Chapter 13 Tracking the Macroeconomy
What's in This Chapter and Why
This chapter contains a discussion of gross domestic product and its components--consumption,
gross investment, government purchases, and net exports. This discussion is particularly important
for the development of aggregate demand and supply curves.
This chapter also introduces readers to the distinction between nominal and real GDP. The
price index concept is introduced in this context and the GDP deflator is discussed.
The nation's economic performance over time is considered and the business cycle concept is
introduced. This concept is used in subsequent chapters.
Finally, aggregate demand and supply curves are derived in this chapter. Various factors that
cause them to shift are discussed. This analysis is very important in subsequent chapters.
Instructional Objectives
After completing this chapter, your students should know:
1.
2.
3.
4.
How the nation's output is measured.
The importance of distinguishing between nominal and real magnitudes.
How price indexes are constructed and interpreted.
Why it is difficult to compare the nation's output in one year with its output in another year or
to compare the output of one country with that of another country.
5. That the nation's level of economic activity doesn't increase steadily.
6. How aggregate demand and supply curves are defined and derived and how to apply them with
regard to the determination of the GDP deflator, real GDP, and employment levels.
Key Terms
These terms are introduced in this chapter:
Gross domestic product (GDP)
Final goods
Intermediate goods
Personal consumption expenditures
Gross private domestic investment
Capital stock
Government purchases of goods and services
Net exports of goods and services
Exports
Imports
Price index
Nominal GDP
Real GDP
GDP deflator
Business cycles
Expansion phase
Peak
Contraction phase
Trough
Aggregate demand curve
Real balance effect
Interest rate effect
Foreign trade effect
Fiscal policy
Money supply
Monetary policy
Aggregate supply curve
Suggestions for Teaching
This chapter is intended to provide an introduction to the macroeconomic chapters. If covered in
its entirety, three or four class sessions will be required.
In addition to the various measures discussed in this chapter, an instructor may wish to discuss
the unemployment rate (covered in Chapter 14) and the CPI (discussed in Chapter 15).
Regardless of approach, the instructor may wish to spend some time discussing the current
level of economic activity and its relevancy to society and to the individual.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Gary E. Clayton and Martin Gerhard Giesbrecht, A Guide to Everyday Economic Statistics (3rd
ed.), New York: McGraw-Hill, 1995.
2. Clifford W. Cobb and John B. Cobb, Jr., The Green National Product: A Proposed Index of
Sustainable Economic Welfare, Lanham, Maryland: University Press of America, 1994.
3. Norman Frumkin, Tracking America’s Economy (3rd ed.), Armonk, New York: M.E. Sharpe,
1998.
Outline
I. GROSS DOMESTIC PRODUCT (GDP)
A. Comments and General Definitions
1. Gross domestic product (GDP) is the market value of the final goods and services
produced in an economy over some time period.
a. Final goods are goods purchased for final use.
1. Intermediate goods, goods purchased for resale or for use in producing other
goods, are not included as double counting would occur.
2. GDP uses market prices because these prices represent the value that people place on
goods and services.
3. GDP measures all final goods produced during the time period whether they are sold or
not.
II. GDP'S COMPONENTS
A. Consumption
1. Personal consumption expenditures consist of household purchases of durable goods,
nondurable goods, and services.
2. Consumption is the largest component of GDP.
3. Consumption is a relatively stable component of GDP.
B. Gross Investment
1. Gross private domestic investment is the purchase of new equipment by firms, the
purchase of all newly produced structures, and changes in business inventories.
2. Gross private domestic investment consists of net private domestic investment and the
consumption of fixed capital.
a. Net private domestic investment is the part of gross investment that adds to the
existing stock of structures and equipment.
b. The consumption of fixed capital consists of depreciation and an allowance for
accidental damage to the nation's structures and equipment.
3. If net private domestic investment is positive, then the nation's capital stock, and hence
the nation's productive capacity increases.
