Page 271
Aggregate supply increases, with the
AS curve shifting to the right, and
potential output staying the same
with the following:
Aggregate supply decreases with the
AS curve shifting to the left, and
potential output staying the same
with the following:
(1) A decrease in input prices due to
(a) a fall in wages
(b) a fall in raw material prices
(1) An increase in input prices due to
(a) a rise in wages
(b) a rise in raw material prices
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Shifts in the Aggregate Supply Curve (b)
Figure 10.8, Page 271
Aggregate supply increases, with the
AS curve shifting to the right, and
potential output increasing with the
following:
Aggregate supply decreases, with the
AS curve shifting to the left, and
potential output decreasing with the
following:
(1) An increase in supplies of economic
resources due to
(a) more labour supply
(b) more capital stock
(c) more land
(d) more entrepreneurship
(2) An increase in productivity due to
technological progress
(3) A change in government policies
(a) lower taxes
(b) less government regulation
(1) A decrease in supplies of economic
resources due to
(a) less labour supply
(b) less capital stock
(c) less land
(d) less entrepreneurship
(2) A decrease in productivity due to
technological decline
(3) A change in government policies
(a) higher taxes
(b) more government regulation
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Equilibrium in the Economy (a)

An economy’s equilibrium occurs at the intersection of
the AD and AS curves.
 A price level above equilibrium means an unintended
increase in inventories (or positive unplanned
investment), lowering the price level towards
equilibrium.
 A price level below equilibrium leads to an unintended
decrease in inventories (or negative unplanned
investment), raising the price level towards equilibrium.
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An Economy at Equilibrium
Figure 10.9, Page 273
Aggregate Demand and Supply Curves
AS
Aggregate Demand and
Supply Schedules
Price
Level
AS – AD
(surplus (+) or
shortage (-))
(2002 $ billions)
200
160
120
(725 – 650) = +75
(700 – 700) = 0
(650 – 750) = -100
Price Level (GDP deflator,
2002 = 100)
200
a
a
Positive Unplanned
Investment
160
b
120
c
c
80
AD
Negative Unplanned
Investment
40
0
650
700
750
Real GDP (2002 $ billions)
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800
Equilibrium in the Economy (b)



An economy’s equilibrium occurs at a point where
total injections (I+G+X) equal total withdrawals
(S+T+M).
When total injections exceed total withdrawals then
real output and spending expand until a new balance
is achieved.
When total withdrawals exceed total injections then
real output and spending contract until a new balance
is achieved.
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An Economy at Its Potential Output
Figure 10.10, Page 275
AS
Price Level (GDP deflator,
2002 = 100)
240
200
160
120
80
Potential
Output
40
725
0
Real GDP (2002 $ billions)
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AD
Recessionary and Inflationary
Gaps

A recessionary gap:
 occurs when equilibrium output falls short of potential
output, and is associated with an unemployment rate
above the natural rate

An inflationary gap:
 occurs when equilibrium output exceeds potential
output, and is associated with an unemployment rate
below the natural rate as well as increased pressure on
prices
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Recessionary and Inflationary Gaps
Figure 10.11, Page 276
Recessionary Gap
Inflationary Gap
AS
Potential
Output
200
160
120
80
Recessionary
Gap
40
AD
0
240
AS
700
Price Level (GDP deflator,
2002 = 100)
Price Level (GDP deflator,
2002 = 100)
240
725
Real GDP (2002 $ billions)
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200
Inflationary
Gap
AD
160
120
80
40
0
Potential
Output
725
730
Real GDP (2002 $ billions)
Economic Growth (a)

Economic growth can be defined in two ways:
 The percentage increase in an economy’s total output
(e.g. real GDP) is most appropriate when measuring an
economy’s overall productive capacity.
 The percentage increase in per capita output (e.g. per
capita real GDP) is most appropriate when measuring
living standards.
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Economic Growth (b)

Economic growth can also be portrayed using the
production possibilities curve in two ways:
 an outward shift in the production possibilities curve
due to technological change or an increase in economic
resources
 a movement towards the curve because not all resources
have been employed or used to their fullest capacity
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The Process of Economic Growth
Figure 10.12, Page 278
Hamburgers
PPC1
PPC0
a
40
0
1
2
Lasers
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Production Options and Their Implications
Figure 10.13, Page 279
Country A
Country B
b
Hamburgers
Hamburgers
250
c
100
a
40
0
d
200
PPC
1
PPCA
2
Lasers
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PPC
0
1
2
Lasers
PPCB
The Rule of 72

