L11 Textbook Notes on Aggregate Demand and Supply PDF

IN THIS CHAPTER YOU WILL... Learn three key facts...

IN THIS CHAPTER YOU WILL... Learn three key facts about shor t-run economic fluctuations Consider how the economy in the shor t run dif fers from the economy in the long run A G G R E G AT E DEMAND AND A G G R E G AT E S U P P LY Use the model of aggregate demand and aggregate supply to explain economic fluctuations Economic activity fluctuates from year to year. In most years, the production of goods and services rises. Because of increases in the labor force, increases in the capital stock, and advances in technological knowledge, the economy can produce more and more over time. This growth allows everyone to enjoy a higher standard of living. On average over the past 50 years, the production of the U.S. economy as measured by real GDP has grown by about 3 percent per year. In some years, however, this normal growth does not occur. Firms find them- See how shifts in selves unable to sell all of the goods and services they have to offer, so they cut aggregate demand or back on production. Workers are laid off, unemployment rises, and factories are aggregate supply can left idle. With the economy producing fewer goods and services, real GDP and cause booms and other measures of income fall. Such a period of falling incomes and rising recessions 701 702 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S recession unemployment is called a recession if it is relatively mild and a depression if it is a period of declining real incomes more severe. and rising unemployment What causes short-run fluctuations in economic activity? What, if anything, can public policy do to prevent periods of falling incomes and rising unemploy- depression ment? When recessions and depressions occur, how can policymakers reduce their a severe recession length and severity? These are the questions that we take up in this and the next two chapters. The variables that we study in the coming chapters are largely those we have already seen. They include GDP, unemployment, interest rates, exchange rates, and the price level. Also familiar are the policy instruments of government spend- ing, taxes, and the money supply. What differs in the next few chapters is the time horizon of our analysis. Our focus in the previous seven chapters has been on the behavior of the economy in the long run. Our focus now is on the economy’s short- run fluctuations around its long-run trend. Although there remains some debate among economists about how to analyze short-run fluctuations, most economists use the model of aggregate demand and aggregate supply. Learning how to use this model for analyzing the short-run effects of various events and policies is the primary task ahead. This chapter introduces the model’s two key pieces—the aggregate-demand curve and the aggregate- supply curve. After getting a sense of the overall structure of the model in this chapter, we examine the pieces of the model in more detail in the next two chapters. T H R E E K E Y FA C T S A B O U T E C O N O M I C F L U C T U AT I O N S Short-run fluctuations in economic activity occur in all countries and in all times throughout history. As a starting point for understanding these year-to-year fluc- tuations, let’s discuss some of their most important properties. FA C T 1 : E C O N O M I C F L U C T U AT I O N S A R E I R R E G U L A R A N D U N P R E D I C TA B L E Fluctuations in the economy are often called the business cycle. As this term sug- gests, economic fluctuations correspond to changes in business conditions. When real GDP grows rapidly, business is good. Firms find that customers are plentiful and that profits are growing. On the other hand, when real GDP falls, businesses have trouble. In recessions, most firms experience declining sales and profits. The term business cycle is somewhat misleading, however, because it seems to suggest that economic fluctuations follow a regular, predictable pattern. In fact, economic fluctuations are not at all regular, and they are almost impossible to pre- dict with much accuracy. Panel (a) of Figure 31-1 shows the real GDP of the U.S. economy since 1965. The shaded areas represent times of recession. As the figure shows, recessions do not come at regular intervals. Sometimes recessions are close  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 703 Figure 31-1 (a) Real GDP A L OOK AT S HORT-R UN Billions of E CONOMIC F LUCTUATIONS. 1992 Dollars This figure shows real GDP in $7,000 panel (a), investment spending 6,500 in panel (b), and unemployment Real GDP 6,000 in panel (c) for the U.S. economy 5,500 using quarterly data since 1965. 5,000 Recessions are shown as the 4,500 shaded areas. Notice that real GDP and investment spending 4,000 decline during recessions, while 3,500 unemployment rises. 3,000 SOURCE: U.S. Department of Commerce; 2,500 1965 1970 1975 1980 1985 1990 1995 U.S. Department of Labor. (b) Investment Spending Billions of 1992 Dollars $1,100 1,000 900 Investment spending 800 700 600 500 400 300 1965 1970 1975 1980 1985 1990 1995 (c) Unemployment Rate Percent of Labor Force 12 10 8 Unemployment rate 6 4 2 0 1965 1970 1975 1980 1985 1990 1995 704 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S together, such as the recessions of 1980 and 1982. Sometimes the economy goes many years without a recession. FA C T 2 : M O S T M A C R O E C O N O M I C Q U A N T I T I E S F L U C T U AT E T O G E T H E R Real GDP is the variable that is most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activ- ity. Real GDP measures the value of all final goods and services produced within a given period of time. It also measures the total income (adjusted for inflation) of everyone in the economy. It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure of economic activity one looks at. Most macroeco- nomic variables that measure some type of income, spending, or production fluc- tuate closely together. When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. Because recessions are economy-wide phenomena, they show up in many sources of macroeconomic data. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. In particular, as panel (b) of Figure 31-1 shows, investment spending varies greatly over the business cycle. Even though investment averages about one-seventh of GDP, declines in investment account for about two-thirds of the declines in GDP during recessions. In other words, when economic conditions deteriorate, much of the decline is attributable to reductions in spending on new factories, housing, and inventories. “You’re fired. Pass it on.”  