4. If net private domestic investment is negative, the nation's capital stock, and hence the
nation's productive capacity decreases.
C. Government Purchases
1. Government purchases of goods and services are the purchases of goods and services
by federal, state, and local governments.
a. Transfer payments are excluded from GDP because they do not involve the
production of goods and services.
D. Net Exports
1. Net exports of goods and services is the difference between exports of goods and
services and imports of goods and services.
a. Exports are produced in this country and purchased by foreigners.
b. Imports are produced abroad and are purchased by persons in this country.
2. In recent years net exports of goods and services has been a negative component of
GDP.
III. NOMINAL GDP, REAL GDP, AND THE GDP DEFLATOR
A. The Effect of Prices on GDP
1. Because changes in GDP can be caused by either a change in the quantity of goods and
services produced or a change in the price of these goods and services, it is easy to be
misled about the output of goods and services in different years.
a. To overcome the problem, economists distinguish between nominal GDP and real
GDP.
1. Changes in nominal GDP, GDP measured in current or nominal prices, can be
caused by changes in prices or output.
2. Changes in real GDP, GDP measured in constant prices, can only be caused by
a change in output.
a. Real GDP is derived by dividing nominal GDP by the GDP deflator.
1. The GDP deflator, a price index for all final goods and services, is a
weighted average of the prices of all final goods and services produced
in the economy.
IV. THE NATION'S ECONOMIC PERFORMANCE
A. Business Cycles
1. Although real GDP has increased over time, this increase has not been steady.
2. Recurring fluctuations in level of economic activity are called the business cycles.
a. During an expansion phase of the business cycle, real GDP is increasing.
1. The expansion phase is sometimes called recovery.
b. At the peak of the business cycle, real GDP is at a maximum.
1. As the economy approaches the peak, inflation may become a major problem.
c. During the contraction phase of the business cycle, real GDP is decreasing.
d. At the trough of the business cycle, real GDP is at a minimum.
1. Unemployment becomes an increasingly severe problem as the economy
approaches the trough.
2. The contraction and trough phases are called a recession.
a. When a recession is particularly severe and prolonged, it is called a
depression.
3. The phases of the business cycle differ both in terms of intensity and duration.
4. Both the long-run trend and cyclical movements of real GDP are determined by
aggregate demand and aggregate supply.
V. DETERMINING THE NATION'S OUTPUT AND PRICE LEVEL
A. Aggregate Demand
1. The aggregate demand curve shows the total amount of final goods and services (real
GDP) that will be purchased at each price level (GDP deflator).
2. The aggregate demand curve slopes downward and to the right.
a. The real balance effect causes the aggregate demand curve to be negatively sloped.
1. The real balance effect is the change in consumption caused by a change in the
real value of financial assets that have fixed dollar values.
b. Changes in the interest rate cause the aggregate demand curve to be negatively
sloped.
1. The impact of prices on real balances will affect the amount households and
firms are willing to borrow, thereby affecting the interest rate.
a. As the interest rate changes both consumption and investment will be
affected.
c. The effect of the price level on exports and imports causes the aggregate demand
curve to be negatively sloped.
1. Changes in the domestic price level will affect the relative price of exports and
imports.
3. Factors other than changes in the price level may cause the aggregate demand curve to
shift.
a. An increase in aggregate demand is represented as a rightward shift of the
aggregate demand curve.
1. An increase in aggregate demand may be caused by an increase in the level of
optimism among households and firms or by expansionary fiscal and monetary
policies.
a. Fiscal policy is the use of government purchases and taxes to achieve full
employment and other economic goals.
1. Expansionary fiscal policy is an increase in aggregate demand caused
by an increase in government purchases or a decrease in taxes.
b. Monetary policy is the use of the money supply to achieve full
employment and other economic goals.
1. Expansionary monetary policy is an increase in the money supply.
b. A decrease in aggregate demand is represented as a leftward shift of the aggregate
demand curve.
