Chapter 10

Economic Fluctuations

Prepared by Murray Davidson, Centennial College.

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Learning Objectives
After this chapter you will be able to:

Identify aggregate demand and the

factors that affect it
Describe aggregate supply and the factors
that influence it
Identify the economy’s equilibrium and
how it differs from its potential
Define economic growth and explain its sources
Understand the business cycle and its
causes.
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Aggregate Demand
Aggregate demand (AD):

 is the relationship between the general price level

and real expenditures (i.e. total spending) in an
economy

 is shown as a schedule or curve

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Aggregate Demand
FIGURE 10.1

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Slope of Aggregate Demand
Two factors cause the aggregate demand curve to be
downward sloping:
 The wealth effect means that higher prices
decrease the real value of financial assets and
decrease consumption, because households feel
poorer (and vice versa for lower prices).
 The foreign trade effect means that higher prices
decrease exports and increase imports (and vice
versa for lower prices).

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Changes in Aggregate Demand
Aggregate demand changes are shown by shifts in
the AD curve.

 An increase in spending causes a rightward shift

in the AD curve.

 A decrease in spending causes a leftward shift in

the AD curve.

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Changes in Aggregate Demand
FIGURE 10.2

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Aggregate Demand Factors (a)
AD changes are caused by the factors related to each
of the four main spending components:

 Consumption (C)
 disposable income

 wealth (other than wealth changes caused by a

varying price level)

 consumer expectations

 interest rates

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Aggregate Demand Factors (b)
 Investment (I)
 interest rates

 business expectations

 Government purchases (G)

 Net exports (X-M)

 foreign incomes

 exchange rates

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Investment Demand
 Investment demand is the relationship between the
interest rate and investment and depends on the
real rate of return and the real interest rate.

 Businesses pursue projects whose real rate of

return at least equals the real interest rate, which
means the investment demand curve is downward-
sloping, since more projects are profitable at lower
interest rates.

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Investment Demand
FIGURE 10.3

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Shifts in the Aggregate Demand
Curve

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Aggregate Supply
Aggregate supply (AS) is:

 the relationship between the general price

level and real output in an economy

 shown as a schedule or curve

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Aggregate Supply
FIGURE 10.5

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The Aggregate Supply Curve
 The AS curve is upward-sloping because higher
prices encourage businesses to produce more, while
at lower prices businesses are forced to reduce
output.

 The AS curve becomes steep above potential output

because a relatively large increase in the price level
is required if businesses are to increase output in
this range.

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Short-Run Changes in Aggregate
Supply
Short-run AS changes are shown by shifts in the AS curve
and a constant potential output for the economy.

 A short-run increase in AS occurs when the AS curve

shifts rightward while potential output stays
constant.

 A short-run decrease in AS occurs when the AS curve

shifts leftward while potential output stays constant.

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A Short-Run Change in Aggregate
Supply FIGURE 10.6

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Long-Run Changes in Aggregate
Supply
Long-run AS changes are shown by shifts in both the
AS curve and in potential output.

 A long-run increase in AS occurs when the AS

curve and potential output both shift rightward.

 A long-run decrease in AS occurs when the AS

curve and potential output both shift leftward.

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A Long-Run Change in Aggregate
Supply FIGURE 10.7

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Aggregate Supply Factors
AS changes are caused by the factors related
either to short-run or long-run trends.

 Short-run changes in AS are caused by varying

input prices.

 Long-run changes in AS are caused by varying:

 resource supplies

 productivity

 government policies

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Shifts in the Aggregate Supply Curve
Shifts10.8
FIGURE in the Aggregate Supply Curve (a)
Figure 10.8, Page 271

21
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Equilibrium in the Economy (a)
An economy’s equilibrium occurs at the intersection
of the AD and AS curves.

