Chapter 12
MACROECONOMIC INSTABILITY: AGGREGATE DEMAND AND
AGGREGATE SUPPLY
Chapter in a Nutshell
1. The growth of the U.S. economy has been uneven. Although the output of goods and services
has risen in most years, in some years economic growth has not occurred. The central focus of
macroeconomics is what causes short-run fluctuations in economic activity and what, if
anything, the government can do to promote full employment without inflation.
2. Prior to the Great Depression of the 1930s, the classical economists dominated economic
thinking. According to the classical economists, the market economy automatically ensures
full employment of all of its resources. The optimism of the classical economists was largely
based on the assumption of freely flexible wages and prices.
3. During the 1930s, John Maynard Keynes formed a theory that provided an explanation for the
Great Depression. According to Keynes, the level of economic activity depends on the total
spending of the economy. If business expectations are pessimistic, investment spending will
be reduced, resulting in a series of decreases in total spending. If this should occur, the
economy can move into a depression and remain there. Because the market economy is
inherently unstable, Keynes argued that government must intervene to protect jobs and
income.
4. The model of aggregate demand and aggregate supply can be used to show how output and
prices are determined in the short run. An economy is in equilibrium when aggregate demand
equals aggregate supply.
5. The aggregate demand curve shows the total amount of real output that buyers will purchase at
alternative price levels during a given year. Movements along an aggregate demand curve are
caused by changes in the price level of the economy. The inverse relationship between
aggregate quantity demanded and the price level is explained by the real wealth effect, the
interest rate effect, and the foreign trade effect. Shifts in the aggregate demand curve are
caused by changes in non-price factors that affect household consumption expenditures,
business investment, government expenditures, and net exports of goods and services.
6. According to the multiplier effect, a change in any one of the components of aggregate
demand (consumption, investment, government spending, or net exports) tends to result in a
magnified impact on national output and income. The size of the multiplier depends on the
spending and saving habits of consumers and business. The formula for the multiplier is
1 / (1 - MPC) or 1 / MPS.
7. The aggregate supply curve shows the relationship between the level of prices and amount of
real output that will be produced by the economy in a given year. The aggregate supply curve
is horizontal when the economy is in deep recession or depression, upward sloping when the
economy approaches full employment and vertical when the economy achieves full
employment. Changes in factors such as resource prices, resource availability, and the level of
technology will cause the aggregate supply curve to shift to a new location.
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Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
119
8. The aggregate demand and aggregate supply model can be applied to the problem of recession
and also inflation. According to this model, decreases in aggregate demand or decreases in
aggregate supply can result in a recession for the economy; inflation may be the result of
increases in aggregate demand or decreases in aggregate supply. An economy experiences
“stagflation” when there is both recession and inflation.
Chapter Objectives
After reading this chapter, you should be able to:
1. Explain why the classical economists felt that the market economy would automatically move
to full employment and why John Maynard Keynes argued that the market economy is
inherently unstable.
2. Develop the macroeconomic model of aggregate supply and aggregate demand.
3. Use the model of aggregate supply and aggregate demand to analyze the origins of recession
and inflation.
4. Distinguish between demand-pull inflation and cost-push inflation.
5. Identify the policies which government might use to counteract recession
Knowledge Check
Key Concept Quiz
1. classical economists
2. Say’s Law
3. aggregate demand curve
4. aggregate quantity
supplied
5. real-wealth effect
6. interest-rate effect
7. foreign-trade effect
_____ a. when unemployment and prices rise
_____ b. the ratio of change in output to changes in
aggregate demand
_____ c. “supply creates it demand”
_____ d. the quantity of final output that will be supplied by
producers at a particular price level
_____ e. demonstrates the positive relationship between
interest rates and the price level
8. multiplier
_____ f. shows the total demand of all people for all final
goods and services
9. marginal propensity to
save
_____ g. the fraction of additional income that is saved
10. stagflation
11. income policies
12. multiplier effect
_____ h. helps explain why the purchasing power of assets
and changes in the price level exhibit a negative
relationship
_____ i. changes in aggregate demand that cause larger
changes in real income
_____ j. the group of economists who dominated economic
thinking prior to the Great Depression
_____ k. illustrates the negative relationship between the
price level and net exports
_____ l. may consist of formal wage and price controls
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Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
Multiple Choice Questions
1. According to the nineteenth century economist, Jean Baptiste Say
a.
b.
c.
d.
supply creates its own demand
demand creates its own supply
prices are inflexible
the economy can never be at full employment
2. Overproduction was considered to be an impossibility by
a.
b.
c.
d.