1. A decrease in aggregate demand may be caused by a decrease in the level of
optimism among households and firms or by contractionary fiscal and
monetary policies.
a. Contractionary fiscal policy is a decrease in aggregate demand caused by a
decrease in government purchases or an increase in taxes.
b. Contractionary monetary policy is a decrease in the money supply.
B. Aggregate Supply
1. The aggregate supply curve shows the total output of final goods and services (real
GDP) that will be produced at each price level (the GDP deflator).
2. The aggregate supply curve has two segments: a segment that is positively sloped up to
the full employment level of output and a segment that becomes vertical at the full
employment level of output.
a. The positively sloped segment is derived on the assumption that wage rates and
other input prices are constant.
b. The vertical segment is derived on the assumption that wage rates and other input
prices are variable.
3. Factors other than a change in the price level can shift the aggregate supply curve.
a. An increase in aggregate supply is represented as a rightward shift of the curve.
1. A decrease in input prices will cause a rightward shift in the positively sloped
portion of the aggregate supply curve.
2. An increase in the nation's labor supply, capital stock, or technology will cause
a rightward shift of the entire curve.
b. A decrease in aggregate supply is represented as a leftward shift of the curve.
1. An increase in input prices will cause a leftward shift in the positively sloped
portion of the aggregate supply curve.
2. A decrease in the nation's labor supply, capital stock, or technology will cause
a leftward shift of the entire curve.
C. Aggregate Demand and Supply Interaction
1. The intersection of aggregate demand and supply determines the equilibrium levels of
real GDP and the GDP deflator.
a. If the price level is below the equilibrium price level, aggregate quantity demanded
will exceed aggregate quantity supplied and there will be an upward pressure on
prices.
b. If the price level is above the equilibrium price level, aggregate quantity supplied
will exceed aggregate quantity demanded and there will be an downward pressure
on prices.
2. Equilibrium does not necessarily imply that real GDP will be at its full employment
level.
a. Decreases in aggregate demand can lead to unemployment.
Answers to Review Questions
1. Define GDP. Why are only final goods and services included? Why are changes in
business inventories included?
Gross domestic product or GDP is the market value of all final goods and services produced in
the economy over some time span, usually one year. Only final goods, goods purchased for
final use, are included in the measurement of GDP. If intermediate goods (goods purchased for
resale or for use in producing another good) were counted, part of the nation's output would be
counted twice. For example if both the output of the miller and the bread baker were included
in GDP, double counting would occur. That part of the miller's output (flour) used by the
baker would be counted twice, first as part of the miller's output and second as part of the
baker's output. To avoid double counting, only final goods and services are included in GDP.
Changes in inventories are included because GDP is a measure of output, not sales. Because of
this, all final goods and services produced during the year are counted whether they are sold or
not. If they are not sold, these goods are simply added to the stock of a business's inventories.
Hence, changes in business inventories are counted as a part of GDP.
2. List and briefly describe GDP's major components.
There are four major components of GDP, consumption, gross investment, government
purchases, and net exports. Consumption consists of household expenditures for durable
goods, nondurable goods, and services. These expenditures are not only the major component
of GDP, but they are also a relatively stable component.
Gross investment consists of the purchases of new equipment by firms, the purchases of all
newly produced structures, and changes in business inventories. Gross investment is less
stable than consumption.
Government purchases are the purchases of goods and services by local, state, and federal
government. State and local government account for the bulk of these purchases. Government
purchases account for only a small percentage of GDP because transfer payments are excluded.
Net exports is the difference between a country's exports of goods and services and its imports
of goods and services. Exports are produced in this country and sold abroad. Because they are
a part of this nation's output, they must be included in GDP. Imports are produced abroad and
sold in this country. Because they are not a part of this nation's output they must be excluded
from GDP. Net exports may be positive, negative, or zero depending upon whether exports are
greater than, less than, or equal to imports, respectively.
