Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

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N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

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Chapter 22: Aggregate Demand, Aggregate Supply, and a New Equilibrium

Figure 22.1: Spending on construction grows during economic expansions and falls during recessions. [1]​

   The Economy: Job Market Slump Is Expected To Remain Grim in Near Term [1]

"The nation's labor market is experiencing one of its most protracted slumps in post-World War II history, and economists don't see it getting much better in the next few months.

The Labor Department reported Friday that payroll employment contracted by 101,000 in December, led by more hemorrhaging in the manufacturing sector, which eliminated jobs for the 29th straight month, and by struggling retailers that hired less than they normally do during the Christmas selling season. The unemployment rate held steady in December at 6%, but mainly because workers are leaving the labor force, which shrank by 191,000 last month."

                       -The Wall Street Journal, January 13, 2003

           ​May Jobs Growth Unexpectedly Strong [2]

​"The American economy bounced back in May, as employers added nearly twice the numbers of jobs they had in April, and the manufacturing sector grew at its fastest rate in more than a year…

The report found that not only did businesses hire more employees in May, they paid workers more as well. Hourly wages for rank-and-file workers rose 3.8 percent over the last year."

                          -The New York Times, June 3, 2006

            ​U.S. Jobless Rate Hits 14-Year High [3]

"In a sign that American workers may face even more difficult times for many months to come, the nation’s unemployment rate last month jumped to the highest level in 14 years as job losses mounted."

                        -The New York Times, November 7, 2008

         Skilled Workers Are Scarce in Tight Labor Market [4]

"​Small U.S. employers have complained that it’s difficult to find the right workers. Now, with unemployment near its lowest in nine years, they are doing more of the difficult work of training them."

                                    ​ -The Wall Street Journal, February 2,  2017

​Why can the economy be 'turbo-charged' in one year and find that its “labor market is experiencing one of its most protracted slumps in post-World War II history” in another? When unemployment is high, millions of workers who could be producing valuable goods and services are idle. So how can it be that in 2008 “the nation’s unemployment rate…jumped to the highest level in 14 years as job losses mounted,” when there are so many social and economic problems and plenty of people who would very much enjoy having more goods and services or more travel or more leisure? And yet recently we hear that “Skilled Workers Are Scarce in Tight Labor Market.” Sometimes, unemployment is very low, and nearly everyone who wants a job can find one quickly. In this chapter, we will begin to explore the forces behind unemployment, inflation, and economic expansion and contraction.

22.1 Objectives for Chapter 22

​ After completing this chapter, you will be able to:

  • Derive an aggregate demand curve, explain movements along the curve, and describe how and why the curve shifts.
  • Derive an aggregate supply curve, explain movements along the curve, and describe how and why the curve shifts.
  • Use the aggregate demand and aggregate supply model to discuss how changes in spending and changes in the factors influencing our ability to produce goods and services affect output, employment, and prices in the economy.
  • Discuss how changes in spending and in the factors influencing our ability to produce goods and services affect output, employment, and prices in the economy without specific references to the graphical model.

​Changing rates of growth of real GDP, inflation, employment, and unemployment affect the well-being of millions of people. Figure 22.2 shows real GDP, employment, unemployment, and rates of inflation since 1970. Real GDP actually fell during some years (marked in shaded areas) in the mid-1970s, in the early 1980s, at the beginning of the 1990s, and most recently between 2007 and 2009. These periods of falling GDP coincide with recessions.

​Unemployment rose and employment fell during each period of low or negative GDP growth. Normally, during recessions, production falls, employment falls, and unemployment rises. The rises in unemployment clearly coincide with recessions in the second chart in Figure 22.2. The changes in employment are even more dramatic in the third chart.

Historically, inflation tended to rise before recessions and then fall during and after recessions (1973-75, 1980, 1990-91).

ECN22_Figure22.1_updated.jpg
Figure 22.2: Real Gross Domestic Product, Inflation, and Unemployment.

To explain these changes in the overall economy, we will develop a model for the whole economy – one that is similar to the supply and demand model used to analyze markets for individual products. Just as it was in the supply and demand model, price and quantity are determined jointly by spending decisions and production decisions. One of the big differences, though, is that we’ll be thinking about real GDP instead of the quantity of a single good, and we’ll also be looking at the overall price level instead of the price of a single good. Our first step is to consider how spending in the economy is related to the overall price level, holding everything else constant – the demand side of our model. The second step is to look at our ability to produce and how it is related to the overall price level, again holding everything else constant – the supply side. And finally, we put the two together in order to understand the events contributing to a variety of changing economic conditions.

Let’s try to get the basic idea with a thought experiment. Imagine an economy where the only thing produced and consumed are meals at restaurants. Everyone who works, works in some capacity for a restaurant, either growing the food, preparing it, serving it, or maintaining the restaurant. Households earn income from working and from the profits of the restaurants they own and spend that income on meals at restaurants. Of course, such an economy is absurd, but this is an example of the kind of simplifications we often start with in order to begin to study a very complicated topic.

Question 22.01

Question 22.01

Suppose that suddenly most people in our restaurant economy decide they wish to cut back on spending by making fewer trips to restaurants and by buying less expensive items when they do go out to eat. How are restaurants likely to respond to this sudden change? Will they continue to produce the same amount of meals when fewer people show up to buy them? What might restaurant owners do to attract more customers?

Hover here to see the hint for Question 22.01.
Click here to see the answer to Question 22.01. 

Question 22.02

Question 22.02

Now suppose that suddenly everyone decides to spend more at restaurants. How will restaurants respond? How does a restaurant’s capacity to produce affect the restaurant’s response?

Hover here to see the hint for Question 22.02. 
Click here to see the answer to Question 22.02.

Question 22.03

Question 22.03

Suppose a restaurant wishes to expand capacity, but cannot find any workers to hire at the going wage. What might the restaurant manager do? How might this affect the average price of a meal?

Hover here to see the hint for Question 22.03. 
Click here to see the answer to Question 22.03. 

With this simple story, we have illustrated that the quantity produced and the price level depend both on spending plans and on the capacity to produce. In the following sections, we will carefully lay out a model that includes other types of spending decisions as well as production decisions.

​The supply and demand model used to describe markets for individual goods and services is a useful starting place for thinking about supply and demand in the entire economy. The nomenclature will be somewhat different. Demand for all goods and services in the economy is called aggregate demand. Similarly, the supply of these goods becomes aggregate supply. The quantities and prices used in the aggregate models are quite different from the quantities and prices determined in the individual market model. The quantities are all goods and services. We will use real GDP as a measure of those quantities. The price for a single good or service is obviously inappropriate. The appropriate measure is the average price level of all goods and services. The average price level is measured by the GDP price index (also known as the GDP deflator).