The Rule of 72:
 shows the effects of exponential growth
 states that the number of years it takes a variable to
double can be estimated by dividing 72 by the variable’s
annual percentage change
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GDP and Growth Rates
Figure 10.14, Page 280
Year
Year
Year
Year
Year
Year
Year
Year
Year
Year
Year
1
2
3
4
5
6
7
8
9
10
11
Real GDP in Country X
(2% annual growth
in real GDP)
Real GDP in Country Y
(4% annual growth
in real GDP)
$ 100.00 billion
102.00 billion
104.04 billion
106.12 billion
108.24 billion
110.41 billion
112.62 billion
114.87 billion
117.17 billion
119.51 billion
121.90 billion
$100.00 billion
104.00 billion
108.16 billion
112.49 billion
116.99 billion
121.67 billion
126.53 billion
131.59 billion
136.86 billion
142.33 billion
148.02 billion
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Sources of Economic Growth (a)


A main cause of growth in Canada’s real output is the
increase in the quantity of labour.
Growth in per capita output is closely associated with
growth in labour productivity, which depends on six
factors:
 the quantity of capital
 technological progress
 the quality of labour
 efficiency in production
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Sources of Economic Growth (b)
 the quantity of natural resources
 social and political factors
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Labour Productivity Growth in Selected
Countries (1973-2006)
Figure 10.15, Page 281
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The Benefits of Growth

There are three main advantages of economic growth:
 its positive effect on living standards
 its possible effect on social improvements
 its psychological benefits
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The Costs of Growth

There are three main disadvantages of economic
growth:
 its opportunity cost in terms of sacrificed current
consumption
 its environmental costs
 its social costs
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Canada’s Economic Growth (a)
Figure 10.16, Page 287
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Economic Growth in Canada
 Before World War I (1870-1914), Canada’s per-capita
output (in 1997 dollars) more than doubled from $2312
to $5283.
 In the interwar period (1914-1945), the country’s percapita real output almost doubled from $5283 to
$9660.
 In the postwar period (1945-), per-capita real output
has increased more than four times.
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Business Cycles (a)

The business cycle is the cycle of expansions and
contractions in an economy.
 An expansion is a sustained rise in real output.
 A contraction is a sustained fall in real output.
 A peak is the point in the business cycle at which real
output is at its highest.
 A trough is the point in the business cycle at which real
output is at its lowest.
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The Business Cycle
Figure 10.17, Page 288
Real GDP
CONTRACTION
EXPANSION
Long-Run Trend
of Potential Output
Peak
a
c
Recessionary gap
Inflationary gap
b
d
Trough
Time
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Contractions

A contraction:
 is usually caused by a decrease in AD magnified by the
reactions of both households and businesses, who spend
less due to pessimism about the future
 may be a recession, which is a decline in real output for
six months or more
 may be a depression, which is a particularly long and
harsh period of reduced real output
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Expansions