3. Describe the effects of each of the following on U.S. GDP:
a. A terrorist attack that destroys a dam and destroys 1,500 homes downstream
b. A ban on U.S. imports from Germany
c. The legalization of marijuana
d. U.S. involvement in a war in the Middle East
a. If the dam and homes were reconstructed, this reconstruction would be counted as a part of
gross domestic private investment, thereby increasing GDP.
b. Imports are excluded from GDP. As a result, a ban on U.S. imports from Germany would
have no immediate effect on GDP. However, if U.S. firms increase their output to meet
the demand previously satisfied by these imports, GDP may rise.
c. Illegal activities, including the production of marijuana, are not included in GDP. If
marijuana were legalized, its market value would be included in GDP. GDP, therefore,
would rise.
d. If the United States became involved in a war in the Middle East, the federal government
would increase their purchases of goods and services in order to provide supplies for the
war effort. As a result of these increased purchases, GDP would rise.
4. What is the underground economy? Why do people participate in the underground
economy? How might its size be reduced?
The underground economy consists of economic activity that avoids official detection and
measurement. Activities in the underground economy are either inherently illegal or are not
reported to avoid taxes, to avoid detection by the Immigration and Naturalization Service, or
for other reasons. Many believe that the more people are participating in the underground
economy because the tax burden in the United States has grown, because government
regulation has increased, and because there is widespread dissatisfaction with government.
Suggestions to reduce the size of the underground economy include: reducing tax rates, making
the tax system more equitable, devoting more resources to law enforcement, and increasing the
penalties for participating in the underground economy. However, given the nature of the
underground economy and the incentives individuals have for being participants, it is unlikely
that any of the above remedies will have a significant impact on the size of the underground
economy.
5. What is the difference between nominal and real GDP?
Nominal GDP is GDP measured on the basis of current or nominal prices. It reflects both
changes in prices and output. Real GDP is GDP measured on the basis of constant prices. It
reflects only changes in output.
6. "An increase in nominal GDP means that more goods and services are available to
society." Using a specific example, explain why this statement is true or false.
This statement is false. To illustrate consider the following table which shows the price and
quantity of the two goods produced by the "Tropical Economy" during two consecutive years.
Goods
Bananas
Coconut
Milk
1996
Price
$1.00/lb.
$2.00/qt.
1996
Quantity
100 lbs.
300 qts.
1997
Price
$3.00/lb.
$6.00/qt.
1997
Quantity
100 lbs.
300 qts.
Nominal GDP in 1996 would be ($1.00 X 100) + ($2.00 X 300) = $700.
Nominal GDP in 1997 would be ($3.00 X 100) + ($6.00 X 300) = $2,100.
As can be seen, nominal GDP increased in 1997; however, this increase is due solely to the
increase in prices. Output was the same in both years. Because nominal GDP reflects both
changes in prices and output, it is possible for it to rise without more goods and services being
produced.
7. Fill in the blanks in the following table:
YEAR
2002
2003
2004
NOMINAL GDP
(billions of current $)
______
6,500.0
9,000.0
REAL GDP
(billions of 1992 $)
4,800.0
5,000.0
______
GDP
DEFLATOR
120.0
_____
150.0
Real GDP = Nominal GDP/Price Deflator (in decimal form). Solving for nominal GDP gives
Real GDP X Price Deflator = Nominal GNP. Hence, nominal GNP in 2002 is $4,800 X 1.20,
or $5,760.
Real GDP = Nominal GDP/Price Deflator. Solving for the price deflator gives Price Deflator =
Nominal GDP/Real GDP. This must be multiplied by 100 to remove the decimal. Hence, the
GDP price deflator in 2003 is ($6,500/$5,000) X 100, or 130.0.
Real GDP = Nominal GDP/Price Deflator. Hence real GDP in 2004 is $9,000/1.50, or $6,000.
