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led by energy costs”rose rapidly
(more than in Figure 8).
What about the opposite case? Suppose the economy experiences a favorable supply
shock, as it did in the late 1990s, so that the aggregate supply curve shifts outward at an
unusually rapid rate.
Figure 14 depicts the consequences. The aggregate demand curve shifts out from D0D0
to D1D1 as usual, but the aggregate supply curve shifts all the way out to S1S1. (The dot-
ted line indicates what would happen in a “normal” year.) So the economy™s equilibrium
winds up at point B rather than at point C. Compared to C, point B represents faster eco-
nomic growth (B is to the right of C) and lower inflation (B is lower than C). In brief, the
economy wins on both fronts: Inflation falls while GDP grows rapidly, as happened in
the late 1990s.
Combining these two cases, we conclude that
If fluctuations in economic activity emanate mainly from the supply side, higher rates
of inflation will be associated with lower rates of economic growth.

Nor mal growth The Effects of a
of aggregate supply Favorable Supply Shock

Price Level (P )

A Effect of favorable
supply shock

S1 D0

Real GDP (Y )

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Part 2
216 The Macroeconomy: Aggregate Supply and Demand

What we have learned in this chapter helps us to understand why the U.S.
economy performed so poorly in the 1970s and early 1980s, when both unem-
ployment and inflation rose together. The OPEC cartel first flexed its muscles
in 1973“1974, when it quadrupled the price of oil, thereby precipitating the
first bout of serious stagflation in the United States and other oil-importing na-
tions. Then OPEC struck again in 1979“1980, this time doubling the price of
oil, and stagflation returned. Unlucky? Yes. But mysterious? No. What was happening
was that the economy™s aggregate supply curve was shifted inward by the rising price of
energy, rather than moving outward from one year to the next, as it normally does.
Unfavorable supply shocks tend to push unemployment and inflation up at the same
time. It was mainly unfavorable supply shocks that accounted for the stunningly poor
economic performance of the 1970s ands early 1980s.3

Chapter 8 emphasized the volatility of investment spending, and Chapter 9 noted that
changes in investment have multiplier effects on aggregate demand. This chapter took the
next step by showing how shifts in the aggregate demand curve cause fluctuations in both
real GDP and prices”fluctuations that are widely decried as undesirable. It also suggested
that the economy™s self-correcting mechanism works, but slowly, thereby leaving room for
government stabilization policy to improve the workings of the free market. Can the gov-
ernment really accomplish this goal? If so, how? These are some of the important ques-
tions for Part 3.

1. The economy™s aggregate supply curve relates the quan- inflation decreases the multiplier by reducing both
tity of goods and services that will be supplied to the consumer spending and net exports.
price level. It normally slopes upward to the right be- 5. The equilibrium of aggregate supply and demand can
cause the costs of labor and other inputs remain rela- come at full employment, below full employment (a re-
tively fixed in the short run, meaning that higher selling cessionary gap), or above full employment (an infla-
prices make input costs relatively cheaper and therefore tionary gap).
encourage greater production.
6. The economy has a self-correcting mechanism that
2. The position of the aggregate supply curve can be erodes a recessionary gap. Specifically, a weak labor
shifted by changes in money wage rates, prices of other market reduces wage increases and, in extreme cases,
inputs, technology, or quantities or qualities of labor and may even drive wages down. Lower wages shift the ag-
capital. gregate supply curve outward. But it happens very
3. The equilibrium price level and the equilibrium level slowly.
of real GDP are jointly determined by the intersection of 7. If an inflationary gap occurs, the economy has a similar
the economy™s aggregate supply and aggregate demand mechanism that erodes the gap through a process of in-
schedules. flation. Unusually strong job prospects push wages up,
4. Among the reasons why the oversimplified multiplier which shifts the aggregate supply curve to the left and
formula is wrong is the fact that it ignores the inflation reduces the inflationary gap.
that is caused by an increase in aggregate demand. Such

As we mentioned in the box on page 212, questions have been

raised, and only partially answered, about why stagflation did not
return in the 2003“2007 period.

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Chapter 10 217
Bringing in the Supply Side: Unemployment and Inflation?

