Second Edition
Chapter 13
Business Fluctuations and
the Dynamic Aggregate
Demand-Aggregate
Supply Model
Chapter Outline




The Dynamic Aggregate Demand Curve
The Solow Growth Curve
Real Shocks
Aggregate Demand Shocks and the ShortRun Aggregate Supply Curve
 Shocks to the Components of Aggregate
Demand
 Understanding the Great Depression:
Aggregate Demand Shocks and Real
Shocks
2
Introduction
 Real GDP grew at an average rate of 3.3%
over the past 50 years. Growth is not a
smooth process.
3
Introduction
 Business fluctuations – fluctuations in the
growth rate of real GDP around its trend
growth rate.
 Recession – a significant, widespread
decline in real income and employment.
4
Introduction
 The unemployment rate increases during a
recession:
5
The Dynamic Aggregate
Demand Curve
 Dynamic aggregate demand curve –
shows all the combinations of inflation and
real growth that are consistent with a
specified rate of spending growth, M  
 Recall the quantity theory in dynamic form:
M    P  YR  Inflation  Real Growth
 The AD curve – gives combinations of
inflation and real growth consistent with a
given rate of spending growth, M v .
6
The Dynamic Aggregate
Demand Curve
Inflation
Note: The sum of inflation
and real growth will always
equal spending growth,
which equals money growth
plus the growth of velocity.
i.e.
M  v  P  YR
Rate (p)
7%
5%
2%
0%
-2%
5% + 0% = 5%
2% + 3% = 5%
AD (spending growth = 5%)
0%
3%
5%
7%
Real GDP
growth rate7
Check The Math
 If the money supply is growing a 5% per
year ( M = 5%) and velocity is stable
(  = 0%) then Inflation + Real growth must
equal 5%. If Real growth is 3% then
inflation must be 2%.
8
Shifts in the Dynamic Aggregate
Demand Curve
Inflation
Rate (p)
1. Increases in spending growth,
 M and/or  
7%
shifts the AD curve to the right.
2. Decreases in spending growth,
5%
 M and/or  
shifts the AD curve to the left.
AD (spending growth = 7%)
2%
AD (spending growth = 5%)
0%
-2%
0%
3%
5%
7%
Real GDP
growth rate
9
Check Yourself
 If we have a dynamic aggregate demand
curve with M = 7% and  = 0%, what will
inflation plus real growth equal? If we find
out that real growth is 0%, what is
inflation?
 Increased spending growth shifts the
dynamic aggregate demand curve which
way: inward or outward?
10
The Solow Growth Curve
 Solow growth rate – is an economy’s
potential growth rate, the rate of economic
growth that would occur given the flexible
prices and existing real factors of
production.
 Important point – If markets are working
well and prices are perfectly flexible, the
economy will grow at the potential growth
rate.
11
The Solow Growth Curve
Inflation
Rate (p)
Solow growth
curve
Why is the Solow Growth
Curve vertical?
• Potential growth does
not
depend on the inflation
rate.
3%
Real GDP
growth rate
12
Shifts in the Solow Growth Curve
 Real shock – also called a productivity
shock, is any shock that increases or
decreases the potential growth rate.
• Positive real shock – shifts the Solow growth
curve to the right → higher real growth.
• Negative real shock – shifts the Solow growth
curve to the left → lower real growth.
Let’s see how this works.
13
Shifts in the Solow Growth Curve
Solow growth
curve
Inflation
Rate (p)
Negative
shock
-1%
Positive
shock
3%
7%
Positive productivity shocks
• Shifts the Solow growth
curve to the right.
Negative productivity shocks
• Shifts the Solow growths
curve to the left.
Real GDP
growth rate
14
Putting the AD and the Solow Growth
Curve Together
Inflation
Rate (p)
Solow growth
curve
Negative
shock
Positive
shock
11%
7%
1. A positive shock results
in a higher real growth
rate, 7%, and lower
inflation, 3%.
2. A negative shock