In our aggregate model, we will see movements along the aggregate demand and supply curves. Those movements will be caused by changes in prices. The aggregate demand and supply curves will also shift when other factors change. And the economy will tend to move toward an equilibrium where the aggregate quantity supplied and aggregate quantity demanded are equal. However, there are significant differences between the aggregate model and the individual market model. Those differences are primarily in how movements along the curves and how shifts of both curves are explained. So, that is where we will begin.

22.2 Aggregate Demand

Figure 22.3: Aggregate Quantity Demanded = Consumption + Investment + Government Spending + Net Exports.​​

Aggregate demand is the total amount of spending, measured in constant dollars, at each price level. So, for example, in Figure 22.3, at a price level of 112, total spending is equal to $17 trillion. That $17 trillion consists of $12 trillion of consumption, about $2 trillion of investment, $2 of trillion of government spending, and $1 trillion of net exports. Note that in total, these numbers are close to the actual data for the U.S. economy as of the second quarter of 2017, when real GDP was estimated at $17 trillion (chained 2009 dollars), and the implicit price deflator was 113. (This graph treats net exports as actually being positive, whereas they are currently a negative number. More on this issue soon.)

22.2.1 Movements Along an Aggregate Demand Curve

Demand in the model for individual product markets is downward-sloping. The primary reason for the inverse relationship between the price of a good and the quantity demanded is that as the price falls, consumers will substitute the now less expensive goods for other goods. When we use the same concept to think about the entire economy, the reasoning is more challenging. Now the model includes all goods and services, so it is difficult to understand how consumers switch from all goods and services to other goods and services. If the overall price level changes in our model, we can identify three possible effects on spending: a change in net exports, a new level of consumption spending, and a change in investment. The resulting changes in these components of total spending then lead to a change in total spending.

22.2.1.1 ​Net Exports

The net export effect is the easiest to understand, perhaps because the reasoning is the closest to the demand in an individual market. What happens to our exports, if prices rise in the U.S.? Think back to the supply and demand diagrams in chapter 8. Or think about demand for our exports.

Question 22.04

Question 22.04

What will happen to U.S. exports if U.S. prices increase? Why?

Hover here to see the hint for Question 22.04.
Click here to see the answer for Question 22.04. 

As U.S. automobile prices rise, Europeans are more likely to buy European-manufactured cars. To keep things simple, we assume for now that exchange rates remain unchanged so that a rise in the dollar price of a U.S. good means that they will be more expensive for foreigners. We discuss this further in Chapter 29: International Currency Markets. In general, as prices rise in the U.S. and all other determinants of demand for exports (income and prices abroad) remain the same, U.S. goods become relatively more expensive for people abroad to buy. Individuals and businesses abroad will substitute their own goods for ours, and the quantity demanded of U.S. exports will fall. Figure 22.4 shows a demand curve for exports and the effect on our exports of rising prices in the U.S. As the price level in the U.S. rises, our goods are more expensive and foreigners substitute their own goods.

Figure 22.4: The U.S. Export Market with Higher U.S. Prices​​

What about U.S. imports?

Graphing Question 22.01




Figure 22.5: The U.S. Import Market Shifts with Higher U.S. Prices​

If the prices of our cars increase, American consumers will buy more European- and Asian-made automobiles. Because our goods become more expensive, we will begin to substitute imports for some of our own goods and thus demand more imports into the U.S. In Figure 22.5, the U.S. demand for imports increases. As we demand more imports, the price and quantity of imports will begin to rise.

​To summarize, when U.S. prices rise, exports fall and imports rise. Net exports are equal to exports minus imports, and if exports fall and imports rise, net exports will decrease. Thus, one effect of rising prices in the U.S. is that U.S. net exports decrease. The fall in net exports reduces one part of total spending. Since the aggregate demand curve represents total spending in the economy at each price level, the aggregate quantity demanded will decrease as prices increase in the U.S. In Figure 22.6, an increase in the GDP price index from 114 to 118 would cause a fall in real GDP from $16 trillion to $14 trillion. That decrease in the aggregate quantity demanded is partly due to the decrease in net exports.

Figure 22.6: Increasing prices and falling net exports cause a decrease in the aggregate quantity demanded.​​

22.2.1.2 ​Consumption

​ A number of factors influence consumption spending, including individuals’ incomes, taxes, wealth, desires for saving, expectations, and interest rates. The primary way changes in prices affect consumption spending is through the effects of prices on wealth and then through the effects of changes in wealth on consumption. To understand how prices play a role, we begin with how changes in prices affect the real value of wealth or how many goods and services that wealth will buy.

​Currency and bank deposits make up a portion of most people’s wealth. Among OECD countries, the average fraction of wealth held as currency and deposits was between 13 percent (USA) and 80 percent (Turkey).1 As prices rise, that part of wealth will be able to buy fewer goods and services. So if the real value of wealth falls, consumption should fall. Once again, think of this happening as nothing else is changing. The effect of a change in the overall level of prices affects the real value of wealth, which in turn affects how much consumers want to buy. If consumption spending falls, total spending in the economy falls, as in Figure 22.6. The similar nature of the effects of the decrease in consumption and the decrease in net exports should be obvious. One component of total spending has decreased in both cases, and as a result, total spending has decreased. An increase in the overall level of prices has caused a decrease in aggregate quantity demanded.

Graphing Question 22.02


22.2.1.3 ​Investment

Understanding the third reason for the downward-sloping aggregate demand curve requires us to think about the interaction of two different models. As prices rise, the demand for money rises. The rationale is simply that as the dollar volume of sales increases, households and businesses need more money to facilitate a higher volume of transactions. In other words, at higher prices, we simply need more money to carry on daily life and business. For example, a large department store needs more money than does a corner newsstand. This is because a department store purchases a lot more inventory and has a much higher wage bill than a corner newsstand. The increase in the demand for money causes an increase in interest rates (note: we’ve not yet covered why this is the case, but we will do so in the chapter on Money). As interest rates rise, the cost of funds used for investment increases; investment spending thus falls; and one part of total spending decreases. So we have established that higher prices have caused total spending to fall in the economy by way of a fall in investment spending as well.

In representing these changes graphically, we begin in Figure 22.7A. An increase in the demand for money increases interest rates. In Figure 22.7B, the increase in interest rates causes a decrease in investment spending. Finally, in Figure 22.7C, the decrease in investment spending causes a decrease in the quantity of real GDP demanded. To summarize, an increase in prices causes the demand for money to rise, interest rates to rise, investment spending to fall, and thus a fall in real GDP. Again, this is a movement along the aggregate demand curve.

Figure 22.7: (A) A rise in the price level increases the demand for money, causing a rise in interest rates. (B) Higher interest rates reduces investment spending. (C) Lower investment spending decreases the aggregate quantity demanded.​

All three of these relationships – prices and net exports, wealth and consumption, and interest rates and investment – contribute to the downward-sloping shape of the aggregate demand curve. 


Question 22.05

Question 22.05

What is aggregate demand? Why does the aggregate demand curve slope downward to the right? Summarize in your own words.