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 705 FA C T 3 : A S O U T P U T FA L L S , U N E M P L O Y M E N T R I S E S Changes in the economy’s output of goods and services are strongly correlated with changes in the economy’s utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises. This fact is hardly surprising: When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed. Panel (c) of Figure 31-1 shows the unemployment rate in the U.S. economy since 1965. Once again, recessions are shown as the shaded areas in the figure. The figure shows clearly the impact of recessions on unemployment. In each of the re- cessions, the unemployment rate rises substantially. When the recession ends and real GDP starts to expand, the unemployment rate gradually declines. The unem- ployment rate never approaches zero; instead, it fluctuates around its natural rate of about 5 percent. QUICK QUIZ: List and discuss three key facts about economic fluctuations. EXPLAINING SHORT-RUN E C O N O M I C F L U C T U AT I O N S Describing the regular patterns that economies experience as they fluctuate over time is easy. Explaining what causes these fluctuations is more difficult. Indeed, compared to the topics we have studied in previous chapters, the theory of eco- nomic fluctuations remains controversial. In this and the next two chapters, we de- velop the model that most economists use to explain short-run fluctuations in economic activity. HOW THE SHORT RUN DIFFERS FROM THE LONG RUN In previous chapters we developed theories to explain what determines most im- portant macroeconomic variables in the long run. Chapter 24 explained the level and growth of productivity and real GDP. Chapter 25 explained how the real in- terest rate adjusts to balance saving and investment. Chapter 26 explained why there is always some unemployment in the economy. Chapters 27 and 28 ex- plained the monetary system and how changes in the money supply affect the price level, the inflation rate, and the nominal interest rate. Chapters 29 and 30 ex- tended this analysis to open economies in order to explain the trade balance and the exchange rate. All of this previous analysis was based on two related ideas—the classical di- chotomy and monetary neutrality. Recall that the classical dichotomy is the sepa- ration of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money). According to classical macroeconomic theory, changes in the money supply affect nominal vari- ables but not real variables. As a result of this monetary neutrality, Chapters 24, 25, 706 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S and 26 were able to examine the determinants of real variables (real GDP, the real interest rate, and unemployment) without introducing nominal variables (the money supply and the price level). Do these assumptions of classical macroeconomic theory apply to the world in which we live? The answer to this question is of central importance to under- standing how the economy works: Most economists believe that classical theory de- scribes the world in the long run but not in the short run. 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 variables. When studying year-to-year changes in the economy, however, the assumption of monetary neu- trality is no longer appropriate. Most economists believe that, in the short run, real and nominal variables are highly intertwined. In particular, changes in the money supply can temporarily push output away from its long-run trend. To understand the economy in the short run, therefore, we need a new model. To build this new model, we rely on many of the tools we have developed in pre- vious chapters, but we have to abandon the classical dichotomy and the neutrality of money. T H E B A S I C M O D E L O F E C O N O M I C F L U C T U AT I O N S Our model of short-run economic fluctuations focuses on the behavior of two vari- ables. The first variable is the economy’s output of goods and services, as mea- sured by real GDP. The second variable is the overall price level, as measured by the CPI or the GDP deflator. Notice that output is a real variable, whereas the price level is a nominal variable. Hence, by focusing on the relationship between these two variables, we are highlighting the breakdown of the classical dichotomy. model of aggregate We analyze fluctuations in the economy as a whole with the model of aggre- demand and gate demand and aggregate supply, which is illustrated in Figure 31-2. On the ver- aggregate supply tical axis is the overall price level in the economy. On the horizontal axis is the the model that most economists overall quantity of goods and services. The aggregate-demand curve shows the use to explain short-run quantity of goods and services that households, firms, and the government want fluctuations in economic activity to buy at each price level. The aggregate-supply curve shows the quantity of around its long-run trend goods and services that firms produce and sell at each price level. According to this model, the price level and the quantity of output adjust to bring aggregate de- aggregate-demand curve mand and aggregate supply into balance. a curve that shows the quantity of It may be tempting to view the model of aggregate demand and aggregate goods and services that households, supply as nothing more than a large version of the model of market demand and firms, and the government want to market supply, which we introduced in Chapter 4. Yet in fact this model is quite buy at each price level different. When we consider demand and supply in a particular market—ice aggregate-supply curve cream, for instance—the behavior of buyers and sellers depends on the ability of a curve that shows the quantity of resources to move from one market to another. When the price of ice cream rises, goods and services that firms choose the quantity demanded falls because buyers will use their incomes to buy prod- to produce and sell at each price level ucts other than ice cream. Similarly, a higher price of ice cream raises the quantity supplied because firms that produce ice cream can increase production by hiring workers away from other parts of the economy. This microeconomic substitution from one market to another is impossible when we are analyzing the economy as a whole. After all, the quantity that our model is trying to explain—real GDP— measures the total quantity produced in all of the economy’s markets. To under- stand why the aggregate-demand curve is downward sloping and why the  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 707 Figure 31-2 Price A GGREGATE D EMAND Level AND A GGREGATE S UPPLY. Economists use the model of aggregate demand and aggregate Aggregate supply to analyze economic supply fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the Equilibrium economy’s total output of price level goods and services. Output and the price level adjust Aggregate to the point at which demand the aggregate-supply and aggregate-demand curves intersect. 0 Equilibrium Quantity of output Output aggregate-supply curve is upward sloping, we need a macroeconomic theory. Developing such a theory is our next task. Q U I C K Q U I Z : How does the economy’s behavior in the short run differ from its behavior in the long run? ◆ Draw the model of aggregate demand and aggregate supply. What variables are on the two axes? T H E A G G R E G AT E - D E M A N D C U R V E The aggregate-demand curve tells us the quantity of all goods and services de- manded in the economy at any given price level. As Figure 31-3 illustrates, the aggregate-demand curve is downward sloping. This means that, other things equal, a fall in the economy’s overall level of prices (from, say, P1 to P2) tends to raise the quantity of goods and services demanded (from Y1 to Y2). W H Y T H E A G G R E G AT E - D E M A N D C U R V E S L O P E S D O W N WA R D Why does a fall in the price level raise the quantity of goods and services de- manded? To answer this question, it is useful to recall that GDP (which we denote as Y ) is the sum of consumption (C ), investment (I), government purchases (G), and net exports (NX): 708 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S Figure 31-3 Price T HE A GGREGATE -D EMAND Level C URVE. A fall in the price level from P1 to P2 increases the quantity of goods and services demanded from Y1 to Y2. There are three reasons for this negative P1 relationship. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects P2 stimulate spending on 1. A decrease consumption, investment, and Aggregate in the price net exports. Increased spending level... demand on these components of output means a larger quantity of goods 0 Y1 Y2 Quantity of and services demanded. Output 2.... increases the quantity of goods and services demanded. Y ⫽ C ⫹ I ⫹ G ⫹ NX. Each of these four components contributes to the aggregate demand for goods and services. For now, we assume that government spending is fixed by policy. The other three components of spending—consumption, investment, and net ex- ports—depend on economic conditions and, in particular, on the price level. To un- derstand the downward slope of the aggregate-demand curve, therefore, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment, and net exports. T h e P r i c e L e v e l a n d C o n s u m p t i o n : T h e We a l t h E f f e c t Con- sider the money that you hold in your wallet and your bank account. The nominal value of this money is fixed, but its real value is not. When prices fall, these dollars are more valuable because then they can be used to buy more goods and services. Thus, a decrease in the price level makes consumers feel more wealthy, which in turn en- courages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. The Price Level and Investment: The Interest-Rate Ef fect As we discussed in Chapter 28, the price level is one determinant of the quantity of money demanded. The lower the price level, the less money households need to hold to buy the goods and services they want. When the price level falls, therefore, households try to reduce their holdings of money by lending some of it out. For in- stance, a household might use its excess money to buy interest-bearing bonds. Or it might deposit its excess money in an interest-bearing savings account, and the bank would use these funds to make more loans. In either case, as households try to convert some of their money into interest-bearing assets, they drive down  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 709 interest rates. Lower interest rates, in turn, encourage borrowing by firms that want to invest in new plants and equipment and by households who want to in- vest in new housing. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. The Price Level and Net Expor ts: The Exchange-Rate Ef- f e c t As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response, some U.S. investors will seek higher returns by investing abroad. For instance, as the interest rate on U.S. government bonds falls, a mutual fund might sell U.S. government bonds in order to buy German govern- ment bonds. As the mutual fund tries to move assets overseas, it increases the sup- ply of dollars in the market for foreign-currency exchange. The increased supply of dollars causes the dollar to depreciate relative to other currencies. Because each dollar buys fewer units of foreign currencies, foreign goods become more expen- sive relative to domestic goods. This change in the real exchange rate (the relative price of domestic and foreign goods) increases U.S. exports of goods and services and decreases U.S. imports of goods and services. Net exports, which equal ex- ports minus imports, also increase. Thus, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and this depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. S u m m a r y There are, therefore, three distinct but related reasons why a fall in the price level increases the quantity of goods and services demanded: (1) Con- sumers feel wealthier, which stimulates the demand for consumption goods. (2) Interest rates fall, which stimulates the demand for investment goods. (3) The ex- change rate depreciates, which stimulates the demand for net exports. For all three reasons, the aggregate-demand curve slopes downward. It is important to keep in mind that the aggregate-demand curve (like all de- mand curves) is drawn holding “other things equal.” In particular, our three ex- planations of the downward-sloping aggregate-demand curve assume that the money supply is fixed. That is, we have been considering how a change in the price level affects the demand for goods and services, holding the amount of money in the economy constant. As we will see, a change in the quantity of money shifts the aggregate-demand curve. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of money. W H Y T H E A G G R E G AT E - D E M A N D C U R V E M I G H T S H I F T The downward slope of the aggregate-demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other fac- tors, however, affect the quantity of goods and services demanded at a given price level. When one of these other factors changes, the aggregate-demand curve shifts. Let’s consider some examples of events that shift aggregate demand. We can categorize them according to which component of spending is most directly affected. S h i f t s A r i s i n g f r o m C o n s u m p t i o n Suppose Americans suddenly be- come more concerned about saving for retirement and, as a result, reduce their current consumption. Because the quantity of goods and services demanded at 710 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S any price level is lower, the aggregate-demand curve shifts to the left. Conversely, imagine that a stock market boom makes people feel wealthy and less concerned about saving. The resulting increase in consumer spending means a greater quan- tity of goods and services demanded at any given price level, so the aggregate- demand curve shifts to the right. Thus, any event that changes how much people want to consume at a given price level shifts the aggregate-demand curve. One policy variable that has this effect is the level of taxation. When the government cuts taxes, it encourages people to spend more, so the aggregate-demand curve shifts to the right. When the government raises taxes, people cut back on their spending, and the aggregate- demand curve shifts to the left. S h i f t s A r i s i n g f r o m I n v e s t m e n t Any event that changes how much firms want to invest at a given price level also shifts the aggregate-demand curve. For instance, imagine that the computer industry introduces a faster line of computers, and many firms decide to invest in new computer systems. Because the quantity of goods and services demanded at any price level is higher, the aggregate-demand curve shifts to the right. Conversely, if firms become pes- simistic about future business conditions, they may cut back on investment spend- ing, shifting the aggregate-demand curve to the left. Tax policy can also influence aggregate demand through investment. As we saw in Chapter 25, an investment tax credit (a tax rebate tied to a firm’s investment spending) increases the quantity of investment goods that firms demand at any given interest rate. It therefore shifts the aggregate-demand curve to the right. The repeal of an investment tax credit reduces investment and shifts the aggregate- demand curve to the left. Another policy variable that can influence investment and aggregate demand is the money supply. As we discuss more fully in the next chapter, an increase in the money supply lowers the interest rate in the short run. This makes borrow- ing less costly, which stimulates investment spending and thereby shifts the aggregate-demand curve to the right. Conversely, a decrease in the money supply raises the interest rate, discourages investment spending, and thereby shifts the aggregate-demand curve to the left. Many economists believe that throughout U.S. history changes in monetary policy have been an important source of shifts in ag- gregate demand. S h i f t s A r i s i n g f r o m G o v e r n m e n t P u r c h a s e s The most direct way that policymakers shift the aggregate-demand curve is through government pur- chases. For example, suppose Congress decides to reduce purchases of new weapons systems. Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left. Conversely, if state governments start building more highways, the result is a greater quantity of goods and services demanded at any price level, so the aggregate-demand curve shifts to the right. Shifts Arising from Net Expor ts Any event that changes net exports for a given price level also shifts aggregate demand. For instance, when Europe ex- periences a recession, it buys fewer goods from the United States. This reduces U.S. net exports and shifts the aggregate-demand curve for the U.S. economy to  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 711 the left. When Europe recovers from its recession, it starts buying U.S. goods again, shifting the aggregate-demand curve to the right. Net exports sometimes change because of movements in the exchange rate. Suppose, for instance, that international speculators bid up the value of the U.S. dollar in the market for foreign-currency exchange. This appreciation of the dollar would make U.S. goods more expensive compared to foreign goods, which would depress net exports and shift the aggregate-demand curve to the left. Conversely, a depreciation of the dollar stimulates net exports and shifts the aggregate- demand curve to the right. Summary In the next chapter we analyze the aggregate-demand curve in more detail. There we examine more precisely how the tools of monetary and fis- cal policy can shift aggregate demand and whether policymakers should use these tools for that purpose. At this point, however, you should have some idea about why the aggregate-demand curve slopes downward and what kinds of events and policies can shift this curve. Table 31-1 summarizes what we have learned so far. Ta b l e 3 1 - 1 WHY DOES THE AGGREGATE-DEMAND CURVE SLOPE DOWNWARD? 1. The Wealth Effect: A lower price level increases real wealth, which encourages T HE A GGREGATE -D EMAND spending on consumption. C URVE : S UMMARY 2. The Interest-Rate Effect: A lower price level reduces the interest rate, which encourages spending on investment. 3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which encourages spending on net exports. WHY MIGHT THE AGGREGATE-DEMAND CURVE SHIFT? 1. Shifts Arising from Consumption: An event that makes consumers spend more at a given price level (a tax cut, a stock market boom) shifts the aggregate- demand curve to the right. An event that makes consumers spend less at a given price level (a tax hike, a stock market decline) shifts the aggregate- demand curve to the left. 2. Shifts Arising from Investment: An event that makes firms invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that makes firms invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left. 3. Shifts Arising from Government Purchases: An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate-demand curve to the left. 4. Shifts Arising from Net Exports: An event that raises spending on net exports at a given price level (a boom overseas, an exchange-rate depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, an exchange-rate appreciation) shifts the aggregate-demand curve to the left. 712 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S Q U I C K Q U I Z : Explain the three reasons why the aggregate-demand curve slopes downward. ◆ Give an example of an event that would shift the aggregate-demand curve. Which way would this event shift the curve? T H E A G G R E G AT E - S U P P LY C U R V E The aggregate-supply curve tells us the total quantity of goods and services that firms produce and sell at any given price level. Unlike the aggregate-demand curve, which is always downward sloping, the aggregate-supply curve shows a relationship that depends crucially on the time horizon being examined. In the long run, the aggregate-supply curve is vertical, whereas in the short run, the aggregate-supply curve is upward sloping. To understand short-run economic fluctuations, and how the short-run behavior of the economy deviates from its long-run behavior, we need to examine both the long-run aggregate-supply curve and the short-run aggregate-supply curve. W H Y T H E A G G R E G AT E - S U P P LY C U R V E IS VERTICAL IN THE LONG RUN What determines the quantity of goods and services supplied in the long run? We implicitly answered this question earlier in the book when we analyzed the process of economic growth. In the long run, an economy’s production of goods and ser- vices (its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. Because the price level does not affect these long-run determinants of real GDP, the long-run aggregate-supply curve is vertical, as in Figure 31-4. In other words, in the long run, the economy’s labor, capital, natural resources, and technology de- termine the total quantity of goods and services supplied, and this quantity sup- plied is the same regardless of what the price level happens to be. The vertical long-run aggregate-supply curve is, in essence, just an application of the classical dichotomy and monetary neutrality. As we have already discussed, classical macroeconomic theory is based on the assumption that real variables do not depend on nominal variables. The long-run aggregate-supply curve is consis- tent with this idea because it implies that the quantity of output (a real variable) does not depend on the level of prices (a nominal variable). As noted earlier, most economists believe that this principle works well when studying the economy over a period of many years, but not when studying year-to-year changes. Thus, the aggregate-supply curve is vertical only in the long run. One might wonder why supply curves for specific goods and services can be upward sloping if the long-run aggregate-supply curve is vertical. The reason is that the supply of specific goods and services depends on relative prices—the prices of those goods and services compared to other prices in the economy. For example, when the price of ice cream rises, suppliers of ice cream increase their production, taking labor, milk, chocolate, and other inputs away from the production of other goods, such as frozen yogurt. By contrast, the economy’s overall production of  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 713 Figure 31-4 Price T HE L ONG -R UN A GGREGATE - Level S UPPLY C URVE. In the long run, Long-run the quantity of output supplied aggregate depends on the economy’s supply quantities of labor, capital, and natural resources and on the P1 technology for turning these inputs into output. The quantity supplied does not depend on the P2 overall price level. As a result, the 2.... does not affect long-run aggregate-supply curve 1. A change the quantity of goods is vertical at the natural rate of in the price and services supplied level... output. in the long run. 0 Natural rate Quantity of of output Output goods and services is limited by its labor, capital, natural resources, and tech- nology. Thus, when all prices in the economy rise together, there is no change in the overall quantity of goods and services supplied. W H Y T H E L O N G - R U N A G G R E G AT E - S U P P LY C U R V E M I G H T S H I F T The position of the long-run aggregate-supply curve shows the quantity of goods and services predicted by classical macroeconomic theory. This level of production is sometimes called potential output or full-employment output. To be more accurate, we call it the natural rate of output because it shows what the economy produces when unemployment is at its natural, or normal, rate. The natural rate of output is the level of production toward which the economy gravitates in the long run. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. Because output in the classical model depends on labor, capital, natural resources, and technological knowledge, we can catego- rize shifts in the long-run aggregate-supply curve as arising from these sources. Shifts Arising from Labor Imagine that an economy experiences an in- crease in immigration from abroad. Because there would be a greater number of workers, the quantity of goods and services supplied would increase. As a result, the long-run aggregate-supply curve would shift to the right. Conversely, if many workers left the economy to go abroad, the long-run aggregate-supply curve would shift to the left. The position of the long-run aggregate-supply curve also depends on the nat- ural rate of unemployment, so any change in the natural rate of unemployment shifts the long-run aggregate-supply curve. For example, if Congress were to raise 714 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S the minimum wage substantially, the natural rate of unemployment would rise, and the economy would produce a smaller quantity of goods and services. As a result, the long-run aggregate-supply curve would shift to the left. Conversely, if a reform of the unemployment insurance system were to encourage unemployed workers to search harder for new jobs, the natural rate of unemployment would fall, and the long-run aggregate-supply curve would shift to the right. S h i f t s A r i s i n g f r o m C a p i t a l An increase in the economy’s capital stock increases productivity and, thereby, the quantity of goods and services supplied. As a result, the long-run aggregate-supply curve shifts to the right. Conversely, a decrease in the economy’s capital stock decreases productivity and the quantity of goods and services supplied, shifting the long-run aggregate-supply curve to the left. Notice that the same logic applies regardless of whether we are discussing physical capital or human capital. An increase either in the number of machines or in the number of college degrees will raise the economy’s ability to produce goods and services. Thus, either would shift the long-run aggregate-supply curve to the right. Shifts Arising from Natural Resources An economy’s production depends on its natural resources, including its land, minerals, and weather. A dis- covery of a new mineral deposit shifts the long-run aggregate-supply curve to the right. A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply curve to the left. In many countries, important natural resources are imported from abroad. A change in the availability of these resources can also shift the aggregate-supply curve. As we discuss later in this chapter, events occurring in the world oil market have historically been an important source of shifts in aggregate supply. S h i f t s A r i s i n g f r o m Te c h n o l o g i c a l K n o w l e d g e Perhaps the most important reason that the economy today produces more than it did a generation ago is that our technological knowledge has advanced. The invention of the com- puter, for instance, has allowed us to produce more goods and services from any given amounts of labor, capital, and natural resources. As a result, it has shifted the long-run aggregate-supply curve to the right. Although not literally technological, there are many other events that act like changes in technology. As Chapter 9 explains, opening up international trade has effects similar to inventing new production processes, so it also shifts the long- run aggregate-supply curve to the right. Conversely, if the government passed new regulations preventing firms from using some production methods, perhaps because they were too dangerous for workers, the result would be a leftward shift in the long-run aggregate-supply curve. S u m m a r y The long-run aggregate-supply curve reflects the classical model of the economy we developed in previous chapters. Any policy or event that raised real GDP in previous chapters can now be viewed as increasing the quantity of goods and services supplied and shifting the long-run aggregate-supply curve to the right. Any policy or event that lowered real GDP in previous chapters can now  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 715 be viewed as decreasing the quantity of goods and services supplied and shifting the long-run aggregate-supply curve to the left. A N E W WAY T O D E P I C T L O N G - R U N G R O W T H A N D I N F L AT I O N Having introduced the economy’s aggregate-demand curve and the long-run aggregate-supply curve, we now have a new way to describe the economy’s long- run trends. Figure 31-5 illustrates the changes that occur in the economy from decade to decade. Notice that both curves are shifting. Although there are many forces that govern the economy in the long run and can in principle cause such shifts, the two most important in practice are technology and monetary policy. Technological progress enhances the economy’s ability to produce goods and ser- vices, and this continually shifts the long-run aggregate-supply curve to the right. At the same time, because the Fed increases the money supply over time, the aggregate-demand curve also shifts to the right. As the figure illustrates, the result is trend growth in output (as shown by increasing Y) and continuing inflation (as shown by increasing P). This is just another way of representing the classical analysis of growth and inflation we conducted in Chapters 24 and 28. The purpose of developing the model of aggregate demand and aggregate supply, however, is not to dress our long-run conclusions in new clothing. Instead, Figure 31-5 2.... and growth in the Long-run money supply shifts aggregate L ONG -R UN G ROWTH AND aggregate demand... supply, I NFLATION IN THE M ODEL OF LRAS1980 LRAS1990 LRAS2000 A GGREGATE D EMAND AND Price A GGREGATE S UPPLY. As the Level economy becomes better able to produce goods and services over time, primarily because of 1. In the long run, technological technological progress, the long- progress shifts run aggregate-supply curve shifts P2000 long-run aggregate to the right. At the same time, as supply... 4.... and the Fed increases the money ongoing inflation. supply, the aggregate-demand P1990 curve also shifts to the right. In Aggregate this figure, output grows from Demand, AD2000 Y1980 to Y1990 and then to Y2000, and P1980 AD1990 the price level rises from P1980 to P1990 and then to P2000. Thus, the model of aggregate demand and AD1980 aggregate supply offers a new way to describe the classical 0 Y1980 Y1990 Y2000 Quantity of analysis of growth and inflation. Output 3.... leading to growth in output... 