An expansion is usually caused by an increase in AD
magnified by the reactions of both households and
businesses as they spend more due to more optimistic
expectations of the future.
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Expansion and Contraction
Figure 10.18, Page 289
Price Level (GDP deflator,
2002 = 100)
AS
f
240
Inflationary
Gap
160
e
AD0
Potential
Output
AD1
0
700
725
730
Real GDP (2002 $ billions)
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Recessionary
Gap
The Aggregate Expenditures Model
 The aggregate demand and aggregate supply approach
highlights the impact of price changes on spending
and output.
 In contrast, the aggregate expenditures model focuses
on individual spending components while assuming
that the price level is constant.
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Consumption and Saving (a)
 Households divide their disposable income (DI)
between consumption (C) and saving (S).
 We assume the only component of C to change with DI
is purchases of domestically produced goods.
 Then the effect of a change in DI on consumption is
shown by MPC and the effect on saving is shown by
MPS.
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Consumption and Saving (b)
 When defined relative to disposable income, both
MPC and MPS must sum to one.
 For example, if a $200 billion increase in DI raises C by
$150 billion, then MPC is 0.75 (or $150 b. divided by $200
b.). Meanwhile, the remaining $50 is saved, which
means that MPS is 0.25 (or $50 b. divided by $200 b.).
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Consumption and Saving
Figure A, page 297
Consumption and Saving Lines
Consumption and Saving
Schedules
DI
0
200
400
600
800
1000
1200
1400
C
($ billions)
S
200
350
500
650
800
950
1100
1250
-200
-150
-100
-50
0
50
100
150
Consumptions, Savings ($ billions)
1400
C
1200
1000
800
600
$1250b.
400
200
$200b.
0
-$200b.
-200
$800b.
S
$150b.
200 400 600
800 1000 1200 1400
Disposable Income ($ billions)
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The Spending-Output Approach (a)
 In a private economy with no government purchases or
taxes, DI and GDP are equal.
 Using the spending-output approach, equilibrium
occurs where the aggregate expenditures (AE) line
meets the 45-degree line passing through the origin.
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The Spending-Output Approach (b)
 Along the 45-degree line, all output produced is
purchased.
 At GDP levels below the equilibrium level, there is
negative unplanned investment, since AE exceeds the
45-degree line. GDP expands until equilibrium is
attained.
 At GDP levels above the equilibrium level, there is
positive unplanned investment, since AE is below the
45-degree line. GDP contracts until equilibrium is
attained.
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Equilibrium with No Government (a)
Figure B, page 298 (continued in part (b))
-$50 b.
positive
unplanned
investment
1400
Spending-Output Approach
C
I
($ billions)
0
200
400
600
800
1000
1200
1400
200
350
500
650
800
950
1100
1250
25
25
25
25
25
25
25
25
X-M
25
25
25
25
25
25
25
25
AE
250
400
550
700
820
1000
1150
1300
Expenditures ($ billions)
GDP
1200
-$50 b.
negative
unplanned
investment
1000
800
AE0 = C + I + (X – M)
C
a
600
400
200
0
45°
200 400 600 800 1000 1200 1400
GDP ($ billions)
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The Injections-Withdrawals
Approach (a)
 Using the injections-withdrawals approach,
equilibrium is found where total injections (I+X) equal
total withdrawals (S+M).
 This approach gives the same equilibrium GDP as does
the spending-output approach.
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Equilibrium with No Government (b)
Injections-Withdrawals Approach
GDP
0
200
400
600
800
1000
1200
1400
S
-200
-150
-100
-50
0
50
100
150
M
S+M
($ billions)
350
350
350
350
350
350
350
350
150
200
250
300
350
400
450
500
I
25
25
25
25
25
25
25
25
X
375
375
375
375
375
375
375
375
I+X
400
400
400
400
400
400
400
400
Injections, Withdrawals ($ billions)
Figure B, page 298 (continued from part (a))
600
b
400
I+X
S
200
0
S+M
I
200 400 600 800 1000 1200 1400
-200
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GDP ($ billions)
Making an Economy Grow

Paul Romer:
 has devised a new growth theory which emphasizes the
role of knowledge as an integral factor of production
along with labour and capital
 argues that new ideas should be given a low price to
stimulate further discoveries
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Economic Development (OLC)
The World’s Rich and Poor

The World Bank classifies nations into three groups
based on their per capita GNP (2007 figures):
 high-income countries (US$11456 or more)
 middle-income countries (US$936 to $11455)
 low-income countries (US $935 or less)
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Economic Development (OLC)
Indicators of Living Standards for Selected Countries
(a)
Per Capita
GNP
(2007)
Figure B
High-Income Countries
1. Sweden
2. U.S.
3. Canada
4. Japan
All high-income
countries
Life
Infant
Adult
Carbon Dioxide
Average Population
(millions)
Expectancy
Mortality
Illiteracy
Emissions
Annual
at
(per 1000 (females %)
per capita
Growth
Birth
live
births)
(2005)
(metric
tonnes)
Rate (%)
(years,
(2006)
(2004)
(2006-2007)
2006)
46 060
44 040
39 420
37 670
1.8
-2.1
1.7
1.5
9
307
33
128
79
75
79
78
3
8
6
4
…
…
…
…
5.9
20.6
20.0
9.8
37 566
2.0
1056
76
7
99
13.1
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Economic Development (OLC)
Indicators of Living Standards for Selected Countries (b)
Figure B
Per Capita
GNP
(2007)
Middle-Income Countries
1. Hungary
11 570
2. Mexico
8 340
3. China
2 360
4. India
950
All middle-income
countries
2872
Life
Infant
Adult
Carbon Dioxide
Average Population
(millions)
Expectancy
Mortality
Illiteracy
Emissions
Annual
at
(per 1000 (females %)
per capita
Growth
Birth
live
births)
(2005)
(metric
tonnes)
Rate (%)
(years,
(2006)
(2004)
(2006-2007)
2006)
1.5
2.3
11.2
7.7
10
105
1320
1123
69
72
70
63
7
35
24
76
…
92
91
61
5.7
4.3
3.9
1.2
6.9
4260
67
49
90
3.2
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Economic Development (OLC)
Indicators of Living Standards for Selected Countries (c)
Figure B
Per Capita
GNP
(2007)
Low-Income Countries
1. Yemen
2. Papua New Guinea
3. Bangladesh
4. Ethiopia
All low-income countries
World
Life
Infant
Adult
Carbon Dioxide
Average Population
(millions)
Expectancy
Mortality
Illiteracy
Emissions
Annual
at
(per 1000 (females %)
per capita
Growth
Birth
live
births)
(2005)
(metric
tonnes)
Rate (%)
(years,
(2006)
(2004)
(2006-2007)
2006)
870
850
470
220
578
0.6
4.2
4.8
8.4
4.3
22
6
150
79
1296
61
55
63
51
56
100
73
69
123
135
54
55
47
36
61
1.0
0.4
0.3
0.1
0,6
7958
2.6
6612
66
72
82
4.3
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Economic Development (OLC)
The Gap Between Rich and Poor

