m o d e l o f
a g g r e g a t e d e m a n d
a n d a g g r e g a t e
s u p p l y t o e x p l a i n
e c o n o m i c
f l u c t u a t i o n s
L e a r n t h r e e k e y
f a c t s a b o u t s h o r t -
r u n e c o n o m i c
f l u c t u a t i o n s
C o n s i d e r h o w t h e
e c o n o m y i n t h e
s h o r t r u n d i f f e r s
f r o m t h e e c o n o m y i n
t h e l o n g r u n
Economic activity fluctuates from year to year. In most years, the production of
goods and services rises. Because of increases in the labor force, increases in the
capital stock, and advances in technological knowledge, the economy can produce
more and more over time. This growth allows everyone to enjoy a higher standard
of living. On average over the past 50 years, the production of the U.S. economy as
measured by real GDP has grown by about 3 percent per year.
In some years, however, this normal growth does not occur. Firms find them-
selves unable to sell all of the goods and services they have to offer, so they cut
back on production. Workers are laid off, unemployment rises, and factories are
left idle. With the economy producing fewer goods and services, real GDP and
other measures of income fall. Such a period of falling incomes and rising
A G G R E G A T E D E M A N D
A N D
A G G R E G A T E S U P P L Y
7 0 1 7 0 2
PA R T T W E LV E
S H O R T - R U N E C O N O M I C F L U C T U AT I O N S
unemployment is called a recession if it is relatively mild and a depression if it is
more severe.
What causes short-run fluctuations in economic activity? What, if anything,
can public policy do to prevent periods of falling incomes and rising unemploy-
ment? When recessions and depressions occur, how can policymakers reduce their
length and severity? These are the questions that we take up in this and the next
two chapters.
The variables that we study in the coming chapters are largely those we have
already seen. They include GDP, unemployment, interest rates, exchange rates,
and the price level. Also familiar are the policy instruments of government spend-
ing, taxes, and the money supply. What differs in the next few chapters is the time
horizon of our analysis. Our focus in the previous seven chapters has been on the
behavior of the economy in the long run. Our focus now is on the economys short-
run fluctuations around its long-run trend.
Although there remains some debate among economists about how to analyze
short-run fluctuations, most economists use the model of aggregate demand and
aggregate supply. Learning how to use this model for analyzing the short-run effects
of various events and policies is the primary task ahead. This chapter introduces
the models two key piecesthe aggregate-demand curve and the aggregate-
supply curve. After getting a sense of the overall structure of the model in this
chapter, we examine the pieces of the model in more detail in the next two
chapters.
T H R E E K E Y FA C T S
A B O U T E C O N O M I C F L U C T U AT I O N S
Short-run fluctuations in economic activity occur in all countries and in all times
throughout history. As a starting point for understanding these year-to-year fluc-
tuations, lets discuss some of their most important properties.
FA C T 1 : E C O N O M I C F L U C T U AT I O N S A R E
I R R E G U L A R A N D U N P R E D I C TA B L E
Fluctuations in the economy are often called the business cycle. As this term sug-
gests, economic fluctuations correspond to changes in business conditions. When
real GDP grows rapidly, business is good. Firms find that customers are plentiful
and that profits are growing. On the other hand, when real GDP falls, businesses
have trouble. In recessions, most firms experience declining sales and profits.
The term business cycle is somewhat misleading, however, because it seems to
suggest that economic fluctuations follow a regular, predictable pattern. In fact,
economic fluctuations are not at all regular, and they are almost impossible to pre-
dict with much accuracy. Panel (a) of Figure 31-1 shows the real GDP of the U.S.
economy since 1965. The shaded areas represent times of recession. As the figure
shows, recessions do not come at regular intervals. Sometimes recessions are close
r e c e s s i o n
a period of declining real incomes
and rising unemployment
d e p r e s s i o n
a severe recession C H A P T E R 3 1
A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY
7 0 3
Billions of
1992 Dollars
Real GDP
(a) Real GDP
Billions of
1992 Dollars
Investment spending
(b) Investment Spending
Percent of
Labor Force
Unemployment rate
(c) Unemployment Rate
300
400
500
600
700
800
900
1,000
$1,100
2,500
3,000
3,500
4,000
4,500
5,000
5,500
6,000
6,500
$7,000
0
2
4
6
8
10
12
1965
1970
1975
1980
1985
1990
1995
1965
1970
1975
1980
1985
1990
1995
1965
1970
1975
1980
1985
1990
1995
F i g u r e 3 1 - 1
A L
OOK AT
S
HORT
-R
UN
E
CONOMIC
F
LUCTUATIONS
.