716 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S it is to provide a framework for short-run analysis, as we will see in a moment. As we develop the short-run model, we keep the analysis simple by not showing the continuing growth and inflation depicted in Figure 31-5. But always remember that long-run trends provide the background for short-run fluctuations. Short-run fluctuations in output and the price level should be viewed as deviations from the continu- ing long-run trends. W H Y T H E A G G R E G AT E - S U P P LY C U R V E S L O P E S U P WA R D I N T H E S H O R T R U N We now come to the key difference between the economy in the short run and in the long run: the behavior of aggregate supply. As we have already discussed, the long-run aggregate-supply curve is vertical. By contrast, in the short run, the aggregate-supply curve is upward sloping, as shown in Figure 31-6. That is, over a period of a year or two, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied. What causes this positive relationship between the price level and output? Macroeconomists have proposed three theories for the upward slope of the short- run aggregate-supply curve. In each theory, a specific market imperfection causes the supply side of the economy to behave differently in the short run than it does in the long run. Although each of the following theories will differ in detail, they share a common theme: The quantity of output supplied deviates from its long- run, or “natural,” level when the price level deviates from the price level that people expected. When the price level rises above the expected level, output rises above its natural rate, and when the price level falls below the expected level, out- put falls below its natural rate. Figure 31-6 Price T HE S HORT-R UN A GGREGATE - Level S UPPLY C URVE. In the short run, a fall in the price level from P1 to Short-run P2 reduces the quantity of output aggregate supplied from Y1 to Y2. This supply positive relationship could be P1 due to misperceptions, sticky wages, or sticky prices. Over time, perceptions, wages, and prices adjust, so this positive P2 relationship is only temporary. 1. A decrease 2.... reduces the quantity in the price of goods and services level... supplied in the short run. 0 Y2 Y1 Quantity of Output  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 717 T h e M i s p e r c e p t i o n s T h e o r y One approach to the short-run aggregate- supply curve is the misperceptions theory. According to this theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. As a result of these short- run misperceptions, suppliers respond to changes in the level of prices, and this response leads to an upward-sloping aggregate-supply curve. To see how this might work, suppose the overall price level falls below the level that people expected. When suppliers see the prices of their products fall, they may mistakenly believe that their relative prices have fallen. For example, wheat farmers may notice a fall in the price of wheat before they notice a fall in the prices of the many items they buy as consumers. They may infer from this obser- vation that the reward to producing wheat is temporarily low, and they may re- spond by reducing the quantity of wheat they supply. Similarly, workers may notice a fall in their nominal wages before they notice a fall in the prices of the goods they buy. They may infer that the reward to working is temporarily low and respond by reducing the quantity of labor they supply. In both cases, a lower price level causes misperceptions about relative prices, and these misperceptions induce sup- pliers to respond to the lower price level by decreasing the quantity of goods and services supplied. T h e S t i c k y - Wa g e T h e o r y A second explanation of the upward slope of the short-run aggregate-supply curve is the sticky-wage theory. According to this theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust, or are “sticky,” in the short run. To some extent, the slow adjustment of nominal wages is attributable to long-term contracts between work- ers and firms that fix nominal wages, sometimes for as long as three years. In ad- dition, this slow adjustment may be attributable to social norms and notions of fairness that influence wage setting and that change only slowly over time. To see what sticky nominal wages mean for aggregate supply, imagine that a firm has agreed in advance to pay its workers a certain nominal wage based on what it expected the price level to be. If the price level P falls below the level that was expected and the nominal wage remains stuck at W, then the real wage W/P rises above the level the firm planned to pay. Because wages are a large part of a firm’s production costs, a higher real wage means that the firm’s real costs have risen. The firm responds to these higher costs by hiring less labor and producing a smaller quantity of goods and services. In other words, because wages do not ad- just immediately to the price level, a lower price level makes employment and produc- tion less profitable, which induces firms to reduce the quantity of goods and services supplied. T h e S t i c k y - P r i c e T h e o r y Recently, some economists have advocated a third approach to the short-run aggregate-supply curve, called the sticky-price the- ory. As we just discussed, the sticky-wage theory emphasizes that nominal wages adjust slowly over time. The sticky-price theory emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs. These menu costs include the cost of printing and distributing catalogs and the time required to change price tags. As a result of these costs, prices as well as wages may be sticky in the short run. 718 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S To see the implications of sticky prices for aggregate supply, suppose that each firm in the economy announces its prices in advance based on the economic con- ditions it expects to prevail. Then, after prices are announced, the economy expe- riences an unexpected contraction in the money supply, which (as we have learned) will reduce the overall price level in the long run. Although some firms reduce their prices immediately in response to changing economic conditions, other firms may not want to incur additional menu costs and, therefore, may tem- porarily lag behind. Because these lagging firms have prices that are too high, their sales decline. Declining sales, in turn, cause these firms to cut back on production and employment. In other words, because not all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress sales and induce firms to reduce the quantity of goods and services they produce. S u m m a r y There are three alternative explanations for the upward slope of the short-run aggregate-supply curve: (1) misperceptions, (2) sticky wages, and (3) sticky prices. Economists debate which of these theories is correct. For our pur- poses in this book, however, the similarities of the theories are more important than the differences. All three theories suggest that output deviates from its nat- ural rate when the price level deviates from the price level that people expected. We can express this mathematically as follows: 冢 冣 Quantity of Natural rate of Actual Expected output supplied ⫽ output ⫹ a price level ⫺ price level where a is a number that determines how much output responds to unexpected changes in the price level. Notice that each of the three theories of short-run aggregate supply empha- sizes a problem that is likely to be only temporary. Whether the upward slope of the aggregate-supply curve is attributable to misperceptions, sticky wages, or sticky prices, these conditions will not persist forever. Eventually, as people adjust their expectations, misperceptions are corrected, nominal wages adjust, and prices become unstuck. In other words, the expected and actual price levels are equal in the long run, and the aggregate-supply curve is vertical rather than upward sloping. W H Y T H E S H O R T - R U N A G G R E G AT E - S U P P LY CURVE MIGHT SHIFT The short-run aggregate-supply curve tells us the quantity of goods and services supplied in the short run for any given level of prices. We can think of this curve as similar to the long-run aggregate-supply curve but made upward sloping by the presence of misperceptions, sticky wages, and sticky prices. Thus, when think-  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 719 ing about what shifts the