Hover here to see the hint for Question 22.05.
Click here to see the answer to Question 22.05.

Graphing Question 22.03

22.2.2 Shifts in Aggregate Demand

​We have discussed how price level changes move an economy along the aggregate demand curve. But what happens to the U.S. economy as the Chinese economy rapidly expands due to better economic policy and increased investment? A rise in income abroad means an increase in international demand for U.S. products – an increase in spending on U.S. exports. Thus, a portion of total spending in the U.S. increases. This time, something other than prices is changing so the whole curve shifts. That means that the aggregate quantity demanded at each price will increase. That is the same as an increase in aggregate demand. Figure 22.8 shows an increase in the quantity demanded at each price.

Figure 22.8: An increase in incomes abroad causes an increase in the quantity demanded at every price level. This is depicted as a shift in the aggregate demand curve.​

​What would happen in the U.S. if businesses become pessimistic about future sales and consumers become worried about their own future incomes? And what if they do so to the degree that significantly affects their spending? Some businesses will reduce their investment spending, and some individuals will reduce their consumption spending. As these two parts of total spending fall, aggregate demand will decrease – a shift to the left in the aggregate demand curve, as shown in Figure 22.9.

Figure 22.9: Aggregate demand shifts to the left when businesses and consumers reduce spending at any given price level.​

​If consumption, investment, government, or net export spending change for reasons other than changes in prices, the entire aggregate demand curve shifts. If prices change, consumption, investment, or net exports will change, and there will be a movement along the aggregate demand curve. A movement along the aggregate demand curve is a change in the aggregate quantity demanded.

Question 22.06

Question 22.06

What causes changes in total spending in an economy? Summarize in your own words.

Hover here to see the hint for Question 22.06. 
Click here to see the answer to Question 22.06.

Table 22.1: Factors that influence aggregate demand by spending component.

22.2.3​ A Multiplied Effect on Total Spending

As we discussed in Chapter 21: Spending, when one of the spending components changes, it actually causes further repercussions in the economy. Think back to our circular flow model of the economy. If consumers decide to spend a larger portion of their incomes, spending rises. But we know that spending equals income, so new spending means that someone’s income also increases. Those individuals, in turn, will take part of that increase in income and spend it on goods and services. In that manner, the initial change in spending causes a multiplied effect in total spending.

​The spending multiplier indicates how much total spending, at any given price level, will change by relative to the initial change in spending. For example, if the initial change in spending is $10 million and the indirect effects of that change cause a change in total spending of $30 million, the spending multiplier is equal to three. In Figures 22.5 and 22.6, the increases or decreases in total spending were not just equal to the direct changes in the components of total spending. The effects were multiplied by the subsequent changes in income and then consumption spending.

Question 22.07

Question 22.07

Why does the aggregate demand curve slope downward to the right? In other words, explain why, holding all else constant, three of the four components of real GDP are likely to change in response to an increase in the GDP deflator. Explain exactly why (step by step).

Hover here to see the hint for Question 22.07. 
Click here to see the answer for Question 22.07.

Question 22.08

A decrease in government spending of $100 billion will cause aggregate quantity demanded at each price level to ______________.

A

Increase by $100 billion

B

Decrease by $100 billion

C

Increase by more than a $100 billion

D

Decrease by more than a $100 billion

E

Not change at all

22.3 Aggregate Supply

A local drugstore’s willingness and ability to supply prescription and nonprescription drugs and other goods at a particular price depends upon the number of employees, the size of the store, the amount of equipment, the prices of all of those inputs, and its knowledge about how to produce prescriptions and other goods and services. All individual businesses produce goods and services by hiring workers, purchasing machines, tools, and space, and using existing knowledge about how to produce particular goods. 

22.3.1 The Shape of the Aggregate Supply Curve

​Supply for the entire economy is quite similar to supply in an individual market. Supply in a market refers to the quantity of an individual product that will be supplied at each price. Supply for the entire economy, aggregate supply , represents production of all goods and services, that is, real GDP, that will occur at each price.

​The supply in a market depends upon the number of workers and their skills, the amount of capital, prices of inputs, and the available technology. Supply for the entire economy depends upon prices of all inputs, available technology, and the availability and quality of all labor and all capital.

​To draw a single aggregate supply curve, we will begin by assuming that the amount of labor and capital available to businesses is fixed along with the production technology, and the prices of inputs. We then focus on the relationship between the level of real GDP that businesses are willing and able to produce (the aggregate quantity supplied) and the price level in the economy. We will develop that relationship in three steps.

The first step is to consider the relation between aggregate quantity supplied and prices at relatively low levels of output. Once factories and stores are built, workers are trained, and technology is identified, the economy can produce a variety of levels of output if buyers are there to buy the goods. An increase in spending will simply mean that firms expand production to meet the spending. In this case, the supply curve for the entire economy (the aggregate supply curve) is horizontal. At the current level of the GDP price index, the economy will produce whatever output is demanded. The aggregate supply curve might look like the segment (1) in Figure 22.10. The interpretation is that firms in the economy will produce between zero and $14 trillion of real GDP at the current price level of 110.

At even higher levels of real GDP, the costs of additional units of output begin to increase. Remember diminishing marginal returns and increasing marginal costs? In this range of real GDP, businesses no longer have significant excess capacity. Businesses have to hire new workers, who are perhaps not as skilled as those already employed. Businesses have to use factories and machines at rates that may result in breakdowns or more maintenance than normal. Farmers may have to begin to use land that is not as productive as the land currently being used. All of these events will raise the costs of producing additional output.

If prices of goods and services increase and prices of inputs stay the same, businesses will have incentives to expand production even if additional units are more costly to produce. If prices of goods were to fall, the costs of producing would not be covered, and businesses will have incentives to cut back on output.

This second segment becomes an upward-sloping curve and is the most important part of the aggregate supply curve as this is where economies most often produce. This second segment (2) in Figure 22.10 shows the quantities of real GDP that the economy can produce at each price level when an increase in production can only happen with higher and higher costs.

Another way to think about segments (1) and (2) is that the prices of goods and services tend to be “sticky.” What economists mean is that price setters do not change price every day. Think about how long ago your barber or hair stylist changed the price they charged you. Do restaurants typically print new menus every day so they can update their prices to reflect changes in supply and demand? A great deal of research shows that for a variety of reasons, most prices do not change very frequently. Some prices, like the price of gasoline, change every day, but the prices of most of the things we buy remain unchanged for several months.

Prices are especially sticky in the downward direction; that is, prices do not fall easily (you may remember that we rarely see deflation in the economy from Chapter 19: GDP, Unemployment, and Inflation). Segment (1) in Figure 22.10 reflects this. In this region of the aggregate supply curve, a fall in aggregate demand would not cause prices to fall at all. Instead, output would drop. As aggregate demand increases and firms begin to produce more, some of them will also begin to increase price. This is because increasing production results in rising marginal cost (due to diminishing marginal product) and increases in the demand for their goods and services means that the profit-maximizing price is now higher. This idea is reflected in segment (2).