Classical economists
neoclassical economists
mercantilists
Keynsians
3. Keynes’ argument with the classicists can be located in their very different understanding of
a.
b.
c.
d.
price behavior
production
output
supply
4. Keynes argued that prices
a.
b.
c.
d.
tend to be sticky
tend to be highly flexible
and wages are never influenced by labor unions
are never determined by large businesses
5. Keynes made all of these recommendations for avoiding another depression except
a.
b.
c.
d.
maintaining high levels of demand
decreased government spending
encouraging investment
encouraging consumers to spend more
6. When the price level falls, aggregate quantity demanded increases due to
a.
b.
c.
d.
the real-wealth effect
the interest-rate effect
the foreign-trade effect
all of the above
7. When the price level increases and the purchasing power of assets decline, the aggregate
quantity demanded declines due to
a.
b.
c.
d.
the interest rate effect
the real income effect
the present consumption effect
the real wealth effect
8. The interest rate effect
a. describes the effect of a change in the price level on the interest rate
b. is associated with the effect of a change in the interest rate on spending
c. is associated with the effect of a change in the price level on the amount of money
demanded
d. all of the above
Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
121
9. The foreign trade effect is triggered by
a.
b.
c.
d.
a change in relative price levels between countries
a change in trade restrictions
a change in trade policy
a change in trading patterns
10. The aggregate demand curve for the U.S. will shift to the left when
a.
b.
c.
d.
the stock market is booming
Japan’s economy is doing well
recessionary expectations are strong
the world is enjoying a long period of peace
11. When the multiplier increases
a.
b.
c.
d.
the marginal propensity to consume must rise
the marginal propensity to save must rise
the marginal propensity to import must rise
the marginal propensity to invest must fall
12. When the marginal propensity to consume rises
a.
b.
c.
d.
the marginal propensity to save also rises
the marginal propensity to save falls
the marginal propensity to save remains unchanged
the multiplier decreases
13. When wages increase
a.
b.
c.
d.
the aggregate demand curve shifts to the left
the aggregate demand curve shifts to the right
the aggregate supply curve shifts to the left
the aggregate supply curve shifts to the right
14. When new technologies lead to improvements in productivity
a.
b.
c.
d.
the aggregate demand curve shifts to the right
the aggregate demand curve shifts to the left
the aggregate supply curve shifts to the left
the aggregate supply cure shifts to the right
15. Recessions may be caused by
a. shrinking aggregate demand
b. rising production costs
c. financial and political crises leading to negative expectations about the economy’s
performance
d. all of the above
16. Assume an economy has idle resources and a constant price level. If the marginal propensity
to save is 0.1, a $20 million increase in investment spending will cause equilibrium income
and output to increase by
a.
b.
c.
d.
$160 million
$180 million
$200 million
$220 million
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Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
17. The value of the multiplier equals
a.
b.
c.
d.
1 + MPS
1 - MPS
1 / MPS
1 x MPS
18. If the value of the multiplier is 5, the marginal propensity to consume is
a.
b.
c.
d.
0.6
0.7
0.8
0.9
19. Aggregate demand includes all of the following components except
a.
b.
c.
d.
household consumption expenditures
household savings
government purchases of goods and services
net exports of goods and services
20. Inflation would most likely be caused by a (n)
a.
b.
c.
d.
increase in aggregate supply and a decrease in aggregate demand
increase in aggregate supply and an increase in aggregate demand
decrease in aggregate supply and increase in aggregate demand
decrease in aggregate supply and decrease in aggregate demand
21. Movements along an aggregate demand curve are caused by all of the following except the
a.
b.
c.
d.
real wealth effect
interest rate effect
foreign trade effect
inflationary effect
22. According to the wealth effect
a.
b.
c.
d.
increased stock prices trigger increases in consumer spending
people tend to save more when they expect declines in wealth
falling home values result in declining consumer spending
rising prices induce increasing consumption and decreasing saving
23. According to the classical economists, the market economy
a.
b.
c.
d.
automatically adjusted to ensure full employment of labor
required continual government assistance to achieve full employment of labor
could never achieve the full employment of labor
always suffered from inadequate spending by consumers
24. Movements along the aggregate supply curve are caused by changes in
a.
b.
c.
d.
productivity
resource prices
government prices
the price level
Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
123
25. Rising productivity would contain inflation by causing
a.
b.
c.
d.
aggregate demand to increase more than the aggregate supply
aggregate supply to increase more than the aggregate demand
aggregate supply to decrease more than aggregate demand
aggregate demand to decrease more than aggregate supply
26. During the Great Depression, all of the following occurred except
a.
b.
c.
d.
unemployment increased
national income decreased
many banks and stores shut down
rising prices made farmers wealthy
True-False Questions
1.
T
F
A decrease in aggregate demand may cause inflation.
2.
T
F
An increase in aggregate demand may cause recession.
3.
T
F
When an economy experiences both recession and inflation, stagflation
results.
