Chapter 12: Macroeconomic Instability: Aggregate Demand and Aggregate Supply 1

Chapter 12MACROECONOMIC INSTABILITY: AGGREGATE DEMAND AND AGGREGATE SUPPLY

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.

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.


  1. Identify the policies which government might use to counteract recession

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
  8. multiplier
  9. marginal propensity to save
  10. stagflation
  11. income policies
  12. multiplier 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
_____ f.shows the total demand of all people for all final goods and services
_____ g.the fraction of additional income that is saved
_____ 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

Multiple Choice Questions

  1. According to the nineteenth century economist, Jean Baptiste Say
  1. supply creates its own demand
  2. demand creates its own supply
  3. prices are inflexible
  4. the economy can never be at full employment
  1. Overproduction was considered to be an impossibility by
  1. Classical economists
  2. neoclassical economists
  3. mercantilists
  4. Keynsians
  1. Keynes’ argument with the classicists can be located in their very different understanding of
  1. price behavior
  2. production
  3. output
  4. supply
  1. Keynes argued that prices
  1. tend to be sticky
  2. tend to be highly flexible
  3. and wages are never influenced by labor unions
  4. are never determined by large businesses
  1. Keynes made all of these recommendations for avoiding another depression except
  1. maintaining high levels of demand
  2. decreased government spending
  3. encouraging investment
  4. encouraging consumers to spend more
  1. When the price level falls, aggregate quantity demanded increases due to

a.the real-wealth effect

b. the interest-rate effect

c. the foreign-trade effect

d. all of the above

  1. When the price level increases and the purchasing power of assets decline, the aggregate quantity demanded declines due to
  1. the interest rate effect
  2. the real income effect
  3. the present consumption effect
  4. the real wealth effect
  1. The interest rate effect
  1. describes the effect of a change in the price level on the interest rate
  2. is associated with the effect of a change in the interest rate on spending
  3. is associated with the effect of a change in the price level on the amount of money demanded
  4. all of the above
  1. The foreign trade effect is triggered by
  1. a change in relative price levels between countries
  2. a change in trade restrictions
  3. a change in trade policy
  4. a change in trading patterns
  1. The aggregate demand curve for the U.S. will shift to the left when
  1. the stock market is booming
  2. Japan’s economy is doing well
  3. recessionary expectations are strong
  4. the world is enjoying a long period of peace
  1. When the multiplier increases
  1. the marginal propensity to consume must rise
  2. the marginal propensity to save must rise
  3. the marginal propensity to import must rise
  4. the marginal propensity to invest must fall
  1. When the marginal propensity to consume rises
  1. the marginal propensity to save also rises
  2. the marginal propensity to save falls
  3. the marginal propensity to save remains unchanged
  4. the multiplier decreases
  1. When wages increase
  1. the aggregate demand curve shifts to the left
  2. the aggregate demand curve shifts to the right
  3. the aggregate supply curve shifts to the left
  4. the aggregate supply curve shifts to the right
  1. When new technologies lead to improvements in productivity
  1. the aggregate demand curve shifts to the right
  2. the aggregate demand curve shifts to the left
  3. the aggregate supply curve shifts to the left
  4. the aggregate supply cure shifts to the right
  1. Recessions may be caused by
  1. shrinking aggregate demand
  2. rising production costs
  3. financial and political crises leading to negative expectations about the economy’s performance
  4. all of the above
  1. 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
  1. $160 million
  2. $180 million
  3. $200 million
  4. $220 million
  1. The value of the multiplier equals
  1. 1 + MPS
  2. 1 - MPS
  3. 1 / MPS
  4. 1 x MPS
  1. If the value of the multiplier is 5, the marginal propensity to consume is
  1. 0.6
  2. 0.7
  3. 0.8
  4. 0.9
  1. Aggregate demand includes all of the following components except
  1. household consumption expenditures
  2. household savings
  3. government purchases of goods and services
  4. net exports of goods and services
  1. Inflation would most likely be caused by a (n)
  1. increase in aggregate supply and a decrease in aggregate demand
  2. increase in aggregate supply and an increase in aggregate demand
  3. decrease in aggregate supply and increase in aggregate demand
  4. decrease in aggregate supply and decrease in aggregate demand
  1. Movements along an aggregate demand curve are caused by all of the following except the
  1. real wealth effect
  2. interest rate effect
  3. foreign trade effect
  4. inflationary effect
  1. According to the wealth effect
  1. increased stock prices trigger increases in consumer spending
  2. people tend to save more when they expect declines in wealth
  3. falling home values result in declining consumer spending
  4. rising prices induce increasing consumption and decreasing saving
  1. According to the classical economists, the market economy
  1. automatically adjusted to ensure full employment of labor
  2. required continual government assistance to achieve full employment of labor
  3. could never achieve the full employment of labor
  4. always suffered from inadequate spending by consumers
  1. Movements along the aggregate supply curve are caused by changes in
  1. productivity
  2. resource prices
  3. government prices
  4. the price level
  1. Rising productivity would contain inflation by causing
  1. aggregate demand to increase more than the aggregate supply
  2. aggregate supply to increase more than the aggregate demand
  3. aggregate supply to decrease more than aggregate demand
  4. aggregate demand to decrease more than aggregate supply
  1. During the Great Depression, all of the following occurred except
  1. unemployment increased
  2. national income decreased
  3. many banks and stores shut down
  4. rising prices made farmers wealthy