This figure shows real GDP in
panel (a), investment spending
in panel (b), and unemployment
in panel (c) for the U.S. economy
using quarterly data since 1965.
Recessions are shown as the
shaded areas. Notice that real
GDP and investment spending
decline during recessions, while
unemployment rises.
S
OURCE
: U.S. Department of Commerce;
U.S. Department of Labor. 7 0 4
PA R T T W E LV E
S H O R T - R U N E C O N O M I C F L U C T U AT I O N S
together, such as the recessions of 1980 and 1982. Sometimes the economy goes
many years without a recession.
FA C T 2 : M O S T M A C R O E C O N O M I C
Q U A N T I T I E S F L U C T U AT E T O G E T H E R
Real GDP is the variable that is most commonly used to monitor short-run changes
in the economy because it is the most comprehensive measure of economic activ-
ity. Real GDP measures the value of all final goods and services produced within a
given period of time. It also measures the total income (adjusted for inflation) of
everyone in the economy.
It turns out, however, that for monitoring short-run fluctuations, it does
not really matter which measure of economic activity one looks at. Most macroeco-
nomic variables that measure some type of income, spending, or production fluc-
tuate closely together. When real GDP falls in a recession, so do personal
income, corporate profits, consumer spending, investment spending, industrial
production, retail sales, home sales, auto sales, and so on. Because recessions are
economy-wide phenomena, they show up in many sources of macroeconomic data.
Although many macroeconomic variables fluctuate together, they fluctuate by
different amounts. In particular, as panel (b) of Figure 31-1 shows, investment
spending varies greatly over the business cycle. Even though investment averages
about one-seventh of GDP, declines in investment account for about two-thirds of
the declines in GDP during recessions. In other words, when economic conditions
deteriorate, much of the decline is attributable to reductions in spending on new
factories, housing, and inventories.
Youre fired. Pass it on. C H A P T E R 3 1
A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY
7 0 5
FA C T 3 : A S O U T P U T FA L L S , U N E M P L O Y M E N T R I S E S
Changes in the economys output of goods and services are strongly correlated
with changes in the economys utilization of its labor force. In other words, when
real GDP declines, the rate of unemployment rises. This fact is hardly surprising:
When firms choose to produce a smaller quantity of goods and services, they lay
off workers, expanding the pool of unemployed.
Panel (c) of Figure 31-1 shows the unemployment rate in the U.S. economy
since 1965. Once again, recessions are shown as the shaded areas in the figure. The
figure shows clearly the impact of recessions on unemployment. In each of the re-
cessions, the unemployment rate rises substantially. When the recession ends and
real GDP starts to expand, the unemployment rate gradually declines. The unem-
ployment rate never approaches zero; instead, it fluctuates around its natural rate
of about 5 percent.
Q U I C K Q U I Z :
List and discuss three key facts about economic fluctuations.
E X P L A I N I N G S H O R T - R U N
E C O N O M I C F L U C T U AT I O N S
Describing the regular patterns that economies experience as they fluctuate over
time is easy. Explaining what causes these fluctuations is more difficult. Indeed,
compared to the topics we have studied in previous chapters, the theory of eco-
nomic fluctuations remains controversial. In this and the next two chapters, we de-
velop the model that most economists use to explain short-run fluctuations in
economic activity.
H O W T H E S H O R T R U N D I F F E R S F R O M T H E L O N G R U N
In previous chapters we developed theories to explain what determines most im-
portant macroeconomic variables in the long run. Chapter 24 explained the level
and growth of productivity and real GDP. Chapter 25 explained how the real in-
terest rate adjusts to balance saving and investment. Chapter 26 explained why
there is always some unemployment in the economy. Chapters 27 and 28 ex-
plained the monetary system and how changes in the money supply affect the
price level, the inflation rate, and the nominal interest rate. Chapters 29 and 30 ex-
tended this analysis to open economies in order to explain the trade balance and
the exchange rate.
All of this previous analysis was based on two related ideasthe classical di-
chotomy and monetary neutrality. Recall that the classical dichotomy is the s