4.
T
F
The size of the multiplier is independent of the saving habits of the
private sector.
5.
T
F
According to Keynes, the level of economic activity depends on the total
spending of the economy.
6.
T
F
According to the classical economists, the market economy
automatically ensures full employment.
7.
T
F
Prior to the Great Depression, most economists believed that wages and
prices were flexible.
8.
T
F
Keynes’ explanation of the Great Depression was partially based on the
idea of flexible wages.
9.
T
F
Keynes’ solution to the problem of long-term recession involves
government intervention in markets.
10.
T
F
Movements along the aggregate demand curve are caused by changes in
the price level.
11.
T
F
Real wealth effects can explain movements along the demand curve.
12.
T
F
The foreign trade effect and changes in the price level are unrelated.
13.
T
F
An increase in the price level can change the level of aggregate spending
through the interest rate effect.
14.
T
F
Macroeconomics attempts to explain short-run fluctuations in economic
activity.
15.
T
F
Macroeconomics attempts to explain how the government can achieve
full employment without inflation.
16.
T
F
The aggregate supply curve consists of the three segments: horizontal,
upward-sloping and vertical.
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Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
17.
T
F
According to Say’s Law, “demand creates its own supply.”
18.
T
F
The inverse relationship between aggregate quantity demanded and the
price level can be explained by the real income effect.
19.
T
F
An increase in the marginal propensity to consume tends to increase the
size of the multiplier.
20.
T
F
Tax cuts cause the aggregate supply curve to shift to the left.
21.
T
F
Most economists agree that skyrocketing agricultural prices triggered the
Great Depression of the 1930s..
22.
T
F
The Great Depression set the stage for John Maynard Keynes, and his
emphasis on activist government economic policies, to influence
economic thinking and policymaking.
23.
T
F
When cost-push inflation occurs, the economy experiences an increase in
output and employment and an increase in the price level.
24.
T
F
A reduction in the price of labor causes the economy to slide downward
along its aggregate supply curve.
25.
T
F
According to the wealth effect, a decrease in stock prices causes
households to increase their consumption spending.
26.
T
F
The classical economists disproved the theory of J. M. Keynes by
showing that the market economy does not automatically move towards
full employment.
Application Questions
1.
a. In 1999, the marginal propensity to consume (MPC) in the city of Spend is 0.75. What
is the value of the multiplier?
b. In 2000, the citizens of Spend decide to change their behavior and the name of their
city to Thrift. Now, their marginal propensity to save (MPS) is 0.8. What is the
marginal propensity to consume? What is the value of the multiplier?
c. Investment spending is $100 million in both 1999 and 2000 in this city? In which year
will more income be generated? How much more?
Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
2.
Use an aggregate demand/aggregate supply diagram to show what happened to the
economy as a result of the OPEC-designed oil price increases of the 1970s.
b. What happens to the economy’s price level? How do the economy’s output and
employment change?
c. Are there any solutions to the problems illustrated in questions a and b?
Answers to Knowledge Check Questions
Key Concept Answers
1. j
4. d
2. c
5. h
3. f
6. e
7. k
8. b
9. g
10.
11.
12.
Multiple Choice Answers
1. a
6. d
2. a
7. d
3. a
8. d
4. a
9. a
5. b
10. c
11.
12.
13.
14.
15.
a
b
c
d
d
16.
17.
18.
19.
20.
c
c
c
b
c
21.
22.
23.
24.
25.
d
a
a
d
b
26. d
True-False Answers
1. F
6. T
2. F
7. T
3. T
8. F
4. F
9. T
5. T
10. T
11.
12.
13.
14.
15.
T
F
T
T
T
16.
17.
18.
19.
20.
T
F
F
T
F
21.
22.
23.
24.
25.
F
T
F
F
F
26. F
Application Question Answers
1. a.
1
1

4
1  0.75 0.25
The value of the multiplier is
a
l
i
125
126
Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply
b.
The marginal propensity to consume (MPC) is 1 – MPS = 1 – 0.8 = 0.2
The multiplier is
1
 125
.
0.8
c.
The change in equilibrium income = the multiplier x the change in aggregate demand =
multiplier x investment. Therefore,
In 1999, the change in equilibrium income = $4 x 100 million = $400 million and
in 2000, the change in equilibrium income = $1.25 x 100 million = $125 million
More income is generated in 1999—$275 million more.
2. a.
The following figure shows the affect on the economy as a result of the OPEC-designed
oil price increases of the 1970s.
AS'
AS
P'
P
AD
GDP' GDP
Real GDP
b. The price level rises. The output and employment decrease.
c. Yes, any measures that lead to productivity improvements may reverse these problems.
For example, tax cuts that reduce per-unit production costs can shift the aggregate supply
curve to the right.