Figure 22.10: The slope of the aggregate supply curve depends on the level of real GDP. At low levels of GDP, businesses will increase production without prices increases because they have excess capacity. As spending in the economy increases, diminishing marginal product kicks in and it becomes more costly to produce additional units so prices must rise. Eventually, the economy reaches full capacity, and increases in spending only result in price increases with no additional output.​

Finally, the economy may reach a level of real GDP where, given the current quantities of labor and capital and the level of technology, it simply cannot produce any more. Until labor or capital increase or technology improves, this level of real GDP is the absolute maximum capacity. This part of the supply curve is perfectly inelastic, meaning that even with higher prices, the economy can produce only its absolute maximum - and no more. We depict this third segment (3) in Figure 22.10 as a vertical line drawn at the maximum level of real GDP.

The shape of the entire aggregate supply curve is determined by a combination of these three different segments. At low levels of output, business will increase production without price increases, if buyers want to purchase more goods and services. At some point, costs of producing additional output begin to increase, and that requires prices to increase if businesses are to become willing to increase output. Finally, at the economy’s current capacity, no more can be produced; the aggregate supply curve is perfectly inelastic.

22.3.1.2 ​Employment and the Aggregate Supply Curve

An aggregate supply curve assumes that the labor force, the amount of capital, technology, and the prices of inputs are fixed. A movement along the aggregate supply curve means that businesses are using more or less of the available labor and capital. Using more of the economy’s available labor and capital increases production. Using less reduces production. For example, a movement to the right along an aggregate supply curve will mean falling unemployment, and because the labor force is not changing, the unemployment rate must be falling. A movement to the left along a specific aggregate supply curve means a decrease in output and a rising unemployment rate.

Question 22.09

As we move up the aggregate supply curve, the amount of labor available in the economy ________.

A

Increases

B

Decreases

C

Stays the same

Question 22.10

If businesses have excess capacity and will produce more without an increase in prices, the slope of the aggregate supply curve is _______.

A

Vertical

B

Steep

C

Impossible to determine

D

Flat

22.3.2​ Shifts in Aggregate Supply

In discussing the shape of the aggregate supply curve and movements along the curve, we assumed that a number of factors were not changing. If, however, those other factors do change, the entire relationship changes.

22.3.2.1 ​Changes in the Labor Force, Capital, and Technology

More labor and more capital increase the capacity of an economy to produce. At each price level, the quantity of real GDP that can be produced increases. If a firm has more of all of its inputs, it can increase production. In the same fashion, so can the economy. Thus, when the labor force or the skill of the existing labor increases, or the number of capital increases, aggregate supply will increase. The aggregate supply curve will shift to the right.

Technological advances have similar effects. Manufacturing, farming, and data and record management have all benefited from discovery and invention of new ways of producing. Those innovations have allowed those industries to increase production using existing resources, or in some cases with fewer resources. Improvements in technology cause increases in productivity, that is, increases in the amount of production per worker or per machine. If all or many businesses experience rising productivity, the result is an increase in aggregate supply and a shift of the aggregate supply curve to the right, as is shown in Figure 22.11. Notice that as this shift in aggregate supply is drawn, a price level lower than previously possible could be obtained. With a large permanent decrease in the cost of inputs, businesses may be more motivated to cut prices than they would be in response to a reduction in aggregate demand.

Figure 22.11: An improvement in technology allow more to be produced at any given price and shifts aggregate supply to the right.​

22.3.2.2 ​A Change in Prices of Inputs

Changes in wages and prices of raw materials, land, and capital change the costs of producing. A pizza shop faced with rising prices of cheese or hourly wages for its employees will find that its profits fall at existing output levels and current prices for pizza. The owner has a strong incentive to reduce production at current pizza prices. The same is true for the entire economy. Higher input prices mean higher costs of producing. Because of those higher costs, firms will produce smaller quantities at each overall price level. An increase in input prices will reduce the aggregate supply and shift the aggregate supply curve to the left.

A decrease in input prices, with prices of the goods themselves constant, will increase profits and encourage businesses to expand production. In this case, aggregate supply increases as a result. More is produced at each existing overall price level.

Figure 22.12: A photo from Japan after the tsunami of March 11, 2011. This natural disaster severely increased the cost of producing things in the areas

most affected by the tsunami.​ [2]

​ It is important to distinguish between changes that occur within our model (changes in the overall price level and changes in the amount of goods and services produced) and changes we make from outside the model and that we explain with our model. One example of a change made outside the model would be a change in policy that affects the cost of producing things. For example, we could think about what would happen to the supply curve if the Federal Government increased the payroll tax. Other examples of outside-the-model changes that would affect the location of the aggregate supply curve include a change in the world price of oil, natural disasters, and technological discoveries, just to name a few. Figure 22.12 is a photograph taken in Japan after the tsunami of March 11, 2011. This natural disaster severely increased the cost of producing things in the areas most affected by the tsunami.

Question 22.11

​How will each of the following likely change the aggregate supply curve? Why? Answer each of these questions before you go on.

Question 22.11a

An increase in the labor force?

Hover here to see the hint for Question 22.11a.

Question 22.11b

An increase in capital?

Hover here to see the hint for Question 22.11b. 

Question 22.11c

An increase in cost of raw materials?

Hover here to see the hint for Question 22.11c. 

Question 22.11d

A reduction in the costs created by regulations?

Hover here to see the hint for Question 22.11d. 

Question 22.11e

Compare the effects of an increase in unemployment with the decrease in the labor force. (Be careful here.)

Hover here to see the hint for Question 22.11e. 
Click here to see the answer to Question 22.11. ​

Question 22.12

Which of the following changes will eventually cause a shift in the aggregate supply curve? I. increase in investment II. decrease in productivity III. increase in consumption

A

I only.

B

II and III only.

C

I and III only.

D

I and II only.

E

I, II, and III.

Question 22.13

Question 22.13

Why does the aggregate supply curve begin to slope upward and to the right at higher levels of real GDP?

Hover here to see the hint for Question 22.13. 
Click here to see the answer to Question 22.13. 

Question 22.14

In the following sentence, indicate the direction of the change and whether the demand or the supply curve changes. If people in the U.S. develop an increasing taste for Latin American products, the effect is a (rightward/leftward) movement of the aggregate (demand/supply) curve.

A

Rightward; demand

B

Rightward; supply

C

Leftward; supply

D

Leftward; demand

Question 22.15

An increase in the tax on wages will cause which of the following? [Select all that apply]

A

A decrease in aggregate demand

B

An increase in aggregate demand

C

A decrease in aggregate supply (less output at each price)

D

An increase in aggregate supply (more output at each price)

Question 22.16

The immediate or short-run effect of an increase in government spending on goods and services will be a ______________ movement of the aggregate demand curve and ______________ movement of the aggregate supply curve.

