Summary of Lecture Notes from Chapter 15 and Practice Questions.
1. All societies experience short▯run economic fluctuations around long▯run trends. These fluctuations
are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of
income, spending, and production fall, and unemployment rises.
2. Economists analyze short▯run economic fluctuations using the model of aggregate demand and
aggregate supply. According to this model, the output of goods and services and the overall level of
prices adjust to balance aggregate demand and aggregate supply.
3. The aggregate▯demand curve slopes downward for three reasons. First, a lower price level raises the
real value of households’ money holdings, which stimulates consumer spending. Second, a lower
price level reduces the quantity of money households demand; as households try to convert money
into interest▯bearing assets, interest rates fall, which stimulates investment spending. Third, a lower
price level reduces the real exchange rate. This depreciation makes Canadian▯produced goods and
services cheaper relative to foreign▯produced goods and services, and in this way stimulates net
4. Any event or policy that raises consumption, investment, government purchases, or net exports at a
given price level increases aggregate demand. Any event or policy that reduces consumption,
investment, government purchases, or net exports at a given price level decreases aggregate
5. The long▯run aggregate▯supply curve is vertical. In the long run, the quantity of goods and services
supplied depends on the economy’s labour, capital, natural resources, and technology, but not on the
overall level of prices.
6. Three theories have been proposed to explain the upward slope of the short▯run aggregate▯supply
curve. According to the sticky▯wage theory, an unexpected fall in the price level temporarily raises
real wages, which induces firms to reduce employment and production. According to the sticky▯price
theory, an unexpected fall in the price level leaves some firms with prices that are temporarily too
high, which reduces their sales and causes them to cut back production. According to the
misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that
their relative prices have fallen, which induces them to reduce production. All three theories imply
that output deviates from its natural rate when the price level deviates from the price level that
7. Events that alter the economy’s ability to produce output, such as changes in labour, capital, natural
resources, or technology shift the short▯run aggregate supply curve (and may shift the long▯run
aggregate supply curve as well). In addition, the position of the short▯run aggregate supply curve
depends on the expected price level.
8. One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate▯
demand curve shifts to the left, for instance, output and prices fall in the short run. Over time, as a
change in the expected price level causes perceptions, wages, and prices to adjust, the short▯run
aggregate▯supply curve shifts to the right, and the economy returns to its natural rate of output at a
new, lower price level.
1 2 ☞ Chapter 15/Aggregate Demand and Aggregate Supply
9. A second possible cause of economic fluctuations is a shift in aggregate supply. When the
aggregate▯supply curve shifts to the left, the short▯run effect is falling output and rising prices―a
combination called stagflation. Over time, as perceptions, wages, and prices adjust, the price level
falls back to its original level, and output recovers.
I. Economic activity fluctuates from year to year.
A. Definition of recession: a period of declining real incomes and rising
B. Definition of depression : a severe recession.
II. Three Key Facts about Economic Fluctuations
A. Fact 1: Economic Fluctuations Are Irregular and Unpredictable
1. Fluctuations in the economy are often called the business cycle.
2. Economic fluctuations correspond to changes in business conditions.
3. These fluctuations are not at all regular and are almost impossible to predict.
4. Panel (a) of Figure 15.1 shows real GDP since 1966. The shaded areas represent
times of recession.
B. Fact 2: Most Macroeconomic Quantities Fluctuate Together
1. Real GDP is the variable that is most commonly used to monitor short▯run
changes in the economy.
2. However, most macroeconomic variables that measure some type of income,
spending, or production fluctuates closely together.
3. Panel (b) of Figure 15.1 shows how investment changes over the business cycle.
Note that investment falls during recessions just as real GDP does.
C. Fact 3: As Output Falls, Unemployment Rises
1. Changes in the economy’s output level will have an effect on the economy’s
utilization of its labour force.
2. When firms choose to produce a smaller amount of goods and services, they lay
off workers, which increases the unemployment rate.
3. Panel (c) of Figure 15.1 shows how the unemployment rate changes over the
business cycle. Note that during recessions, unemployment substantially rises.
Note also that the unemployment rate never approaches zero but instead
fluctuates around its natural rate. Chapter 15/Aggregate Demand and Aggregate Supply ☞ 3
D. In the News: The Trash Indicator
1. When the economy goes into a recession, many economic variables fall together.
2. This is an article from The Chicago Tribune discussing how the volume of trash
generated by consumers is related to the health of the economy.
III. Explaining Short▯Run Economic Fluctuations
A. How the Short Run Differs from the Long Run
1. Most economists believe that the classical theory describes the world in the long
run but not in the short run.
2. Beyond a period of several years, changes in the money supply affect prices and
other nominal variables, but do not affect real GDP, unemployment, or other real
3. However, when studying year▯to▯year fluctuations in the economy, the
assumption of monetary neutrality is not appropriate. In the short run, most real
and nominal variables are intertwined.