8. Discuss the business cycle and its phases. What are the short- and long-run implications
of the business cycle for the growth of real GDP?
Over the years, real GDP in the U.S. has grown at about 3 percent per year; however, there has
been a great deal of fluctuation around this trend. These recurring fluctuations in the level of
economic activity are known as business cycles. The various phases of a cycle include the
expansion and contraction phases, a trough, and a peak. During the expansion phase, real GDP
increases relatively rapidly and employment increases. A relatively higher percentage of the
economy's productive capacity is used. As time passes, wages and prices begin to rise.
Eventually, a high point called the peak will be reached. At the peak real GDP, employment,
and productive capacity use are at a maximum. Rising wages and prices become a serious
problem.
During the contraction phase, real GDP will decline as will employment and productive
capacity use. Eventually a low point called the trough will be reached. At the trough, real
GDP, employment, and productive capacity use are at a low point. With high unemployment
and low capacity use, wages and prices will rise less rapidly or even fall.
In the short run, the business cycle means that output will fluctuate. These fluctuations
translate into unemployment and inflation. Despite these short-run fluctuations, the long-run
trend in real GDP has been upward. Thus, despite short-run problems with inflation and
unemployment, the economy has been successful in increasing its output, employment, and
productive capacity.
9. What is the aggregate demand curve? Why is it negatively sloped?
The aggregate demand curve shows the total amount of final goods and services (real GDP)
that will be purchased at each price level (the GDP deflator). It is composed of consumption,
investment, government purchases, and net exports. This curve is depicted in the graph below.
GDP Deflator
P1
P2
AD
0
Q1
Q
2
Real GDP
As can be seen the curve is negatively sloped indicating that a greater quantity of goods and
services will be demanded at lower price levels. For example, at price level P1, people are
willing to buy quantity Q1. At the lower price level P2, individuals are willing to purchase a
greater quantity, Q2.
There are three factors that account for the negative slope of the aggregate demand curve: 1)
the real balance effect, 2) the interest rate effect, and 3) the effect of the price level on imports
and exports. The real balance effect deals with the impact of price level changes on the real
value (or purchasing power) of financial assets. As the price level rises, the purchasing power
of financial assets such as currency and checking and savings account balances will fall. As
the value of these assets in real terms erodes, households will cut back on consumption. Since
consumption is one component of aggregate demand, when households are willing to buy less,
aggregate demand will fall.
The interest rate effect deals with the impact that price level changes have on the interest rate.
As the price level increases there is a tendency for interest rates to rise. This may occur
because as the value of their real balances fall, households attempt to borrow money in order to
maintain their spending. As interest rates rise it becomes more costly for firms to invest.
Investment is a component of aggregate demand. As it falls, aggregate demand will fall.
These higher rates may also discourage housing construction and the purchase of automobiles
and other consumer durables. Thus, increases in interest rates may not only affect aggregate
demand through decreases in investment, but also through decreases in consumption.
Finally, the changes in the price level will affect imports and exports. If the price level in the
United States increases relative to the price level abroad, goods produced in the United States
will become relatively more expensive. This will cause a decline in exports as foreigners cut
back on their purchases of the now relatively more expensive U.S. products. Likewise there
will be an increase in imports as U.S. consumers buy more of the relatively less expensive
foreign products. The fall in exports and the rise in imports work to decrease net exports, a
component of aggregate demand. Thus the effect of the price level on real balances, the
interest rate, and net exports will cause the aggregate demand curve to be negatively sloped.
10. What factors may cause the aggregate demand curve to shift? Graphically illustrate both
an increase and a decrease in aggregate demand.
There are several factors that can cause a shift in the aggregate demand curve. One factor is
the expectations of households and firms about the future of the economy. For example,
suppose both households and firms expect the economy to be doing very well during the next
few years. Households may increase their consumption and firms may undertake more
investment. These increases in consumption and investment will cause an increase in
aggregate demand. On the other hand, if households and firms were pessimistic about the
future of the economy, consumption and investment would fall, thereby causing a decrease in
aggregate demand.