A

Rightward; a rightward

B

Rightward; a leftward

C

Leftward; a leftward

D

Leftward; a rightward

E

Rightward; no

​22.4 Equilibrium

The next step in building our model is to put aggregate supply and aggregate demand together. The determinants of current consumption, investment, government spending, and net exports give us an aggregate demand, perhaps like that shown in Figure 22.13. Behind a specific aggregate supply curve like the one shown in Figure 22.13 are current prices of inputs, technology, and the amounts and qualities of labor and capital. If any one of the factors that influence aggregate demand or aggregate supply change, either the aggregate demand or the aggregate supply relationship will change and the corresponding curve will shift.

Figure 22.13: Equilibrium occurs where the aggregate quantity supplied is equal to the aggregate quantity demanded.​​

​Given aggregate demand and aggregate supply, the economy will move to an equilibrium where spending equals output. That equilibrium is where the aggregate quantity demanded is equal to the aggregate quantity supplied – a price level of about 112, and output equal to $17 trillion. This means that buyers are buying exactly what businesses are producing, and producers are willing and able to produce those quantities at the current price level.

To understand the process that brings an economy to that equilibrium, we will begin by asking what happens if the economy is not producing at the level of real GDP where the aggregate quantities demanded and supplied are equal. For example, if the price level were 120, above the equilibrium price level for the economy, businesses would want to produce more (about $19 trillion in Figure 22.13) than the amount buyers would want to buy (about $13 trillion). In this situation, because businesses are producing more than buyers are willing to buy, inventories begin to expand. Prices begin to fall as businesses try to sell all they are producing. As prices fall, the aggregate quantity demanded begins to rise. Increases in net exports, consumption, and investment are the causes. Buyers, in effect, move down along the aggregate demand curve. As prices fall, some producers cut back on production, as they can no longer cover their costs. Prices continue to fall until the aggregate quantity demanded is equal to the aggregate quantity supplied. Because there will no longer be downward pressure on prices, the economy is in equilibrium at that point. The equilibrium price is equal to 112 and the equilibrium output is equal to $17 trillion.

You should be able to use the same analysis with a price level that is below the equilibrium price. Try the explanation now.

Question 22.17

Question 22.17

What will happen in the economy depicted in Figure 22.13 if the price level in the economy is equal to 105?

Hover here to see the hint for Question 22.17. 
Click here to see the answer to Question 22.17.

Between 2009 and 2012, Greece experienced roughly a 20 percent drop in total nominal spending. The following video shows what it’s like in one market when there is a sudden reduction in aggregate demand. As you watch the video, think about how it relates to the aggregate supply and aggregate demand model we have developed.

Question 22.18

Greece experienced a large drop in total spending. How would we model this change in our model of aggregate supply and aggregate demand?

A

With a shift to the right of aggregate supply

B

With a shift to the left of aggregate supply

C

With a shift to the right of aggregate demand

D

With a shift to the left of aggregate demand

E

None of the curves have shifted.

Question 22.19

Question 22.19

Based on the video, does it appear that the price of seafood at the fish market has dropped enough so that fishermen can sell their entire catch? How is this behavior reflected in the model of aggregate supply and aggregate demand?

Hover here to see the hint for Question 22.19.
Click here to see the answer to Question 22.19. 

For each of the following questions, assume that we are currently in an equilibrium similar to that shown in Figure 22.13. One of the factors that influence aggregate supply or one of the components of total spending will change. It is up to you to figure out which changes and how the change will affect equilibrium real GDP and the price level. Make sure you can explain why the changes take place in each instance.

Question 22.20

When consumers become optimistic and plan to spend more:

Premise
Response
1

Aggregate demand changes? (yes/no)

A

No

2

Aggregate supply changes? (yes/no)

B

Yes

3

Real GDP (increase/decrease/ambiguous)

C

Increases

4

Price level (increase/decrease/ambiguous)

D

Ambiguous

E

Decreases

F

Decreases

G

Increases

Question 22.21

When government increases spending:

Premise
Response
1

Aggregate demand changes? (yes/no)

A

Increases

2

Aggregate supply changes? (yes/no)

B

Yes

3

Real GDP (increase/decrease/ambiguous)

C

No

4

Price level (increase/decrease/ambiguous)

D

Decreases

E

Decreases

F

Ambiguous

G

Increases

Question 22.22

When foreigners’ preferences for U.S. goods fall:

Premise
Response
1

Aggregate demand changes? (yes/no)

A

Decreases

2

Aggregate supply changes? (yes/no)

B

Decreases

3

Real GDP (increase/decrease/ambiguous)

C

Increases

4

Price level (increase/decrease/ambiguous)

D

No

E

Increases

F

Ambiguous

G

Yes

Question 22.23

When labor force participation increases:

Premise
Response
1

Aggregate demand changes? (yes/no)

A

Decreases

2

Aggregate supply changes? (yes/no)

B

Increases

3

Real GDP (increase/decrease/ambiguous)

C

Yes

4

Price level (increase/decrease/ambiguous)

D

Ambiguous

E

Decreases

F

Decreases

G

No

Table 22.2: This table summarizes the effect of several different types of changes we can analyze with the aggregate supply and aggregate demand model. The changes are listed in the first column, and the effects of the changes are given in columns 2 – 5.​​

Graphing Question 22.04

Graphing Question 22.05

22.4.1​ Investment – A Unique Effect on Aggregate Demand and Aggregate Supply

Investment is unique among the factors influencing aggregate demand. We have discussed how changes in investment spending affect total spending and how those changes in total spending have a multiplied effect on total spending and real GDP. That analysis is correct. However, investment will also eventually affect aggregate supply. Why?

Question 22.24

Question 22.24

How can investment spending affect aggregate supply? Use the definition of investment to begin your thinking.

Hover here to see the hint for Question 22.24.
Click here to see the answer for Question 22.24.

The most accurate and easiest way to think about the effects of investment is first to consider the effects on aggregate demand and to discuss how the economy will move to a new equilibrium. In the longer run, once the new capital is produced and ready to be used, aggregate supply will change, allowing the economy to go to an even higher level of output. In Figure 22.14, the aggregate demand curve shifts as investment spending increases. The economy will begin to move from point A to point B. As the increased capital is put to use, the aggregate supply curve will shift to the right, and the economy will begin to move toward point C. We know that point C will be at a higher real GDP than when the process started. However, we are not able to tell whether the ultimate price level will be greater or less than the original level. That depends upon the relative sizes of the changes in the demand and supply.