B. The Basic Model of Economic Fluctuations
1. Definition of model of aggregate demand and aggregate supply : the
model that most economists use to explain short-run fluctuations in
economic activity around its long-run trend.
2. We can show this model using a graph.
a. The variable on the vertical axis is the overall price level in the economy.
b. The variable on the horizontal axis is the overall quantity of goods and
c. Definition of aggregate-demand curve : a curve that shows the
quantity of goods and services that households, firms, and the
government want to buy at each price level.
d. Definition of aggregate-supply curve : a curve that shows the
quantity of goods and services that firms choose to produce and
sell at each price level.
3. In this model, the price level and the quantity of output adjust to bring
aggregate demand and aggregate supply into balance. 4 ☞ Chapter 15/Aggregate Demand and Aggregate Supply
IV. The Aggregate▯Demand Curve
A. Why the Aggregate▯Demand Curve Is Slopes Downward
1. Recall that GDP (Y) is made up of four components: consumption (C),
investment (I), government purchases (G), and net exports (NX).
Y = C + I + G + NX
2. Each of the four components is a part of aggregate demand.
a. Government purchases are assumed to be fixed by policy.
b. This means that to understand why the aggregate▯demand curve slopes
downward, we must understand how changes in the price level affect
consumption, investment, and net exports.
Table 15.3 Chapter 15/Aggregate Demand and Aggregate Supply ☞ 5
3. The Price Level and Consumption: The Wealth Effect
a. A decrease in the price level makes consumers feel wealthier, which in
turn encourages them to spend more.
b. The increase in consumer spending means a larger quantity of goods
and services demanded.
4. The Price Level and Investment: The Interest▯Rate Effect
a. The lower the price level, the less money households need to buy goods
b. When the price level falls, households try to reduce their holdings of
money by lending some out (either in financial markets or through
c. As households try to convert some of their money into interest▯bearing
assets, the interest rate will drop.
d. Lower interest rates encourage borrowing by firms that want to invest in
new plants and equipment and by households who want to invest in new
e. Thus, a lower price level reduces the interest rate, encourages greater
spending on investment goods, and therefore increases the quantity of
goods and services demanded.
5. The Price Level and Net Exports: The Real Exchange▯Rate Effect
a. For a given nominal exchange rate, a lower price level reduces the real
exchange rate by making Canadian▯produced goods and services
cheaper relative to foreign▯produced goods and services.
b. The depreciation of the real exchange rate causes exports to rise,
imports to fall, and net exports to increase.
6. All three of these effects imply that, all else equal, there is an inverse
relationship between the price level and the quantity of goods and services
B. Why the Aggregate▯Demand Curve Might Shift
1. Shifts Arising from Consumption
a. If Canadians become more concerned with saving for retirement and
reduce current consumption, aggregate demand will decline.
b. If the government cuts taxes, it encourages people to spend more,
resulting in an increase in aggregate demand. 6 ☞ Chapter 15/Aggregate Demand and Aggregate Supply
2. Shifts Arising from Investment
a. Suppose that the computer industry introduces a faster line of computers
and many firms decide to invest in new computer systems. This will lead
to an increase in aggregate demand.
b. If firms become pessimistic about future business conditions, they may
cut back on investment spending, shifting aggregate demand to the left.
c. An investment tax credit increases the quantity of investment goods that
firms demand, which results in an increase in aggregate demand.
d. An increase in the supply of money lowers the interest rate in the short
run. This lead to more investment spending, which causes an increase
in aggregate demand.
3. Shifts Arising from Government Purchases
a. If Parliament decides to increase purchases of new equipment for
Canada’s armed forces, aggregate demand will rise.
b. If provincial governments decide to spend less on highway construction,
aggregate demand will shift to the left.
4. Shifts Arising from Net Exports
a. When the U.S. experiences a recession, it buys fewer Canadian goods,
which lowers net exports. Aggregate demand will shift to the left.
b. If the value of the Canadian dollar increases, Canadian goods become
more expensive to foreigners. Net exports fall and aggregate demand
shifts to the left.
V. The Aggregate▯Supply Curve
A. The relationship between the price level and the quantity of goods and services supplied
depends on the time horizon being examined.
B. Why the Aggregate▯Supply Curve Is Vertical in the Long Run
1. In the long run, an economy’s production of goods and services depends on its
supplies of resources along with the available production technology. Chapter 15/Aggregate Demand and Aggregate Supply ☞ 7
2. Because the price level does not affect these determinants of output in the long
run, the long▯run aggregate▯supply curve is vertical.
C. Why the Long▯Run Aggregate▯Supply Curve Might Shift
1. The position of the aggregate supply curve occurs at an output level sometimes