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Copyright 2005 © McGraw-Hill Ryerson Ltd.
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CHAPTER
6
Business Cycles and the
Aggregate Demand-Aggregate
Supply Model
Learning objectives




Identify business cycle movements in output, the
unemployment rate, and the inflation rate.
Understand that output and prices are determined by the
interaction of aggregate supply and aggregate demand.
Understand that the slope of the aggregate supply curve
reflects assumptions concerning the economy's price
adjustment mechanism.
Understand that in the very short run, we assume that
there is no price adjustment and that the aggregate
supply curve is horizontal.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
CHAPTER
6
Business Cycles and the
Aggregate Demand-Aggregate
Supply Model
Learning objectives (cont’d)



Understand that in the long run, we assume that prices
are completely flexible and that the aggregate supply
curve is vertical.
Understand that the aggregate demand curve slopes
downward and shifts due to change in monetary or fiscal
policy.
Understand that changes in aggregate demand change
output in the short run and changes in the long run.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Business Cycles
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 6: Business Cycles and the AD-AS Model
o Business Cycle: The more or less regular pattern
of expansion (recovery) and contraction
(recession) in economic activity around full
employment output.
o Expansion (Recovery): A sustained period of
rising real income.
o Contraction (Recession): That period of time in a
business cycle when output is falling below full
employment.
o Potential GDP: Output that is produced when all
factors of production are fully employed.
o Output gap: Measures the difference between
actual output and the output that could be
produced at full employment, or potential output.
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Business Cycles
Figure 6-1: A Stylized GDP Business Cycle
Output
Peak
Trend
Peak
The business
cycle is the
movement of
current GDP
around its trend
path. At a cyclical
peak, economic
activity is high; at
a through, output
is below trend.
Trough
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Time
Slide 4
Business Cycles
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-2: Actual and Potential GDP, 1961-2002
Slide 5
Business Cycles
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-3: The Cyclical Behaviour of the Unemployment Rate, 1968-2002
Slide 6
Business Cycles
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-4: The Cyclical Behaviour of the Inflation Rate, 1961-2002
Slide 7
Introduction to AD and AS
o Aggregate Demand (AD) Curve: Shows
combinations of the price level and the level of
output for which the demanders of goods and
services are equilibrium.
o Aggregate Supply (AS) Curve: Relationship
between the amount of final goods and services
produced in an economy and the price level.
o Keynesian aggregate supply curve: Is horizontal
because firms will supply whatever amount of goods
are demanded at the existing price level.
o Classical aggregate supply curve: Is vertical because
firms will supply the same amount of goods no matter
what the price level.
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 6: Business Cycles and the AD-AS Model
Aggregate Demand and Aggregate Supply
Slide 8
Introduction to AD and AS
P
Price Level
P’
P0
AD’
AD
Y0
Y
The AD curve slopes
downward because as
the price level
increases, with the
nominal money stock
held constant, the real
money stock
decreases. An
increase in the
nominal money stock
shifts the AD curve
outward. The vertical
shift in the AD curve
proportional to the
change in the nominal
money stock. For a
given level of income,
Y0, the level of the real
money stock is
unchanged after the
shift in AD.
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-5: The Aggregate Demand (AD) Curve
Output, Income
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 9
Introduction to AD and AS
Price Level
P
P’
AS
Y
The Keynesian AS
curve is horizontal,
indicating that any
amount of output will
be supplied at a given
price. This is a very
short run model.
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-6: The Aggregate Supply (AS) Curve (a)
Output, Income
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 10
Introduction to AD and AS
AS
The Classical AS curve
is vertical at the level
of full employment
income, Y*. This is
based on the
assumptions of the
classical market
clearing model
discussed in Chapter
3.
Price Level
P
Y*
Y
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-6: The Aggregate Supply (AS) Curve (b)
Output, Income
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 11
AD Policy and Alternative Supply Assumptions
Price Level
P
AS
P0
AD’
AD
Y0
Y’
In the very short
run the
aggregate
supply curve is
horizontal.
When the AD
curve shifts to
the right, output
increases, while
the price level
remains
constant.
Y
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-7: Aggregate Demand Expansion: The Keynesian Case
Output, Income
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 12
AD Policy and Alternative Supply Assumptions
AS
P
Due to the
assumption of
full market
clearing, a
shift in the AD
curve leads to
only a price
level increase
in the long
run.
E’’
Price Level
P1
E
P0
E’
AD’
AD
Y0
Y
Chapter 6: Business Cycles and the AD-AS Model
Figure 6-8: Aggregate Demand Expansion: The Classical Case
Output, Income
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Slide 13
BOX
Vertical or Horizontal: A Matter of Timing?
6-2
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Slide 14
Chapter Summary
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 6: Business Cycles and the AD-AS Model
• The business cycle is the more or less pattern of
expansion and contraction in economic activity around
full employment output.
• Movements in output, the unemployment rate, and the
inflation rate are related through the business cycle.
• The output gap measures deviations of current output
from potential output.
• The aggregate demand curve shows for each price level
the quantity of goods demanded.
• For a given AD curve, the level of nominal money stock
is constant. As the price level increases for a given
nominal money stock, the real money stock decreases.
Therefore, the aggregate demand curve slopes
downward.
Slide 15
Chapter Summary (cont’d)
Copyright 2005 © McGraw-Hill Ryerson Ltd.
Chapter 6: Business Cycles and the AD-AS Model
• A change in the level of nominal money stock or change
in fiscal policy will shift the aggregate demand curve.
• An increase in the nominal money stock will shift the
aggregate demand curve upward by an amount
proportional to the change in the money stock.
• The Keynesian aggregate supply curve is horizontal, the
Classical aggregate supply curve is vertical.
• Supply0side economics make the claim that reducing
tax rates generates very large increases in aggregate
supply.
Slide 16
The End
Chapter 6: Business Cycles and the AD-AS Model
Copyright 2005 © McGraw-Hill Ryerson Ltd.
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