Figure 22.14: An Increase in Investment Spending​

Graphing Question 22.06

Graphing Question 22.07

22.5 Conclusion

At the beginning of the chapter are five excerpts from news articles about economic conditions and unemployment in the U.S. You can now use what you have learned in this chapter to explain what might have caused falling output and rising unemployment in the U.S. between 2007 and 2009 and what might have caused the rising output and falling unemployment in the U.S. in 2000. While the situations are quite different, you should be able to suggest possible causes. To get the full picture about what was happening, refer back to Figure 22.2.

Question 22.25

Question 22.25

In 2008, inflation was unusually high (meaning prices increased more than usual), GDP growth fell, and unemployment increased. Use the aggregate supply and demand model to suggest what might have happened at the beginning of the great recession.

Hover here to see the hint for Question 22.25.
Click here to see the answer to Question 22.25. 

Question 22.26

Question 22.26

In 2009, the U.S. experienced deflation (meaning prices were falling), and GDP actually decreased. Unemployment increased to 10%. Use the aggregate supply and demand model to suggest what might have happened during the second half of the great recession.

Hover here to see the hint for Question 22.26.
Click here to see the answer to Question 22.26. 

Our aggregate supply and demand model can be used to describe a number of possible conditions in an economy from a recession with falling output and rising unemployment, to boom times with inflationary conditions, to situations with both rising prices and falling output. For example, if spending falls in an economy, aggregate demand decreases. See panel (a) in Figure 22.15. There will be downward pressure on prices and real GDP. As output falls, workers will be laid off and unemployment will rise. Less of the existing capital will also be used. This was probably the case for the U.S. in 2009.

Figure 22.15: A Summary of the Impact of Each Type of Macroeconomic Change​

​A third possibility is shown in the case of a rise in prices of inputs (panel c). That will cause a shift to the left in the supply curve. There will be upward pressure on prices and downward pressure on output – a recession, combined with inflation. In this case, two undesirable events are taking place. The 1970s recession, as well as the beginning of the Great Recession in 2008 with falling output, rising unemployment, and rising prices (as shown in Figure 22.14), can be described by decreasing aggregate supply caused by rising oil prices.

The fourth scenario might occur following an increase in technology. Panel (d) shows the increase in the supply curve and the falling prices and rising output – good times in the economy. These are the simple uses of the model. We will expand the model in the next chapter and see the changes in aggregate supply and aggregate demand often happen simultaneously.

Like all economic models, in order to master aggregate supply and aggregate demand, you need to practice using it. The following three questions will give you a chance to do so. In the first two questions, you will be presented with an event that changes something in the model. Your first task is to figure out whether and how the change affects spending (aggregate demand) or one of the factors influencing aggregate supply. Your next task is to explain from the beginning to the end how the process of adjustment to a new equilibrium works.

In general, you should practice thinking the process through with increases and decreases in aggregate demand and then with increases and decreases in aggregate supply. Practice the manipulation of the graphs and then explain the process in words.

Question 22.27

Question 22.27

Assume the economy is in equilibrium. Explain exactly, i.e., one step at a time, why the price level and real GDP will change if the price of oil (a major input in many businesses) increases. Describe the process from the beginning to where the economy reaches a new equilibrium.

Hover here to see the hint for Question 22.27.
Click here to see the answer to Question 22.27.

Question 22.28

Question 22.28

An economy is currently producing at an equilibrium level of real GDP of $14 trillion. What will happen if government spending (alone, with no other changes) decreases by $100 billion? Will real GDP increase or decrease? Explain why it will change by $100 billion, by less, or by more.

Hover here to see the hint for Question 22.28.
Click here to see the answer to Question 22.28.

Question 22.29

Question 22.29

Explain why rising prices reduce the spending multiplier effect of an increase in aggregate demand.

Hover here to see the hint for Question 22.29.
Click here to see the answer to Question 22.29.

Graphing Question 22.08

22.6 Summary

  • Changes in prices will change net export, consumption, and investment spending. This relationship shows that as the price level decreases, the aggregate quantity demanded, that is, total spending, will increase. A change in price will cause a movement along the aggregate demand curve.
  • If consumption, investment, government, or net export spending increases or decreases for reasons other than changes in prices, aggregate demand will increase or decrease. The entire curve will shift by a multiple of the original change in spending. An increase in aggregate demand is a shift to the right of the aggregate demand curve. A decrease in aggregate demand is a shift to the left of the aggregate demand curve.
  • The aggregate supply curve represents the levels of real GDP at each price level that businesses and governments are willing to produce. Changes in prices will cause movement along the aggregate supply curve. At relatively low levels of real GDP, the aggregate supply curve will be relatively horizontal. At higher levels of output, the aggregate supply curve will slope upward to the right, that is, higher prices will bring forth more output. Given existing labor, capital, and technology, there will be a level of maximum output, at which point the aggregate supply curve becomes vertical.
  • Changes in the amount and quality of labor, the amount of capital, technology, and prices of inputs will shift the aggregate supply curve. For example, increases in labor and capital, enhanced technology, and decreases in prices of inputs will increase aggregate supply and shift the aggregate supply curve to the right. 
  • The economy will tend to move to equilibrium levels of prices and real GDP where the aggregate quantity demanded will be equal to the aggregate quantity supplied.
  • Changes in either aggregate demand or aggregate supply create new equilibrium levels of prices and output in the economy. As a result, the economy will experience growing or shrinking output, falling or rising unemployment, and increasing or decreasing price levels.

22.7​ Key Concepts in Chapter 22

  • ​Aggregate demand
  • Effects of changes in prices
  • Net export effect
  • Wealth effect on consumption
  • Investment spending effect
  • Shifts in an aggregate demand curve
  • Changes in components of total spending
  • Spending multiplier
  • Aggregate supply
  • Effects of changes in prices
  • Shifts in an aggregate supply curve
  • Changes in size and quality of the labor force, capital, technology, and prices of inputs
  • Equilibrium in the economy

22.8 Glossary

Aggregate demand: The total amount (aggregate quantity demanded) of spending on goods and services that consumers, businesses, governments, and other countries want to do at each overall level of prices.

Aggregate supply: The total amount of production (aggregate quantity supplied) of goods and services that businesses and governments are willing and able to produce at each overall level of prices, given the size and quality of the labor force, the stock of capital, technology, and the prices of inputs.

Capital: The dollar value of the factories, machines, and tools in an economy.

Consumption: Spending by households; which includes: durable goods (washing machine, stereos, and cars), non-durable goods (food, clothing, and gasoline), and services (haircuts, medical care, education).

Equilibrium in the aggregate demand and supply model: In the aggregate supply and demand model, equilibrium is reached when the aggregate quantities demanded and supplied are equal at the current price level.

Exports: Goods and services produced in the United States but sold abroad.

GDP price index: A price index for all goods and services included in GDP. The measure compares the cost of the present basket of goods and services relative to the cost of that basket in a base year. A similar measure is the GDP implicit deflator.

GDP: The total market value of the final goods and services produced annually within a nation.

Government spending: The sum of federal government, state, and local government purchases of goods and services.