short-run aggregate-supply curve, we have to consider all those variables that shift the long-run aggregate-supply curve plus a new variable—the expected price level—that influences misperceptions, sticky wages, and sticky prices. Let’s start with what we know about the long-run aggregate-supply curve. As we discussed earlier, shifts in the long-run aggregate-supply curve normally arise from changes in labor, capital, natural resources, or technological knowledge. These same variables shift the short-run aggregate-supply curve. For example, when an increase in the economy’s capital stock increases productivity, both the long-run and short-run aggregate-supply curves shift to the right. When an in- crease in the minimum wage raises the natural rate of unemployment, both the long-run and short-run aggregate-supply curves shift to the left. The important new variable that affects the position of the short-run aggregate-supply curve is people’s expectation of the price level. As we have dis- cussed, the quantity of goods and services supplied depends, in the short run, on misperceptions, sticky wages, and sticky prices. Yet perceptions, wages, and prices are set on the basis of expectations of the price level. So when expectations change, the short-run aggregate-supply curve shifts. To make this idea more concrete, let’s consider a specific theory of aggregate supply—the sticky-wage theory. According to this theory, when people expect the price level to be high, they tend to set wages high. High wages raise firms’ costs and, for any given actual price level, reduce the quantity of goods and services that firms supply. Thus, when the expected price level rises, wages rise, costs rise, and firms choose to supply a smaller quantity of goods and services at any given actual price level. Thus, the short-run aggregate-supply curve shifts to the left. Con- versely, when the expected price level falls, wages fall, costs fall, firms increase production, and the short-run aggregate-supply curve shifts to the right. A similar logic applies in each theory of aggregate supply. The general lesson is the following: An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right. As we will see in the next section, this influence of expectations on the position of the short-run aggregate-supply curve plays a key role in reconciling the economy’s behavior in the short run with its be- havior in the long run. In the short run, expectations are fixed, and the economy finds itself at the intersection of the aggregate-demand curve and the short-run aggregate-supply curve. In the long run, expectations adjust, and the short- run aggregate-supply curve shifts. This shift ensures that the economy eventually finds itself at the intersection of the aggregate-demand curve and the long-run aggregate-supply curve. You should now have some understanding about why the short-run aggregate-supply curve slopes upward and what events and policies can cause this curve to shift. Table 31-2 summarizes our discussion. Q U I C K Q U I Z : Explain why the long-run aggregate-supply curve is vertical. ◆ Explain three theories for why the short-run aggregate-supply curve is upward sloping. 720 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S Ta b l e 3 1 - 2 WHY DOES THE SHORT-RUN AGGREGATE-SUPPLY CURVE SLOPE UPWARD? T HE S HORT-R UN 1. The Misperceptions Theory: An unexpectedly low price level leads some A GGREGATE -S UPPLY suppliers to think their relative prices have fallen, which induces a fall C URVE : S UMMARY in production. 2. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers and produce a smaller quantity of goods and services. 3. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher-than-desired prices, which depresses their sales and leads them to cut back production. WHY MIGHT THE SHORT-RUN AGGREGATE-SUPPLY CURVE SHIFT? 1. Shifts Arising from Labor: An increase in the quantity of labor available (perhaps due to a fall in the natural rate of unemployment) shifts the aggregate-supply curve to the right. A decrease in the quantity of labor available (perhaps due to a rise in the natural rate of unemployment) shifts the aggregate-supply curve to the left. 2. Shifts Arising from Capital: An increase in physical or human capital shifts the aggregate-supply curve to the right. A decrease in physical or human capital shifts the aggregate-supply curve to the left. 3. Shifts Arising from Natural Resources: An increase in the availability of natural resources shifts the aggregate-supply curve to the right. A decrease in the availability of natural resources shifts the aggregate-supply curve to the left. 4. Shifts Arising from Technology: An advance in technological knowledge shifts the aggregate-supply curve to the right. A decrease in the available technology (perhaps due to government regulation) shifts the aggregate- supply curve to the left. 5. Shifts Arising from the Expected Price Level: A decrease in the expected price level shifts the short-run aggregate-supply curve to the right. An increase in the expected price level shifts the short-run aggregate-supply curve to the left. T W O C A U S E S O F E C O N O M I C F L U C T U AT I O N S Now that we have introduced the model of aggregate demand and aggregate sup- ply, we have the basic tools we need to analyze fluctuations in economic activity. In the next two chapters we will refine our understanding of how to use these tools. But even now we can use what we have learned about aggregate demand and aggregate supply to examine the two basic causes of short-run fluctuations. Figure 31-7 shows an economy in long-run equilibrium. Equilibrium output and the price level are determined by the intersection of the aggregate-demand curve and the long-run aggregate-supply curve, shown as point A in the figure. At this point, output is at its natural rate. The short-run aggregate-supply curve passes through this point as well, indicating that perceptions, wages, and prices  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 721 Figure 31-7 Price Level T HE L ONG -R UN E QUILIBRIUM. The long-run equilibrium of Long-run the economy is found where the aggregate Short-run aggregate-demand curve crosses supply aggregate the long-run aggregate-supply supply curve (point A). When the economy reaches this long-run Equilibrium A equilibrium, perceptions, wages, price and prices will have adjusted so that the short-run aggregate- supply curve crosses this point as well. Aggregate demand 0 Natural rate Quantity of of output Output have fully adjusted to this long-run equilibrium. That is, when an economy is in its long-run equilibrium, perceptions, wages, and prices must have adjusted so that the intersection of aggregate demand with short-run aggregate supply is the same as the intersection of aggregate demand with long-run aggregate supply. T H E E F F E C T S O F A S H I F T I N A G G R E G AT E D E M A N D Suppose that for some reason a wave of pessimism suddenly overtakes the econ- omy. The cause might be a scandal in the White House, a crash in the stock market, or the outbreak of a war overseas. Because of this event, many people lose confi- dence in the future and alter their plans. Households cut back on their spending and delay major purchases, and firms put off buying new equipment. What is the impact of such a wave of pessimism on the economy? Such an event reduces the aggregate demand for goods and services. That is, for any given price level, households and firms now want to buy a smaller quantity of goods and services. As Figure 31-8 shows, the aggregate-demand curve shifts to the left from AD1 to AD2. In this figure we can examine the effects of the fall in aggregate demand. In the short run, the economy moves along the initial short-run aggregate-supply curve AS1, going from point A to point B. As the economy moves from point A to point B, output falls from Y1 to Y2, and the price level falls from P1 to P2. The falling level of output indicates that the economy is in a recession. Although not shown in the figure, firms respond to lower sales and production by reducing employment. Thus, the pessimism that caused the shift in aggregate demand is, to some extent, self-fulfilling: Pessimism about the future leads to falling incomes and rising unemployment. 