Chapter
Nine:
Aggregate
Demand and
Economic
Fluctuations
The Business Cycle
Figure 9.1: U.S. Real GDP and Recessions
Source: BEA quarterly data 1985–2012, and NBER
Figure 9.2: U.S. Unemployment Rate and Recessions
Figure 9.3: U.S. Inflation Rate and Recessions
Inflation Rate
(Percent Annual)
15
10
5
0
-5
-10
-15
Source: “Economic Report of the President” 1985–2005; rate is calculated as a three-month moving average of the CPI; NBER.
Figure 9.4: A Stylized Business Cycle
Expansion
GDP
Contraction
Peak
Peak
Y*
Trough
Year
Table 9.1: The Early Years of the Great Depression
in the United States
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
Real Standard and Poor’s Stock Index
Unemployment rate (official)
Price level (CPI)
Real gross domestic product
Real personal consumption
expenditures
Real gross private domestic
investment
Real private debt
Bankruptcy cases
Non-farm real estate foreclosures
Food energy per capita per day
(calories)
1929
100.0
3.2%
100.0
865.2 billion
1933
45.7
24.9%
75.4
635.5 billion
661.4 billion
541.0 billion
91.3 billion
88.9 billion
56,867
134,900
17 billion
102.0 billion
67,031
252,400
3460
3280
Sources: (a) from Historical Statistics of the United States, p. 1004, series X495.; (b)-(c) from Dornbusch, Fischer, & Startz (2001);( d)-(f) from
http://www.bea.doc.gov/bea/dn/nipaweb/TableView.asp#Mid; (g) from Historical Statistics of the United States, p. 989, series X399.; (h) from Bradley Hansen and Mary
Eschenbach Hansen, The Transformation of Bankruptcy in the United States (http://academic2.american.edu/~mhansen/transform.pdf ); (i) from Historical Statistics of the
United States, p. 651, series N301; (j) from Ibid., p. 328, series 851; (d) and (e) are inflation-corrected using (b)
Macroeconomic Modeling and
Aggregate Demand
Figure 9.5: The Output-Income-Spending Flow of
an Economy in Equilibrium
Production
generates
incomes
Output
Income
(Y )
(Y )
Incomes give
actors the ability
to spend
Spending
stimulates firms
to produce
Spending
(Aggregate Demand or AD )
Figure 9.6: The Output-Income-Spending Flow with
Leakages and Injections
Production
generates
income to
households
Output (Y )
Income (Y )
leakage
Sufficient to
sustain output at
a steady level
?
Consumption (C )
Saving (S )
households decide how
much to consume and
save
Spending (AD )
injection
firms decide
how much to
invest
Intended Investment ( II )
Figure 9.7: The Classical Model of the Market for
Loanable Funds
Interest rate
Supply of
Loanable
Funds
E1
5%
Demand for
Loanable Funds
140
Quantity of funds
borrowed and lent
Figure 9.8: Adjustment to a Reduction in Intended
Investment in the Classical Model
Interest rate
Supply of
Loanable
Funds
E0
5%
3%
E1
Original
Demand
New Demand
60
140
Quantity of funds
borrowed and lent
Figure 9.9: Macroeconomic Equilibrium at Full
Employment in the Classical Model
Production
generates
income
Income (Y* )
Output (Y* )
leakage
Consumption (C )
Spending
stimulates
firms to
produce
Spending sufficient
to sustain full
employment
AD = Y*
Saving (S )
Equilibrium in
the market for
loanable
funds
injection
Intended Investment
(II ) is equal to S
The Keynesian Model
Table 9.2: The Consumption Schedule (and Saving)
(1)
Income
(Y)
0
100
200
300
400
500
600
700
800
(3)
The part of consumption that
depends on income, with mpc
= 0.8
20
20
20
20
20
20
20
20
20
=0.8  column(1)
0
80
160
240
320
400
480
560
640
(4)
Consumption
C = 20 + 0.8 Y
(5)
Saving
S = Y–C
= column(2)
+ column(3)
20
100
180
260
340
420
500
580
660
= column(1)
–column(4)
-20
0
20
40
60
80
100
120
140