Imports: Goods produced abroad but purchased domestically.

Income: The total of wages, rents, interest, and profits.

Inflation: The rate of increase in the overall level of prices of all goods and services in the economy.

Investment: When used in reference to GDP or the entire economy, it is any spending intended to increase future output. For example, goods purchased by individuals and firms consisting of fixed investment (new factories, new machines, and new houses) and inventory investment (change in inventories at business firms). Investment increases the amount of capital.

Labor force: The number of individuals who have jobs plus the number who are actively looking for work.

Marginal Propensity to Consume: The percentage of an additional dollar of income that is spent on consumption.

Multiplier: See spending multiplier.

Net exports: Exports of goods and services minus imports of goods and services.

Output: Production of all final goods and services. Total output in a year is equal to real GDP.

Real GDP: The real value of all final goods and services produced in an economy. Real GDP is measured in dollars adjusted for changes in the overall price level.

Recession: The National Bureau of Economic Research (NBER) identifies the official beginning and ending of recessions in the U.S. The organization uses a definition of a recession that is widely accepted by economists and policy makers. A recession includes the following: a significant decline in production and employment; the decline is spread throughout the economy; and it lasts more than a few months.

Spending multiplier: Total spending will change by a multiple of the change in consumption, investment, government, or net export spending. That multiple is the spending multiplier.

Total spending: Consumption, investment, government, and net export spending.



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Answer Keys:

Answer to Question 22.01

Restaurants will produce fewer meals, at least initially. This means they won’t need as much labor so they may reduce the hours of their employees or let some of them go. Eventually, they may begin to offer lower prices in order to fill some of the empty tables.

Click here to return to Question 22.01.






Answer to Question 22.02

Initially, restaurant owners will increase output, serving more meals. Eventually, they will run out of capacity and try to hire more workers in order to expand capacity.

Click here to return to Question 22.02.






Answer to Question 22.03

They may try offering higher wages to attract the workers they need to expand production. Other restaurants will respond by raising wages in order to keep their workers. As the price of the main input to production rises, restaurants may begin to raise the price of meals.

Click here to return to Question 22.03.






Answer to Question 22.04

As the prices of goods produced in the U.S. rise, our trading partners (people from Europe, Asia, and all over the world) will buy fewer U.S. goods as they substitute goods produced elsewhere. As U.S. prices increase (and assuming all else equal), our exports fall. As U.S. automobile prices rise, Europeans are more likely to buy European-manufactured cars. To keep things simple, we assume for now that exchange rates remain unchanged so that a rise in the dollar price of a U.S. good means that they will be more expensive for foreigners. We discuss this further in Chapter 29: International Currency Markets. In general, as prices rise in the U.S. and all other determinants of demand for exports (income and prices abroad) remain the same, U.S. goods become relatively more expensive for people abroad to buy. Individuals and businesses abroad will substitute their own goods for ours, and the quantity demanded of U.S. exports will fall. Figure 22.4 shows a demand curve for exports and the effect on our exports of rising prices in the U.S. As the price level in the U.S. rises, our goods are more expensive and foreigners substitute their own goods.

Click here to return to Question 22.04.






Answer to Question 22.05

The aggregate demand curve shows combinations of price levels and total spending in the economy. Changes in the level of prices in the economy will affect spending by causing changes in net exports, consumption, and investment. As prices rise in the U.S., our exports become more expensive and export spending falls. In addition, consumers will shift some buying to substitute imported goods, which are now relatively cheaper. Foreigners buy fewer goods from the U.S. since they are now relatively more expensive. Imports rise and exports fall, thus net exports fall. Total spending in our economy is reduced as a result. The value of wealth in the economy will also be affected. If the real value of wealth decreases, consumers may feel less well-off and reduce consumption spending even if income does not change. As prices increase, the demand for money will increase causing interest rates to rise. Investment spending will fall as a result. Part of total spending will thus decrease at each level of income.

Click here to return to Question 22.05.






Answer to Question 22.06

Your summary of causes of changes in total spending should include changes in prices of goods and services and changes in the four components of total spending – consumption, investment, government spending, and net exports, which are not caused by the price level. You should emphasize the differences between a movement along an aggregate demand curve caused by changes in prices in the economy and shifts in the aggregate demand curve caused by changes in other factors influencing the four components of spending.

Click here to return to Question 22.06.






Answer to Question 22.07

If prices increase, the value of individuals’ money and therefore wealth will decrease. The wealth will buy less. Since individuals will not be as wealthy in a real sense, they will spend less at each level of income. Thus, consumption spending will fall as prices increase. Assuming that foreign prices do not change, an increase in U.S. prices will mean that U.S. exports are now more expensive for foreigners. They will demand fewer U.S. exports as they substitute less expensive goods. Imports will now be relatively less costly for us. Because of that, we will reduce spending on U.S. goods and increase spending on imports. Again, spending on goods and services in the U.S. decreases as a result of a price increase. As prices rise, the demand for money will increase. Interest rates will rise, and investment spending will fall. The fall in investment spending will cause total spending to decrease. In all three of the above cases, aggregate quantity demanded decreases.

Click here to return to Question 22.07.






Answer to Question 22.11

A) With an increase in the labor force, the supply curve will shift to the right. That is, more can be produced at each price level given the increase in labor resources.

B) An increase in capital will have the same effect as an increase in the labor force. There are now more resources, so more goods and services can be produced.

C) An increase in the cost of raw materials causes businesses to raise their prices in order to cover the increased costs. The aggregate supply curve should shift as shown in Figure 22.13. Another interpretation of that shift is that it is a reduction in supply. That is, less is produced at each price. A decrease in aggregate supply is a shift to the left of the aggregate supply curve.

D) A reduction in the costs created by regulations causes the aggregate supply curve to move, as shown in Figure 22.11. This change is caused by falling costs and the subsequent competition among business bringing prices down. The effect is similar to an increase in available resources.

E) The effect of an increase in unemployment is a little trickier. If you said that the aggregate supply curve does not move, but that the economy moves along the curve, you are correct. Changes in employment and unemployment, with a given labor force, are only movements along the curve. Decreases in the labor force itself will cause aggregate supply (the entire curve) to decrease as shown in Figure 22.13.

Click here to return to Question 22.11.






Answer to Question 22.13

As businesses begin to expand, they will eventually use less efficient factories, less experienced laborers, and less efficient land. Thus, costs will begin to increase, and businesses will have to have higher prices to cover those costs.

Click here to return to Question 22.13.






Answer to Question 22.17

If the price level is 105, below the equilibrium price level for the economy, businesses will want to produce about $14 trillion, which is less than the $20.5 trillion that buyers want to purchase (the aggregate quantity demanded). Because businesses will produce less than buyers will buy, inventories will begin to fall. Businesses will begin to increase production and raise prices to cover increasing costs. As prices rise, spending begins to decrease (net exports, consumption, and investment fall). Prices will continue to rise until the aggregate quantity demanded is equal to the aggregate quantity supplied. The changes in the economy will end in an equilibrium at a new higher price level (112) and a new higher level of real GDP ($17 trillion).