results in a lower real
growth rate, -1%, and
higher inflation, 11%.
3%
AD (M  v  10%)
-1%
3%
7%
Real GDP
growth rate
15
Real Shocks
 Changes in economic conditions that
increase or decrease the productivity of
capital and labor.
 We will take a closer look at different kinds
of real shocks:
• Weather
• Oil shocks
• Other shocks including wars, terrorist attacks,
major new regulations, mass strikes, tax
changes, and new technologies.
16
Real Shocks
 Weather
• Economies that depend heavily on agriculture
are most effected by weather.
• India is a good example.
• Let’s look at the next diagram and see what
we can learn about weather on the overall
economy.
17
Real Shocks: Weather
Panal A: changes in rainfall have a large impact on agricultural output.
Panal B: Prior to 1980 changes in the growth rate of real GDP are closer
Related to changes in rainfall than after 1980. Why?
18
Real Shocks: Oil
 Economy with a large manufacturing
sector: a reduction in oil supply is like a
decrease in rainfall in an agricultural
economy.
 First oil shock: 1973, Oil embargo
• Price of oil more than tripled → higher gas
prices.
• Higher gas prices reduced the demand for
larger cars → costly changes in the auto
industry
19
Real Shocks: Oil
 Sharp increases in oil prices adversely
affects many industries including:
• Those industries that convert oil into products
such as plastics and textiles.
• Transport of goods
• Industries that depend on people traveling to
destinations e.g. the hospitality industry
(resorts and hotels), airlines.
 The cumulative effect of these impacts can
result in recessions.
20
Real Shocks: Oil
21
Real Shocks: Oil
 It is more difficult to eyeball the effect of
smaller oil shocks.
 Statistical analysis can disentangle the
effect of oil shocks from other shocks that
occur at the same time.
 The following graph shows that the impact
of a 10% increase in the price of oil can
impact real GDP growth for two and a half
years!
22
Real Shocks: Oil
23
More Shocks
 Economies are continually hit by many
small shocks.
 Typical year: good shocks outweigh the
bad and the economy grows.
 Bad year: A recession results when:
• Economy is hit by a large bad shock, or
• More small shocks are negative than positive.
The next table summarizes the major shocks that can
shift the Solow growth curve
24
Real Shocks
25
Check Yourself
 Consider the ubiquity of cell phones
throughout the world. How can this
ubiquity be considered a positive stock?
(Hint: Compared with 10 years ago).
 How would a large and sudden increase in
taxes, for example, a tax on energy, shift
the Solow growth curve?
26
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
 John Maynard Keynes (1883–1946)
• The General Theory of Employment, Interest,
and Money, 1936.
• Wrote in the context of the
Great Depression.
• Explained that when prices are
not perfectly flexible (sticky),
deficiencies in aggregate
demand could cause
recessions.
27
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
 Aggregate demand shock – a rapid and
unexpected shift in the AD curve (spending
growth)
• Short-run: Increase in AD is split between
increases in inflation and increases in real
growth.
• Long-run: Increase in AD results only in higher
inflation.
• Essence of the short-run aggregate supply
curve – the short-run increase in output
resulting from sticky prices and wages
28
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
 SRAS – shows the positive relationship
between the inflation rate and real growth
when prices and wages are sticky.
• Upward sloping – increase in AD will increase
both inflation and real growth.
• Each SRAS curve is associated with a
