Aggregate Demand and Aggregate Supply
Economic activity fluctuates from year to year. In most years, the production of goods and services rises. Because of increases in the labor force, increases in the capital stock, and advances in technological knowledge, the economy can produce more and more over time. This growth allows everyone to enjoy a higher standard of living. On average over the past 50 years, the production of the U.S. economy as measured by real GDP has grown by about 3 percent per year.
In some years, however, this normal growth does not occur. Finns find themselves unable to sell all of the goods and services they have to offer, so they cut back on production. Workers are laid off, unemployment rises, and factories are left idle. With the economy producing fewer goods and services. real GDP arid other measures of income fall. Such a period of falling incomes and rising unemployment is called a recession if it is relatively mild and a depression if it is more severe.
What causes short-run fluctuations in economic activity? What, if anything, can public policy do to prevent periods of falling incomes and rising unemployment? When recessions and depressions occur, how can policy makers reduce their length and severity? These are the questions that we take up now.
The variables that we study are largely those we have already seen in previous chapters. They include GDp, unemployment, interest rates, and the price level. Also familiar are the policy instruments of government spending, taxes, and the money supply. What differs from our earlier analysis is the time horizon. So far, our focus has been on the behavior of the economy in the long run. Our focus now is on the economy’s short-run fluctuations around its long-run trend.
Although there remains some debate among economists about how to analyze short-run fluctuations, most economists use the model of aggregate demand and aggregate supply. Learning how to use this model for analyzing the short-run effects of various events and policies is the primary task ahead. This chapter introduces the model’s two pieces: the aggregate-demand curve and the aggregate-supply curve.But before turning to the model, let’s look at some of the key facts that describe the up and downs in the economy.
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