Fiscal policy, the use of government spending and taxation to achieve full employment and
other goals, can also shift aggregate demand. Government purchases are one component of
aggregate demand. If these purchases increase, aggregate demand will rise. If government
cuts back on spending, aggregate demand will decrease. Changes in taxes affect the disposable
income of households, which in turn affects consumption. If taxes fall, disposable income will
increase, thereby increasing consumption. The increase in consumption will cause an increase
in aggregate demand. If government institutes a tax increase, disposable income, and hence
consumption, will fall. The fall in consumption will lead to a decrease in aggregate demand.
Finally, monetary policy, changes in the money supply brought about by the Federal Reserve in
an attempt to achieve full employment and other economic goals, will also affect aggregate
demand. If the money supply increases, there will be an increase in real balances. This
increase will cause consumption and hence, aggregate demand, to increase. An increase in the
money supply will also lead to a decrease in interest rates. This decline will work to increase
both investment and consumption, thereby increasing aggregate demand. If the money supply
decreases, real balances will fall and the interest rate will rise. This will lead to a decrease in
aggregate demand.
An increase in aggregate demand means that a greater quantity will be demanded at each price
level. The aggregate demand curve will shift to the right or upward. A decrease in aggregate
demand means that a lesser quantity of goods and services will be demanded at each price level
and the aggregate demand curve will shift to the left or downward. These shifts are illustrated
in the following graph.
GDP Deflator
P1
AD
AD
2
1
AD 3
0
Q3
Q1
Q2
Real GDP
Suppose aggregate demand is initially represented by AD1. If the price level is P1, then the
quantity demanded will be Q1. Now suppose there is a decrease in taxes so that aggregate
demand increases to AD2. With the increase in aggregate demand there is a greater quantity
demanded at each price level. For example, at price level P1, quantity demanded is now Q2.
Suppose that instead of a tax cut, government increases taxes. This policy will lead to a
decrease in aggregate demand. The curve will shift left to AD3. With the decrease in
aggregate demand there is a lesser quantity demanded at each price level. For example, at
price level P1, quantity is now Q3.
11. Carefully explain why the aggregate supply curve has two segments: a positively sloped
segment and a vertical segment.
The aggregate supply curve shows the total output of final goods and services (real GDP) that
will be produced at each price level (the GDP deflator). This curve is depicted in the graph
below.
GDP Deflator
AS 5
0
AS 1
AS 4
Real GDP
Note that this curve has two segments: a positively sloped segment and a vertical segment.
The positively sloped segment indicates that as the price level increases the quantity supplied
will rise. For example, at price level P1, the quantity supplied will be Q1. As the price level
increases to P2, the quantity supplied will increase to Q2. This segment of the curve is drawn
on the assumption that input prices, the supply of labor, the capital stock, and technology are
constant. This means that as price increases it will be more profitable for the firm to increase
production.
The vertical segment is drawn on the assumption that the supply of labor, the capital stock, and
technology are constant. It indicates that as the price level increases there will be no
corresponding increase in output. For example, as the price level increases from P2 to P3,
output remains constant at Q2. Why does such a segment occur? Initially as the price level
increases production rises. In order to increase production, firms hire more workers and
unemployment falls. Eventually, as production continues to increase, full employment will be
reached. Output at Q2 represents full employment output, the output that could be produced if
full employment existed in the economy. Once full employment is reached, it is no longer
valid to assume that input prices are constant. Now if a firm wishes to increase output it must
offer a higher wage in order to attract workers away from other firms. Even though the price
level and input prices are rising, output remains constant because increases in one firm's output
are offset by decreases in output that occur as other firms lose workers.
12. What factors will cause the aggregate supply curve to shift? How will these factors affect
the two segments of the curve?
