1. Understanding Economics
3rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson
Chapter 11
Economic Fluctuations
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

2. Learning Objectives In this chapter you will:
learn about aggregate demand and the factors that affect it
analyze aggregate supply and the factors that influence it
study the economy’s equilibrium and how it differs from its potential

3. 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 using a schedule or curve

4. Aggregate Demand (b) Figure 11.1, Page 247
650
700
750
800 40 80
120
160
200
Aggregate Demand Curve
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
Aggregate Demand
Schedule
Price
Level
Real GDP
(1997,
$ billions)
Point on
Graph a b c AD
200
160
120
650
700
750 a b c

5. 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)

6. Changes in Aggregate Demand (a)
AD 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

7. Changes in Aggregate Demand (b) Figure 11.2, Page 249
650
700
750
800 40 80
120
160
200
Aggregate Demand Curve
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
Aggregate Demand
Schedule
Price
Level
Real GDP
(1997 $ billions)
AD0
AD1
AD0
AD1
200
160
120
650
700
750
700
750
800

8. 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

9. Aggregate Demand Factors (b)
investment (I)
interest rates
business expectations
government purchases (G)
net exports (X-M)
foreign incomes
exchange rates

10. 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)

11. Investment Demand (b) Figure 11.3, Page 251
Investment Demand Curve
Investment (1997 $ billions)
Real Rate of Return and
Real Interest Rate (%) 30 60 4 8 12 a
Investment Demand Schedule
Real
Interest
Rate
(%)
Total
Investment
(1997 $ billions)
Point on
Graph
Projects
Undertaken b 12 8 4 30 60 a b c --
A, B
A, B, C, D c D1 A B C D

12. Shifts in the Aggregate Demand Curve Figure 11.4, Page 253
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 rise in disposable income
a rise in wealth unrelated to a change in price level
an expected rise in prices or incomes
a fall in interest rates
(2) An increase in investment due to
an expected rise in profits
(3) An increase in government purchases
(4) An increase in net exports due to
a rise in foreign income
a fall in value of the Canadian dollar
(1) A decrease in consumption due to
a fall in disposable income
a fall in wealth unrelated to a change in price level
an expected fall in prices or incomes
a rise in interest rates
(2) A decrease in investment due to
an expected fall in profits
(3) A decrease in government purchases
(4) A decrease in net exports due to
a fall in foreign income
a rise in value of the Canadian dollar

13. Aggregate Supply (a) Aggregate supply (AS)
is the relationship between the general price level and real output in an economy
is shown using a schedule or curve

14. Aggregate Supply (b) Figure 11.5, Page 254
650
675
700
800 40 80
120
160
240
Aggregate Supply Curve
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
200
750
725 AS d
Aggregate Supply
Schedule
Price
Level
Real GDP
(1997,
$ billions)
Point on
Graph c b
Potential
Output a
120
160
200
240
650
700
725
730 a b c d

15. 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

16. 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

17. A Short-Run Change in Aggregate Supply Figure 11.6, page 256
650
675
700 40 80
120
160
240
Aggregate Supply Curve
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
200
750
725
Aggregate Supply
Schedule
Price
Level
Real GDP
(1997 $ billions)
AS0
AS1
Potential
Output
AS0
AS1
120
160
200
240
650
700
725
730
700
725
730
731

18. 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

19. A Long-Run Change in Aggregate Supply Figure 11.7, Page 256
650
675
700
800 40 80
120
160
240
Aggregate Supply Curve
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
200
750
725
AS0
AS1
Aggregate Supply
Schedule
Price
Level
Real GDP
(1997 $ billions)
AS0
AS1
120
160
200
240
650
700
725
730
700
750
775
780
Original
Potential
Output
New
Potential
Output

20. 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

21. Shifts in the Aggregate Supply Curve (a) Figure 11.8, Page 257
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 fall in wages
a fall in raw material prices
(1) An increase in input prices due to
a rise in wages
a rise in raw material prices