particular rate of expected inflation E(p).
 Let’s put everything together to see what
happens if the money supply increases
unexpectedly.
29
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
Inflation
Rate (p)
Solow growth
curve
1. E(p) = current rate of
inflation, 2%.
2. Note: there is a different
SRAS for every level of
expected inflation, E(p).
SRAS (E(p) = 2%)
2%
AD (M  v  5%)
3%
Real GDP
growth rate
30
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
Inflation
Rate (p)
Solow growth
curve
What if there is an
unexpected ↑ in M ?
• Short-run: a → b
SRAS (E(p) = 2%)
b
4%
2%
AD (M  v  10%)
a
AD (M  v  5%)
3%
6%
Real GDP
growth rate
31
How a Spending Increase Can Create a
Temporary Increase in Growth
 Increase in spending → higher prices
 Higher prices encourage producers to
increase output.
 Increased output → overtime and higher
hourly wages.
 Workers are eager to work longer for
overtime wages.
32
How a Spending Increase Can Create a
Temporary Increase in Growth
 Eventually workers realize they are
working more for lower real wages and
demand higher regular wages.
 Nominal wage confusion – Occurs when
workers respond to their nominal wage
instead of their real wage.
 Prices don’t always change quickly due to
menu costs.
 Menu costs – costs of changing prices.
33
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
Inflation
Rate (p)
Solow growth
curve
SRAS (E(p) = 7%)
What if there is an
unexpected ↑ in M ?
• Short-run: a → b
• Long-run: b → c
c
7%
SRAS (E(p) = 2%)
b
4%
2%
AD (M  v  10%)
a
AD (M  v  5%)
3%
6%
Real GDP
growth rate
34
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
 Why does the SRAS shift up?
• In the long-run, unexpected inflation becomes
expected inflation.
• An increase in AD → higher expected inflation.
• Higher expected inflation causes producers
and workers to raise prices and wages in
order to hold real incomes and wages
constant.
• The SRAS shifts up so that the actual inflation
rate equals the expected inflation rate.
35
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
 Preview of some dilemmas in policy:
• Once c is reached, policy makers may try to
increase growth by increasing the expected
rate of inflation even higher (above 7%) and
may get trapped in an inflationary spiral.
• Lowering the inflation rate by reducing the
growth rate of money may cause a recession
due to prices being more sticky downward.
Let’s use the model to see this.
36
A Fall in Aggregate Demand Could Induce a
Lengthy Recession
Inflation
Rate (p)
Solow growth
curve
(SRAS)
(E(p) = 7%)
7%
6%
a
b
AD1 (M  v  10%)
AD2 (M  v  5%)
-1% 0% 3%
Real Growth
37
Check Yourself
 The Solow Growth curve is vertical, the
short-run aggregate supply curve is not.
What explains the difference?
 Why do inflation expectations form the
dividing line between the short-run and the
long-run?
 Why does growth in spending lead to an
increase in both inflation and real growth in
the short-run? Why isn’t this the case in the
long-run?
38
Shocks to the Components of
Aggregate Demand
 Changes in  are the same as changes in
the spending rate, holding M constant.
 If  increases, the growth rate of C, I, G, or
NX must increase.
 We will look at changes in each of these
components as a change in  .
 Changes in  tend to be temporary (we
will explain why later)
39
A Shock to the Growth Rate of Spending
Inflation
Rate (p)
Solow growth
curve
Fear of consumers
→ temporary
decrease in AD
 Short-run
(SRAS)
• Wages are
(E(p) = 7%)
sticky
• Real growth ↓
 Long-run
• AD returns
a
• Real growth ↑
7%
6%
b
AD1 (M  v  10%)
AD2 (M  v  5%)
-1% 0% 3%
Real Growth
40
Why Changes in  Tend to
Be Temporary