The positively sloped segment of the aggregate supply curve is derived on the assumption that
input prices, the labor supply, the capital stock, and technology are constant. The vertical
segment is drawn on the assumption that the labor supply, the capital stock, and technology are
constant. Given these assumptions, any change in input prices will affect the positively sloped
segment of the curve. A change in the labor supply, the capital stock, or technology will affect
both segments of the curve. Examples of these changes are represented in the graphs below.
GDP Deflator
B
P2
.
AS
P1
AS
0
.A
2
AD
1
Q2
Q1
Real GDP
Suppose there is a change in input prices. This will shift the positively sloped segment of the
aggregate supply curve. Suppose aggregate supply is initially represented by AS1. If there is
an increase in an input price, say an increase in wages, there will be a decrease in aggregate
supply, and the curve will shift to the left or upward to AS2. A decrease in input prices brought
about by a decrease in wages will lead to an increase in aggregate supply. In this case, the
curve will shift to the right or downward to AS3.
Now assume that there is an increase in the capital stock. Given AS1, this change will cause
the entire aggregate supply curve to shift to the right to AS4. Just the opposite will occur if
aggregate supply decreases. For example, suppose there was a decrease in the labor supply.
AS1 will now shift leftward to AS5.
13. Using graphical analysis, explain why the equilibrium levels of GDP and the GDP
deflator are determined by the intersection of the aggregate demand and aggregate
supply curves.
As is usual with demand and supply, equilibrium is determined by the intersection of the two
curves. This equilibrium is illustrated in the graph below.
Given aggregate demand, AD, and aggregate supply, AS, equilibrium occurs at point A.
Equilibrium GDP, Q1, is determined by reading down from point A to the horizontal axis. The
equilibrium GDP deflator, P1, is determined by reading across from point A to the vertical axis.
By considering price levels above and below P1, it can be shown that P1 and Q1 must be the
equilibrium levels. For example, suppose the price level is above the equilibrium level, say P2.
At P2, the aggregate quantity supplied, Q1, exceeds the aggregate quantity demanded, Q2.
Buyers do not buy everything suppliers produce. This excess supply puts a downward pressure
on prices. As the price level falls towards P1 quantity demanded will increase and quantity
supplied will decrease. Prices will continue to fall until the excess supply is eliminated.
The opposite will occur if the price level is below P1, say P3. Now the aggregate quantity
supplied is given by Q2, while the aggregate quantity demanded is given by Q3. Buyers wish to
buy more than suppliers are willing to produce, and excess demand exists. This excess demand
puts an upward pressure on prices. As the price level rises towards P1, quantity demanded will
decrease and quantity supplied will increase. Prices will continue to rise until the excess
demand is eliminated. Thus, only at point A where aggregate quantity demanded is equal to
aggregate quantity supplied, can there be equilibrium. At this point the GDP deflator will be P1
and GDP will be Q1.
14. Over the last three decades, there have been several episodes of increasing oil prices due
to political events. The United States imports much of the oil that it uses. What effect does
a large increase in oil prices this have on real GDP and the GDP deflator? Defend your
answer.
The increasing oil prices have resulted in a decrease in real GDP and an increase in the GDP
deflator. In order to understand why this is so observe the following graph.
GDP Deflator
AS
P2
.A
P1
P3
AD
0
Q2 Q1 Q
3
Real GDP
Suppose the economy is initially in equilibrium at point A. Real GDP, Q1, is at the full
employment level and the GDP deflator is P1. The is a rise in the price of oil, an input used in
the production process. This increase in cost caused a decrease in aggregate supply from AS1
to AS2 which moved the economy to a new equilibrium at point B. At B, real GDP falls to Q2
and the GDP deflator rises to P2. The aggregate demand and aggregate supply model shows
that the results of these actions are to lower real output and increase prices.
GDP Deflator
AS
P2
P1
.A
P3
AD
0
Q2 Q1 Q
3
Real GDP