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now only about half of what it was in the 1970s. That alone cuts
the impact of an oil shock in half.
In addition, for reasons that are not entirely understood, the
United States and other economies seem to have become less
volatile since the mid-1980s. Sound macroeconomic policies have
probably contributed to the reduction in volatility, and so have a
variety of structural changes that have made these economies more
flexible. But in the view of most researchers who have studied the




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Licensed to:

Chapter 10 213
Bringing in the Supply Side: Unemployment and Inflation?



2007
120
2005
2006
2003
110
2001 2004
S
D 1999 2002
100 1997
1995 2000
Price Level (GDP deflator)




1998
1992
90 1996
1991 1994
D
S 1993
1989
S
(2000 = 100)




80 D 1990
1987
1985 1988
70 1983 1986
1982
S 1984 D
60
1981
1980
50 1979
1978
1976
40 1975 1977
1974
30
1972 1973
20


4,000 4,500 5,000 5,500 6,000 6,500 7,000 7,500 8,000 8,500 9,000 9,500 10,000 10,500 11,000 11,500 12,000

Real GDP in Billions of 2000 Dollars


F I GU R E 9
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

The Price Level and
Real GDP Output in
the United States,
This upward trend is hardly mysterious, for both the aggregate demand curve and the
1972“2007
aggregate supply curve normally shift to the right each year. Aggregate supply grows be-
cause more workers join the workforce each year and because investment and technology
improve productivity (Chapter 7). Aggregate demand grows because a growing popula-
tion generates more demand for both consumer and investment goods and because the
government increases its purchases (Chapters 8 and 9). We can think of each point in Fig-
ure 9 as the intersection of an aggregate supply curve and an aggregate demand curve for
that particular year. To help you visualize this idea, the curves for 1984 and 1993 are
sketched in the diagram.
Figure 10 is a more realistic version of the aggregate supply-and-demand diagram that
illustrates how our theoretical model applies to a growing economy. We have chosen the
FIGURE 10
numbers so that the black curves D0D0 and S0S0 roughly represent the year 2005, and the
brick-colored curves D1D1 and S1S1 roughly represent 2006”except that we use nice round Aggregate Supply and
Demand Analysis of a
numbers to facilitate computations. Thus, the equilibrium in 2005 was at point A, with a
Growing Economy
real GDP of $11,000 billion (in 2000 dol-
lars) and a price level of 113. A year later, S0
D1
S1
the equilibrium was at point B, with real
GDP at $11,330 billion and the price level
at 116.5. The blue arrow in the diagram
shows how equilibrium moved from D0 B
2005 to 2006. It points upward and to the 116.5
right, meaning that both prices and out-
Price Level (P )
(2000 = 100)




put increased. In this case, the economy A
grew by 3 percent and prices also rose 113 D1
about 3 percent, which is close to what
actually happened in the United States
S0
over that year.
S1
D0
Demand-Side Fluctuations
11,000 11,330
Let us now use our theoretical model to Real GDP (Y ) in Billions of 2000 Dollars
rewrite history. Suppose that aggregate


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Licensed to:
Part 2
214 The Macroeconomy: Aggregate Supply and Demand



demand grew faster than it actually did
D2
between 2005 and 2006. What difference
S0
would this have made to the performance
of the U.S. economy? Figure 11 provides
S1
C
answers. Here the black demand curve
120
D0D0 is exactly the same as in the previous
diagram, as are the two supply curves,
D2
Price Level (P )
(2000 = 100)




indicating a given rate of aggregate sup-
ply growth. But the brick-colored demand
D0
curve D2D2 lies farther to the right than
A
the demand curve D1D1 in Figure 10. Equi-
113
librium is at point A in 2005 and point C in
2006. Comparing point C in Figure 11 with
S0
point B in Figure 10, you can see that both
S1
output and prices would have increased
D0
more over the year”that is, the economy
would have experienced faster growth and
11,000 11,500
more inflation. This is generally what hap-
Real GDP (Y ) in Billions of 2000 Dollars
pens when the growth rate of aggregate
FIGURE 11 demand speeds up.
The Effects of Faster
For any given growth rate of aggregate supply, a faster growth rate of aggregate demand
Growth of Aggregate
will lead to more inflation and faster growth of real output.
Demand
Figure 12 illustrates the opposite case. Here we imagine that the aggregate demand
curve shifted out less than in Figure 10. That is, the brick-colored demand curve D3D3 in
Figure 12 lies to the left of the demand curve D1D1 in Figure 10. The consequence, we see,
is that the shift of the economy™s equilibrium from 2005 to 2006 (from point A to point E)
would have entailed less inflation and slower growth of real output than actually took place.
Again, that is generally the case when aggregate demand grows more slowly.
For any given growth rate of aggregate supply, a slower growth rate of aggregate demand
will lead to less inflation and slower growth of real output.
Putting these two findings together gives us a clear prediction:
If fluctuations in the economy™s real growth rate from year to year arise primarily from
variations in the rate at which aggregate demand increases, then the data should show
FIGURE 12
the most rapid inflation occurring when output grows most rapidly and the slowest
The Effects of Slower inflation occurring when output grows most slowly.
Growth of Aggregate
Demand Is it true? For the most part, yes. Our
brief review of U.S. economic history
back in Chapter 5 found that most
episodes of high inflation came with
S0
D3
rapid growth. But not all. Some surges
S1
of inflation resulted from the kinds of
D0 supply shocks we have considered in
this chapter.
Price Level (P )
(2000 = 100)




E
A
115
113
Supply-Side Fluctuations
As an historical example, let™s return to
S0
D3
the events of 1973 to 1975 that were
S1
depicted in Figure 8 (page 212). But
D0 now let™s add in something we ignored
there: While the aggregate supply curve
11,000 11,165
was shifting inward because of the
Real GDP (Y ) in Billions of 2000 Dollars
oil shock, the aggregate demand was



Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 10 215
Bringing in the Supply Side: Unemployment and Inflation?



shifting outward. In Figure 13, the FIGURE 13
black aggregate demand curve Stagflation from an
D0D0 and aggregate supply curve S1 Adverse Supply Shock
S0S0 represent the economic situa- D1
tion in 1973. Equilibrium was at B
point E, with a price level of 31.8 39




Price Level (P )
(2000 = 100)
S0
D0
(based on 2000 = 100) and real out-
D1
put of $4,342 billion. By 1975, the E
aggregate demand curve had 31.8
S1
shifted out to the position indi- D0
cated by the brick-colored curve
D1D1, but the aggregate supply S0
curve had shifted inward from S0S0
to the brick-colored curve S1S1. The
equilibrium for 1975 (point B in the
4,311 4,342
figure) therefore wound up to the Real GDP (Y) in Billions of 2000 Dollars
left of the equilibrium point for
1973 (point E in the figure). Real
output declined slightly (although
less than in Figure 8) and prices”

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