Figure 9.10: The Keynesian Consumption Function
Consumption =
Income Line
Consumption (C )
500
Consumption (C )
(= C + mpc Y)
400
340
300
Saving (S)
Slope = mpc
200
100
C = 20
45
0
100
400
Income (Y )
Intended Investment (= II )
Figure 9.11: The Keynesian Investment Function
II = 60
Intended
Investment (II )
(= II )
Income (Y )
Consumption, Investment, and
Aggregate Demand
Figure 9.12: Aggregate Demand
Aggregate Demand
(AD ) = C + II
Consumption (C )
400
Intended Investment (II )
340
C +II = 80
400
Income (Y )
Table 9.3: Deriving Aggregate Demand from the
Consumption Function and Investment
(1)
Income
(Y)
(2)
Consumption
(C)
0
300
400
500
600
700
800
20
260
340
420
500
580
660
(3)
Intended
Investment
(II)
60
60
60
60
60
60
60
(4)
Aggregate Demand
AD = C + II
= column (2) + column (3)
80
320
400
480
560
640
720
Table 9.4: Aggregate Demand with Higher Intended
Investment
(1)
Income
(Y)
(2)
Consumption
(C)
(3)
Intended Investment
(II)
(4)
Aggregate Demand
(AD)
0
300
400
500
600
700
800
20
260
340
420
500
580
660
140
140
140
140
140
140
140
160
400
480
560
640
720
800
Aggregate Demand
Figure 9.13: Aggregate Demand with a Higher
Level of Intended Investment
1000
AD (II = 140)
AD (II = 60)
800
700
600
500
480
400
300
160
C  I = 200
80
C  I = 100
I
I
0
100
400
800
Income (Y )
Table 9.5: The Possibility of Excess Inventory
Accumulation or Depletion
(1)
Income
(Y)
(2)
Aggregate
Demand
(AD)
300
400
500
600
700
800
320
400
480
560
640
720
(3)
Excess Inventory
Accumulation (+) or
Depletion (-)
= column(1)column(2)
-20
0
20
40
60
80
(4)
Intended
Investment
(II)
(5)
Investment
(I)
= column(3)
+ column(4)
(6)
Check that the
macroeconomic
identity still holds:
Y = C+I
60
60
60
60
60
60
40
60
80
100
120
140
300
400
500
600
700
800
Aggregate Demand and Output
Figure 9.14: Unintended Investment in the
Keynesian Model
Output = Income
Line
Aggregate Demand (AD )
1000
800
unintended
investment
(build up of
inventories)
700
720
600
500
E
400
300
200
100
80
45
0
100
400
800
Income (Y )
Aggregate Demand and Output
Figure 9.15: Full Employment Equilibrium with High
Intended Investment
Full Employment
1000
AD0 (II = 140)
800
E0
700
600
500
400
300
200
160
100
45
0
100
400
800
Y*
Income (Y )
Figure 9.16: A Keynesian Unemployment
Equilibrium
Aggregate Demand and Output
Full Employment
1000
E0
800
AD0 (II = 140)
AD1 (II = 60)
700
600
500
400
E1
300
200
160
100
80
0
Persistent
unemployment
equilibrium
45
100
400
800
Y*
Income (Y )
Figure 9.17: Movement to an Unemployment
Equilibrium
Output (Y* )
Production
generates
income
Income goes
to households
Income (Y* )
Lower Income
Lower Spending
Lower Output
AD = lower Y
Insufficient Spending
AD < Y*
If leakages
are larger
than
injections…
Table 9.6: The Multiplier at Work
(1)
Change in Intended Investment
1. Investors lose confidence.
Δ II = 80
(2)
Change in Aggregate Demand
(as C or II change)
and in Output and Income
(as firms respond to changes in AD)
(3)
Change in Consumption
ΔC = mpc Δ Y
= .8  Column (2)
2. Reduced investment spending leads directly
to Δ AD = 80.
Producers respond to reduced demand for their
goods by cutting back on production.
Δ Y =  80
3. Less production means
less income. With income
reduced by 80, households
cut consumption
by mpc Δ Y
= .8  80
ΔC = 64
4. Lowered consumption spending means
lowered AD
Δ AD = 64
Producers respond.
Δ Y = 64
5. Households cut
consumption
by mpc Δ Y
= .8  4
ΔC = 51.2
6. Δ Y = 51.2
7. mpc Δ Y = .8  51.2
ΔC = 40.96
8. Δ Y = 40.96
9. ΔC = 32.77
10. Δ Y = 32.77
11. ΔC = 26.21
etc.
etc.
Sum of changes in Y
= 80 + 64 + 51.2 + 40.96 + 32.77 +. . . .
= 400