 A price level above equilibrium means an

unintended increase in inventories (or positive
unplanned investment), lowering the price level
towards equilibrium.
 A price level below equilibrium leads to an

unintended decrease in inventories (or negative

unplanned investment), raising the price level
towards equilibrium.
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An Economy at Equilibrium
FIGURE 10.9

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Equilibrium in the Economy (b)
 An economy’s equilibrium occurs at a point where
total injections (I+G+X) equal total withdrawals
(S+T+M).
 When total injections exceed total withdrawals then
real output and spending expand until a new
balance is achieved.
 When total withdrawals exceed total injections then
real output and spending contract until a new
balance is achieved.

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An Economy at Its Potential Output
FIGURE 10.10

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Recessionary and Inflationary
Gaps
 A recessionary gap:
 occurs when equilibrium output falls short of

potential output, and is associated with an

unemployment rate above the natural rate

 An inflationary gap:
 occurs when equilibrium output exceeds

potential output, and is associated with an

unemployment rate below the natural rate as
well as increased pressure on prices

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Recessionary and Inflationary Gaps
FIGURE 10.11

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Economic Growth (a)
Economic growth can be defined in two ways:

 The percentage increase in an economy’s total

output (e.g. real GDP) is most appropriate when
measuring an economy’s overall productive
capacity.
 The percentage increase in per capita output

(e.g. per capita real GDP) is most appropriate

when measuring living standards.

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Economic Growth (b)
Economic growth can also be portrayed using the
production possibilities curve in two ways:

 an outward shift in the production possibilities

curve due to technological change or an increase
in economic resources
 a movement from below the curve towards the

curve because not all resources have been

employed or used to their fullest capacity.

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The Process of Economic Growth
FIGURE 10.12

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Production Options and Their
Impact FIGURE 10.13

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The Rule of 72
The Rule of 72:

 shows the effects of exponential growth

 states that the number of years it takes a variable

(e.g. GDP) to double can be estimated by dividing
72 by the variable’s annual percentage change.

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GDP and Growth Rates
FIGURE 10.14

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Sources of Economic Growth (a)
 A main cause of growth in Canada’s real output is
the increase in the quantity of labor (workers).

 Growth in per capita output is closely associated

with growth in labor productivity, which depends on
six factors.

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Sources of Economic Growth (b)
These factors are:

 the quantity of capital

 technological progress

 the quality of labour

 efficiency in production

 the quantity of natural resources

 social, political and legal factors

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Labour Productivity in Selected
Countries FIGURE 10.15

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The Benefits of Growth
 There are three main advantages of economic
growth:

 its positive effect on living standards

 its possible effect on social improvements

 its psychological benefits

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The Costs of Growth
 There are three possible disadvantages of economic
growth:

 its potential to create social insecurity

 its frequent negative effects on the environment

 the opportunity cost of lost consumption

(especially in poor countries).

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Business Cycles
The business cycle is the cycle of expansions and
contractions in an economy.

 An expansion is a sustained rise in real output.

 A contraction is a sustained fall in real output.

 A peak is the point in the business cycle at

which real output is at its highest.

 A trough is the point in the business cycle at

which real output is at its lowest.

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The Business Cycle
FIGURE 10.17

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Contractions
A contraction:

 is usually caused by a decrease in AD magnified

by the reactions of both households and
businesses, who spend less due to pessimism
about the future
 may be a recession, which is a decline in real

output for six months or more

 may be a depression, which is a particularly long

and harsh period of reduced real output

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Expansions
 An expansion is usually caused by an increase in AD
magnified by the reactions of both households and
businesses as they spend more due to more
optimistic expectations of the future.

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Expansion and Contraction
FIGURE 10.17

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The
The Doomsday
Doomsday Prophet
Prophet
 Thomas Malthus formulated a theory of population
based on two principles:
 food increases in an algebraic progression

(1,2,3…)
 population increases in a geometric progression

(1,2,4…)
 He predicted that over time population growth

would outstrip growth in the food supply with

disastrous effects.

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Conclusion
Defined aggregate demand and factors that affect it.
Defined aggregate supply and factors that influence
it.
Identified the economy’s equilibrium and
differentiated it from its potential.
Defined economic growth and its sources and
impacts.
Defined the business cycles and their cause.

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