True-False Questions

1.TFA decrease in aggregate demand may cause inflation.

2.TFAn increase in aggregate demand may cause recession.

3.TFWhen an economy experiences both recession and inflation, stagflation results.

4.TFThe size of the multiplier is independent of the saving habits of the private sector.

5.TFAccording to Keynes, the level of economic activity depends on the total spending of the economy.

6.TFAccording to the classical economists, the market economy automatically ensures full employment.

7.TFPrior to the Great Depression, most economists believed that wages and prices were flexible.

8.TFKeynes’ explanation of the Great Depression was partially based on the idea of flexible wages.

9.TFKeynes’ solution to the problem of long-term recession involves government intervention in markets.

10.TFMovements along the aggregate demand curve are caused by changes in the price level.

11.TFReal wealth effects can explain movements along the demand curve.

12.TFThe foreign trade effect and changes in the price level are unrelated.

13.TFAn increase in the price level can change the level of aggregate spending through the interest rate effect.

14.TFMacroeconomics attempts to explain short-run fluctuations in economic activity.

15.TFMacroeconomics attempts to explain how the government can achieve full employment without inflation.

16.TFThe aggregate supply curve consists of the three segments: horizontal, upward-sloping and vertical.

17.TFAccording to Say’s Law, “demand creates its own supply.”

18.TFThe inverse relationship between aggregate quantity demanded and the price level can be explained by the real income effect.

19.TFAn increase in the marginal propensity to consume tends to increase the size of the multiplier.

20.TFTax cuts cause the aggregate supply curve to shift to the left.

21.TFMost economists agree that skyrocketing agricultural prices triggered the Great Depression of the 1930s..

22.TFThe Great Depression set the stage for John Maynard Keynes, and his emphasis on activist government economic policies, to influence economic thinking and policymaking.

23.TFWhen cost-push inflation occurs, the economy experiences an increase in output and employment and an increase in the price level.

24.TFA reduction in the price of labor causes the economy to slide downward along its aggregate supply curve.

25.TFAccording to the wealth effect, a decrease in stock prices causes households to increase their consumption spending.

26.TFThe 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?
  1. 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?
  2. Investment spending is $100 million in both 1999 and 2000 in this city? In which year will more income be generated? How much more?
  1. 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?

Key Concept Answers

1.j / 4.d / 7.k / 10.a
2.c / 5.h / 8.b / 11.l
3.f / 6.e / 9.g / 12.i

Multiple Choice Answers

1.a / 6.d / 11.a / 16.c / 21.d / 26.d
2.a / 7.d / 12.b / 17.c / 22.a
3.a / 8.d / 13.c / 18.c / 23.a
4.a / 9.a / 14.d / 19.b / 24.d
5.b / 10.c / 15.d / 20.c / 25.b

True-False Answers

1.F / 6.T / 11.T / 16.T / 21.F / 26.F
2.F / 7.T / 12.F / 17.F / 22.T
3.T / 8.F / 13.T / 18.F / 23.F
4.F / 9.T / 14.T / 19.T / 24.F
5.T / 10.T / 15.T / 20.F / 25.F

Application Question Answers


1.a.The value of the multiplier is

  1. The marginal propensity to consume (MPC) is 1 – MPS = 1 – 0.8 = 0.2


The multiplier is

  1. 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.


  1. The price level rises. The output and employment decrease.
  2. 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.