Despite higher average growth rates in low-income
countries than in high-income countries, per capita
incomes in most low-income countries have risen less
quickly in dollar terms.

This is because of the relative size of incomes in each
group of countries.
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Economic Development (OLC)
The Dynamics of Development


Economic development is an increase in a country’s
per capita income accompanied by a rise in living
standards for the bulk of the population.
Many low-income countries trying to foster economic
development are trapped by the vicious cycle of
poverty, whereby low living standards result in slow
growth, thereby keeping living standards low in the
future.
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Economic Development
The Vicious Cycle of Poverty
Figure C
Low per
capita income
Low productivity
growth
Low investment in capital
and human resources
Labour-intensive
production
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Rapid population
growth
Economic Development (OLC)
Strategies for Development (a)

Breaking the vicious cycle of poverty involves three
domestic strategies for development:
 ensuring political and economic stability
 investing in human capital and capital goods
 population control
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Economic Development
Global Populations Trends
Figure D
1990
Low- and Middle-Income Countries
Sub-Saharan Africa
East Asia and Pacific
South Asia
Europe and Central Asia
Middle East and Northern Africa
Latin America and the Caribbean
High-Income Countries
World
4 353
514
1 596
1 113
466
226
438
904
5 256
Population
(millions)
2004
2020
(estimated)
5 361
726
1 870
1 447
473
300
546
1 004
6 365
6 512
1 033
2 108
1 835
477
399
660
1 062
7 574
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Estimated Annual;
Growth Rate (%)
1990-2004 2004-2020
1.5
2.5
1.1
1.9
0.1
2.0
1.6
0.8
1.4
1.2
2.2
0.7
1.5
0.1
1.8
1.2
0.4
1.1
Economic Development (OLC)
Strategies for Development (b)

Breaking the vicious cycle of poverty involves two
international strategies for development:
 trade liberalization
 foreign aid
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Finding the Key (a)
(Online Learning Centre)

Research on long-term economic growth show that
average global living standards hardly changed until a
century ago.
In 2500 BCE, per capita consumption in today’s dollars
was about $270 (US); by 1500 this had risen only slightly
to $360 (US); by 1600 it fell to $322 (US), and today it is
$3116 (US).
 Population figures have also risen over the past 100
years, from 1.6 billion in 1900 to 6 billion today.

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Finding the Key (b)
(Online Learning Centre)

According to research on this issue, the growth rates of
the past century are due largely to the following two
factors:
 population growth, with more people producing more
ideas and knowledge
 a major improvement in many parts of the world in
institutions that promote innovation – in particular
property rights for inventors
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A New Capitalist Manifesto (a)
(Online Learning Centre)
 According to Peruvian Economist Hernando de Soto,
capital serves not only a technical function but also a
social function.
 Without capital, individuals are unable to exchange,
lease and pledge productive assets, which creates
obstacles to entrepreneurial activity.
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A New Capitalist Manifesto (b)
(Online Learning Centre)
 De Soto claims that large segments of the population
of low-income countries live in the extra-legal sector,
so cannot gain the advantages from private property
rights.
 To change this, government leadership is required to
ensure that extra-legal realities are incorporated in
property systems through a grassroots approach.
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5th edition
by Mark Lovewell
Chapter 10
The End
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