22. Shifts in the Aggregate Supply Curve (b) Figure 11.8, Page 257
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
more labour supply
more capital stock
more land
more entrepreneurship
(2) An increase in productivity due to technological progress
(3) A change in government policies
lower taxes
less government regulation
(1) A decrease in supplies of economic resources due to
less labour supply
less capital stock
less land
less entrepreneurship
(2) A decrease in productivity due to technological decline
(3) A change in government policies
higher taxes
more government regulation

23. 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

24. An Economy at Equilibrium Figure 11.9, Page 259
650
800 40 80
120
200
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
750
Aggregate Demand and Supply Curves AS a a
Aggregate Demand and
Supply Schedules
Price
Level
AS – AD
(surplus (+) or
shortage (-))
(1997 $ billions)
Positive Unplanned Investment
160 b c c AD
Negative Unplanned Investment
200
160
120
(725 – 650) = +75
(700 – 700) = 0
(650 – 750) = -100
700

25. 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

26. An Economy at Its Potential Output Figure 11.10, Page 26240 80
120
160
240
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
200
725 AS AD
Potential
Output

27. 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

28. Recessionary and Inflationary Gaps Figure 11.11, Page 26340 80
120
160
240
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
200
725
700
Recessionary Gap 40 80
120
160
240
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
200
725
700
Inflationary Gap AS
Potential
Output AS
Inflationary
Gap AD
Recessionary
Gap
Potential
Output AD

29. Economic Growth 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

30. Canada’s Economic Growth (a) Figure 11.12, Page 265

31. Economic Growth in Canada
Before World War I ( ), Canada’s per-capita output (in 1997 dollars) more than doubled from $2312 to $5283.
In the interwar period ( ), the country’s per-capita real output almost doubled from $5283 to $9660.
In the postwar period (1945-), per-capita real output more than tripled to $ by 2002.

32. Economic Growth and Productivity
Growth in per capita output is closely associated with growth in labour productivity which depends on factors such as
the quantity of capital
the quality of labour
technological progress

33. 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

34. The Business Cycle Figure 11.13, Page 266
Real GDP
Time
CONTRACTION
EXPANSION
Long-Run Trend
of Potential Output
Peak a c
Recessionary gap
Inflationary gap b d
Trough

35. 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

36. 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

37. Expansion and Contraction Figure 11.14, Page 268
700
725
160
240
Real GDP (1997 $ billions)
Price Level (GDP deflator,
1997 = 100)
730 AS f
Inflationary
Gap e
AD0
Recessionary
Gap
Potential
Output
AD1

38. 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.

39. 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.

40. 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.).

41. Consumption and Saving Figure A, page 274
400
1400
1200
1000
800
600
200
Disposable Income ($ billions)
Consumptions, Savings ($ billions)
-200
Consumption and Saving Lines C
Consumption and Saving
Schedules DI C
($ billions) S
200
400
600
800
1000
1200
1400
200
350
500
650
800
950
1100
1250
-200
-150
-100
-50 50
100
150
$1250b.
$800b. S
$200b.
$150b.
-$200b.

42. 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.

43. 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.

44. Spending-Output Approach
Equilibrium with No Government (a) Figure B, page 275 (continued in part (b))
Expenditures ($ billions)
400
200
1400
1200
1000
800
600
GDP ($ billions)
-$50 b. positive unplanned investment
AE0 = C + I + (X – M)
Spending-Output Approach
GDP C I
X-M AE
($ billions) C
-$50 b. negative unplanned investment a
200
400
600
800
1000
1200
1400
200
350
500
650
800
950
1100
1250 25 25
250
400
550
700
820
1000
1150
1300
45°

45. 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.

46. Injections-Withdrawals Approach
Equilibrium with No Government (b) Figure B, page 309 (continued from part (a))
1400
1200
1000
800
600
400
200
Injections, Withdrawals ($ billions)
GDP ($ billions)
-200
Injections-Withdrawals Approach
GDP M S
S+M I X
I+X
($ billions)
S+M b
200
400
600
800
1000
1200
1400
-200
-150
-100
-50 50
100
150
350
150
200
250
300
350
400
450
500 25
375
400
I+X S I

47. 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

48. Understanding Economics
3rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson
Chapter 11
The End
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.