Click here to return to Question 22.17.






Answer to Question 22.19

No, it does not. At one point in the video, a fisherman mentioned that they disposed of a large amount of their catch because it went unsold. In other words, they did not lower the price enough to sell everything they had produced. Our model captures this behavior with the flattening of the aggregate supply curve as we move from right to left. Producers are unlikely to cut prices below a certain point and will eventually cut back on production (or in this case, throw away product that will eventually spoil).

Click here to return to Question 22.19.






Answer to Question 22.24

Investment increases the amount of capital available to be used to produce other goods and services. The aggregate supply relationship depends upon the amounts of labor and capital and the level of technology. If the numbers of factories, machines, and tools increase, total possible production will increase. Thus, aggregate supply will increase.

Click here to return to Question 22.24.






Answer to Question 22.25

The actual causes of the Great Recession are many and complex, but ultimately caused reductions in real GDP. In 2008, inflation was relatively high while real GDP contracted. Unemployment increased to a little over 6% in 2008. This is probably best explained as a reduction in short-run aggregate supply. Indeed, the price of oil increased by nearly 50% between January 2008 and June 2008.

Click here to return to Question 22.25.






Answer to Question 22.26

In 2009, we see that real GDP growth fell even further while inflation, measured by the CPI, was negative for the first time in well over 40 years. A reduction in GDP and falling prices occur when there is a reduction in aggregate demand. The fall in aggregate demand in 2009  probably resulted from a large drop in home prices and stock prices, both of which make up a large fraction of American’s wealth.

Click here to return to Question 22.26.






Answer to Question 22.27

Costs of an important input increase, raising costs for much of the economy. Producers will reduce the production they are willing to undertake at each price. This is represented by a shift of the aggregate supply curve to the left. Production then will be less than total spending. Inventories are falling. Businesses want to increase production. However since costs of producing will increase as businesses expand, businesses must raise prices. As prices increase, business production will increase. 

The rise in prices will cause aggregate quantity demanded to decrease due to the falling value of money wealth (causing consumption to fall), falling investment (due to higher interest rates), and decreasing net exports (because of the higher prices of U.S. goods, relative to other countries’ goods). Thus, spending is falling as a result of the increasing prices. 

As long as total spending is greater than production, prices will continue to rise, production will increase, and aggregate quantity demanded (total spending) will decrease. When spending and output are equal, prices will no longer increase. The economy will be at a higher price level and a lower real GDP than when we started. We will have experienced inflation and rising unemployment.

Click here to return to Question 22.27.






Answer to Question 22.28

Total spending decreases by $100 billion. Income falls because each dollar of spending becomes income. Since consumption spending depends upon income, consumption will also decrease by a portion of the original decrease of $100 billion. Thus, total spending will now be more than $100 billion less than output. Assuming that prices do not change, inventories will accumulate, causing business to reduce production. If that were all that were to happen, the decrease in real GDP would be greater than the original $100 billion. 

However, aggregate quantity demanded at the original price level will be less than what producers are willing to produce. There will be downward pressure on the price level, and that will cause aggregate quantity demanded to increase and to end up between the original amount of output and spending and the multiplied decrease in spending. Prices will have fallen, and real GDP will be less than before the decrease in spending. However, we cannot tell whether the decrease in real GDP will be greater or less than the original decrease in spending.

Click here to return to Question 22.28.






Answer to Question 22.29

An increase in spending will increase the total amount of spending by a multiplied amount, as the initial spending becomes income and further raises spending. However, if prices rise due to the increased spending, the ultimate increase in real spending will be less than the initial multiplied increase in aggregate demand. The increase in prices will reduce real wealth and then cause reduced consumption. Net exports and investment spending are also reduced by the price increase. The effect of the increased spending will be partially offset by this fall in real spending.

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Footnotes:

Image Credits:

[1] Image courtesy of skeeze in the Public Domain. 

[2] Image courtesy of Mohri UN-CECAR under CC BY 2.0.

A period of significant decline in GDP growth rates and employment that is spread throughout the economy and lasts more than a few months. The National Bureau of Economic Research (NBER) identifies the official beginning and ending of recessions in the U.S. This definition of a recession is widely accepted by economists and policy makers and is used by the NBER to identify recessions in the U.S.
Think about what happens to quantity and price in a market when there is a decrease in demand.
Think about what happens to quantity and price in a market when there is an increase in demand.
What would convince you to go take another job?
Total amount of goods and services that consumers (both foreign and domestic), businesses (both foreign and domestic), and governments are willing and able to buy at each overall level of prices.
The total amount of production (aggregate quantity supplied) of goods and services that businesses and governments are willing and able to produce at each overall level of prices, given the size and quality of the labor force, the stock of productive capital, and technology.
Total amount of production of goods and services that consumers, businesses, and governments are willing and able to buy at each overall level of prices.
Think about demand for a single good.
The amount of output consumers, businesses, and governments are willing to buy at each overall level of prices.
A change in the overall price level will cause a movement along the aggregate demand curve. This relationship is much like the one we discussed with individual markets, but the reasons behind the relationship are quite different.
If spending on consumption, investment, government, or net exports changes for any reason other than a change in prices, the aggregate demand will shift to the right or left. Aggregate demand will have increased or decreased.
A movement along the aggregate demand curve is a change in the aggregate quantity demanded that results from a change in the overall price level.
Go through each of the spending components of GDP and think about what causes them to change.
Total spending will change by a multiple of the change in consumption, investment, government, or net export spending. That multiple is the spending multiplier.
How does a rise in the price level affect wealth, the interest rate, and net exports?
The total amount of production (aggregate quantity supplied) of goods and services that businesses and governments are willing and able to produce at each overall level of prices, given the size and quality of the labor force, the stock of productive capital, and technology.
The amount of output businesses and governments are willing to produce at each overall level of prices.
Can the economy produce more or less at any given price level?
Can the economy produce more or less at any given price level?
Will businesses be willing to produce the same amount at the current price level?
Will businesses be willing to produce the same amount at the current price level?
An increase in unemployment does not change the size of the labor force. How does a decrease in the labor force affect the economy’s capacity to produce?
Think about why the supply curve slopes up in any market.
Compare the amount produced to the amount purchased at this price level.
Why don’t prices simply drop when planned spending drops?
Investment adds to the capital stock. How does this affect the model?
Think about what kind of shock causes prices to rise and output to fall.
Think about what kind of change in the model could cause output and prices to fall.
Which side of the model is affected by an increase in the price of an input?
Which side of the model is affected by a change in government spending?
The spending multiplier effect is captured by a shift in aggregate demand. Think about how the change in equilibrium real GDP compares to the size of the shift in the aggregate demand curve.