8. One consequence of this self-correcting mechanism is 11. But things reversed in 1997“1998, when falling oil prices
that, if a surge in aggregate demand opens up an infla- and rising productivity shifted the aggregate supply
tionary gap, the economy™s subsequent natural adjust- curve out more rapidly than usual, thereby boosting real
ment will lead to a period of stagflation”that is, a pe- growth and reducing inflation simultaneously.
riod in which prices are rising while output is falling. 12. Inflation can be caused either by rapid growth of aggre-
9. An inward shift of the aggregate supply curve will cause gate demand or by sluggish growth of aggregate supply.
output to fall while prices rise”that is, it will produce When fluctuations in economic activity emanate from
stagflation. Among the events that have caused such a the demand side, prices will rise rapidly when real out-
shift are abrupt increases in the price of foreign oil. put grows rapidly. But when fluctuations in economic
activity emanate from the supply side, output will grow
10. Adverse supply shifts like this plagued the U.S. econ-
slowly when prices rise rapidly.
omy when oil prices skyrocketed in 1973“1974, in
1979“1980, and again in 1990, leading to stagflation each

Aggregate supply curve 200 Inflation and the multiplier 204 Self-correcting mechanism 209
Productivity 202 Recessionary gap 205 Stagflation 210
Equilibrium of real GDP and the Inflationary gap 205
price level 203

1. In an economy with the following aggregate demand
(1) (2) (3) (4)
and aggregate supply schedules, find the equilibrium
Aggregate Aggregate
levels of real output and the price level. Graph your so-
Demand Demand
lution. If full employment comes at $2,800 billion, is
When When
there an inflationary or a recessionary gap?
Price Investment Investment Aggregate
Level Is $240 Is $260 Supply
Aggregate Aggregate
90 $3,860 $4,060 $3,660
Quantity Price Quantity
95 3,830 4,030 3,730
Demanded Level Supplied
100 3,800 4,000 3,800
$3,200 90 $2,750 105 3,770 3,970 3,870
3,100 95 2,900 110 3,740 3,940 3,940
3,000 100 3,000 115 3,710 3,910 4,010
2,900 105 3,050
2,800 110 3,075 Draw these schedules on a piece of graph paper.
a. Notice that the difference between columns (2) and
NOTE: Amounts are in billions of dollars.
(3), which show the aggregate demand schedule at
2. Suppose a worker receives a wage of $20 per hour. Com-
two different levels of investment, is always $200.
pute the real wage (money wage deflated by the price
Discuss how this constant gap of $200 relates to your
index) corresponding to each of the following possible
answer in the previous chapter.
price levels: 85, 95, 100, 110, 120. What do you notice
b. Find the equilibrium GDP and the equilibrium price
about the relationship between the real wage and the
level both before and after the increase in investment.
price level? Relate your finding to the slope of the aggre-
What is the value of the multiplier? Compare that to
gate supply curve.
the multiplier you found in Test Yourself Question 2
3. Add the following aggregate supply and demand schedules
of Chapter 9.
to the example in Test Yourself Question 2 of Chapter 9
4. Use an aggregate supply-and-demand diagram to show
(page 192) to see how inflation affects the multiplier:
that multiplier effects are smaller when the aggregate
supply curve is steeper. Which case gives rise to more
inflation”the steep aggregate supply curve or the flat
one? What happens to the multiplier if the aggregate
supply curve is vertical?

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Part 2
218 The Macroeconomy: Aggregate Supply and Demand

1. Explain why a decrease in the price of foreign oil shifts 4. Why do you think wages tend to be rigid in the down-
the aggregate supply curve outward to the right. What ward direction?
are the consequences of such a shift? 5. Explain in words why rising prices reduce the multiplier
2. Comment on the following statement: “Inflationary and effect of an autonomous increase in aggregate demand.
recessionary gaps are nothing to worry about because
the economy has a built-in mechanism that cures either
type of gap automatically.”
3. Give two different explanations of how the economy can
suffer from stagflation.

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Licensed to:


Fiscal and Monetary Policy

I n Part 2, we constructed a framework for understanding the macroeconomy. The basic
theory came in three parts. We started with the determinants of the long-run growth rate
of potential GDP in Chapter 7, added some analysis of short-run fluctuations in aggregate
demand in Chapters 8 and 9, and finally considered short-run fluctuations in aggregate sup-
ply in Chapter 10. Part 3 uses that framework to consider a variety of public policy issues”
the sorts of things that make headlines in the newspapers and on television.
At several points in earlier chapters, beginning with our list of Ideas for Beyond the Final
Exam in Chapter 1, we suggested that the government may be able to manage aggregate
demand by using its fiscal and monetary policies. Chapters 11“13 pick up and build on that
suggestion. You will learn how the government tries to promote rapid growth and low
unemployment while simultaneously limiting inflation”and why its efforts do not al-
ways succeed. Then, in Chapters 14“16, we turn explicitly to a number of important con-
troversies related to the government™s stabilization policy. How should the Federal Reserve
do its job? Why is it considered so important to reduce the budget deficit? Is there a trade-
off between inflation and unemployment?
By the end of Part 3, you will be in an excellent position to understand some of the
most important debates over national economic policy”not only today but also in the
years to come.


11 | Managing Aggregate 14 | The Debate over Monetary
Demand: Fiscal Policy and Fiscal Policy
12 | Money and the Banking 15 | Budget Deficits in the Short
System and Long Run
13 | Managing Aggregate 16 | The Trade-Off between
Demand: Monetary Policy Inflation and Unemployment


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