722 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S Figure 31-8 2.... causes output to fall in the short run... A C ONTRACTION IN A GGREGATE D EMAND. A fall in aggregate Price Level demand, which might be due to a wave of pessimism in the Long-run Short-run aggregate aggregate supply, AS1 economy, is represented with a supply leftward shift in the aggregate- AS2 demand curve from AD1 to AD2. 3.... but over The economy moves from point time, the short-run A to point B. Output falls from Y1 P1 A aggregate-supply to Y2, and the price level falls curve shifts... from P1 to P2. Over time, as P2 B 1. A decrease in perceptions, wages, and prices aggregate demand... adjust, the short-run aggregate- P3 C supply curve shifts to the right Aggregate demand, AD1 from AS1 to AS2, and the AD2 economy reaches point C, where 0 Y2 Y1 4.... and output returns Quantity of the new aggregate-demand curve Output to its natural rate. crosses the long-run aggregate- supply curve. The price level falls to P3, and output returns to its natural rate, Y1. What should policymakers do when faced with such a recession? One possi- bility is to take action to increase aggregate demand. As we noted earlier, an in- crease in government spending or an increase in the money supply would increase the quantity of goods and services demanded at any price and, therefore, would shift the aggregate-demand curve to the right. If policymakers can act with suffi- cient speed and precision, they can offset the initial shift in aggregate demand, re- turn the aggregate-demand curve back to AD1, and bring the economy back to point A. (The next chapter discusses in more detail the ways in which monetary and fiscal policy influence aggregate demand, as well as some of the practical dif- ficulties in using these policy instruments.) Even without action by policymakers, the recession will remedy itself over a period of time. Because of the reduction in aggregate demand, the price level falls. Eventually, expectations catch up with this new reality, and the expected price level falls as well. Because the fall in the expected price level alters perceptions, wages, and prices, it shifts the short-run aggregate-supply curve to the right from AS1 to AS2 in Figure 31-8. This adjustment of expectations allows the economy over time to approach point C, where the new aggregate demand-curve (AD2) crosses the long-run aggregate-supply curve. In the new long-run equilibrium, point C, output is back to its natural rate. Even though the wave of pessimism has reduced aggregate demand, the price level has fallen sufficiently (to P3) to offset the shift in the aggregate-demand curve. Thus, in the long run, the shift in aggregate demand is reflected fully in the price level and not at all in the level of output. In other words, the long-run effect of a shift in aggregate demand is a nominal change (the price level is lower) but not a real change (output is the same). 724 PA R T T W E LV E S H O R T - R U N E C O N O M I C F L U C T U AT I O N S percent. At the same time, the price level fell by 22 percent over these four years. Many other countries experienced similar declines in output and prices during this period. Economic historians continue to debate the causes of the Great Depression, but most explanations center on a large decline in aggregate demand. What caused aggregate demand to contract? Here is where the disagreement arises. Many economists place primary blame on the decline in the money supply: From 1929 to 1933, the money supply fell by 28 percent. As you may recall from our discussion of the monetary system in Chapter 27, this decline in the money supply was due to problems in the banking system. As households withdrew their money from financially shaky banks and bankers became more cau- tious and started holding greater reserves, the process of money creation under fractional-reserve banking went into reverse. The Fed, meanwhile, failed to off- set this fall in the money multiplier with expansionary open-market operations. As a result, the money supply declined. Many economists blame the Fed’s fail- ure to act for the Great Depression’s severity. Other economists have suggested alternative reasons for the collapse in aggregate demand. For example, stock prices fell about 90 percent during this period, depressing household wealth and thereby consumer spending. In addi- tion, the banking problems may have prevented some firms from obtaining the financing they wanted for investment projects, and this would have depressed investment spending. Of course, all of these forces may have acted together to contract aggregate demand during the Great Depression. The second significant episode in Figure 31-9—the economic boom of the early 1940s—is easier to explain. The obvious cause of this event is World War II. As the United States entered the war overseas, the federal government had to devote more resources to the military. Government purchases of goods and services increased almost fivefold from 1939 to 1944. This huge expansion in aggregate demand almost doubled the economy’s production of goods and services and led to a 20 percent increase in the price level (although widespread government price controls limited the rise in prices). Unemployment fell from 17 percent in 1939 to about 1 percent in 1944—the lowest level in U.S. history. WARS: ONE WAY TO STIMULATE AGGREGATE DEMAND  CHAPTER 31 A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY 725 The consumer spending spree was IN THE NEWS a major force in the surprisingly robust How Consumers Shift economic data released Friday, econo- mists said. The Labor Department es- Aggregate Demand timated that the economy created 239,000 jobs in June, far more than expected, making that month the fifth consecutive one with strong employ- ment gains. The unemployment rate now stands at 5.3 percent, the lowest in six C ONSUMERS : A GGREGATE - DEMAND SHIFTERS years, and economic growth is so rapid AS WE HAVE SEEN, WHEN PEOPLE CHANGE that it has revived fears of inflation. their perceptions and spending, they up 15 percent from the first three Among the industries showing the shift the aggregate-demand curve and months of 1995.... biggest gains was retailing, which added cause short-run fluctuations in the Most economists also agree that 75,000 jobs in June, nearly half of them economy. According to the following the surge in spending this year has been in what the government classifies as eat- article, such a shift occurred in 1996, driven in large part by temporary fac- ing and drinking places. Job growth was just as the presidential campaign of that tors—including low interest rates, higher- also strong at car dealers, gas stations, year was getting under way. than-expected tax refunds, and rebates hotels, and stores selling building materi- from automakers—that have been re- als, garden supplies, and home furnish- versed or phased out.... ings. Employment in construction was up