 Changes
in  differ from changes in M

• M can be set permanently at any rate.
• Changes in  tend to be temporary.
 Example:
• As consumers cut back on purchases, other
goods become more important so they stop
cutting back
• As consumers cut consumption, savings
increase and they become more reassured
about spending.
41
Why Changes in  Tend to
Be Temporary
 Another example
• The growth rate of government spending can’t
be greater than the growth rate of GDP for too
long.
 The shares of GDP devoted to C, I, G, and
NX have been stable over time.
 Changes C, I, G, and NX do not change
the rate of inflation in the long-run.
42
Other AD Shocks

 Fearand confidence – affect I the same as
with C .
 Wealth shocks
• Stock prices tumble: household
wealth falls

and consumers reduce C .
• House prices rise quickly: household wealth
increases and consumers increase C .

C
 Changes
in
Taxes
are
another
shifter
of

and I
The next table provides a good summary
43
Some Factors That Shift the Dynamic
Aggregate Demand Curve
44
Check Yourself
 What always happens to unexpected
inflation in the long run?
 Show what happens to the dynamic
aggregate demand curve if consumers
fear a recession is coming and cut back on
their expenditures.
45
Understanding the Great Depression:
Aggregate Demand Shocks and Real Shocks
 Most catastrophic economic event in the
history of the United States (1929-1940).
• GDP plummeted by 30 percent.
• Unemployment rates exceeded 20 percent.
• Stock market fell to less than a third of its initial
value.
• It was a worldwide event
 In Germany, it led to a totalitarian regime.
• Economic policy was partly at fault.
46
Understanding the Great Depression:
Aggregate Demand Shocks and Real Shocks
 The “Narrative”:
• October 1929 – the stock market crashed.
 Caused in part by tight monetary policy aimed at
limiting a stock market bubble.
 Created a wealth shock – along with the tight
monetary policy shifted the AD curve to the left.
• 1929-1933 Four waves of bank panics
 By 1933, 40 percent of all American banks had
failed.
47
Understanding the Great Depression:
Aggregate Demand Shocks and Real Shocks
 The “Narrative” (cont.):
• 1929 - 1933 investment spending fell by nearly
75 percent.
 By 1940 the U.S. capital stock was lower than it
was in 1930.
• 1931 – the Fed allowed the money supply to
contract even further.
 The money supply fell by 1/3.
 This is the largest negative shock in U.S. history.
48
Understanding the Great Depression:
Aggregate Demand Shocks and Real Shocks
 What should the Fed have done?
• Increase the money supply:
 To drive up output.
 Increase reserves of banks to stop the panics.
 1937-1938—The Fed caused another
monetary contraction.
• Contracted the economy and unemployment
increased.
• Prolonged the “Great Depression”.
Our model can help understand this narrative.
49
The Great Depression and the Fall in
Aggregate Demand
Solow growth
curve
Inflation
Rate (p)
SRAS
1.  C
C
0%
Sequence:
2.  I
I
3.  M
M
AD (M  v  4%)
-10%
AD (M  v  23%)
-13%
4%
Real GDP
growth rate
50
Real Shocks and the Great Depression
 Linked to AD shocks in most recessions.
 We will look at several that played a role in
the failure of the economy to recover more
quickly:
 Bank failures:
• Reduced the efficiency of financial
intermediation
• The bridge between savers and investors
collapsed.
• Small businesses were especially harmed
51
Real Shocks and the Great Depression
 Policy mistakes
• Fed failed to use monetary policy to increase
aggregate demand
• Policies that tried to combat deflation by
reducing aggregate supply
 NIRA – Businesses were encouraged not to invest in
machinery and to raise prices by creating cartels.
 AAA – Govt. paid farmers to kill animals and plow
under crops
(Both laws were later declared unconstitutional)
52
Real Shocks and the Great Depression
 Smoot-Hawley Tariff of 1930
• Intent was to boost demand for domestic
goods.
• What really happened?
 Other countries retaliated with tariffs and exports
fell. This reduced AD.
 A tariff is a negative productivity shock (shifts LRAS
to the left).
• Pushes capital and labor into lower productivity
sectors.
53
Real Shocks and the Great Depression
 The Dust Bowl – natural shock
• Severe drought ruined millions of acres of
crops.
• Hundreds of thousands of people were forced
to leave their homes.
• Millions of acres of
farmland became
useless.
The Dust Bowl was a real shock
54
Real Shocks and the Great Depression
 Final thought:
• In a good year, any of the real shocks of the
Great Depression individually could have been
absorbed without major difficulty.
Compounded they made a desperate situation
even worse.
55
Takeaway
 We have used the framework of dynamic
aggregate-demand and short-run aggregate
supply to analyze business fluctuations.
 Business fluctuations refers to the fact that the
growth rate of real GDP is volatile in the short-run.
 The aggregate demand curve slopes downward
and the short-run aggregate supply curve slopes
upward.
 When you combine the AD and the SRAS curves
into a single diagram, you can analyze a wide
variety of economic scenarios and how they affect
the growth rate of the economy.
56
Takeaway
 Changes in AD
can be broken 
up into

changes in M and changes in  .

 Changes in can
be
broken down into


changes in C, I , G, NX.
 You should know and understand what
makes wages and prices sticky.
 The Great Depression resulted from
concentrated and interrelated series of
aggregate demand and real shocks.
57
Takeaway
 The material in this chapter is the central
core of macroeconomics.
• If you understand where the curves come
from and how to shift them…
 You will have a basic toolbox for analyzing many
economic questions.
 You will be ready to tackle many of the core topics
of macroeconomics and business cycles.
58
Second Edition
End of Chapter 13