Macroeconomics

1.

When real GDP declines during a recession,

what typically happens to consumption, invest-

ment, and the unemployment rate?

2.

Give an example of a price that is sticky in the

short run but flexible in the long run.

3.

Why does the aggregate demand curve slope

downward?

Q U E S T I O N S   F O R   R E V I E W

4.

Explain the impact of an increase in the

money supply in the short run and in the 

long run.

5.

Why is it easier for the Fed to deal with demand

shocks than with supply shocks?

P R O B L E M S   A N D   A P P L I C A T I O N S

2.

Suppose the Fed reduces the money supply by 5

percent.

a. What happens to the aggregate demand

curve?

b. What happens to the level of output and the

price level in the short run and in the long

run?

c. According to Okun’s law, what happens to

unemployment in the short run and in the

long run?

d. What happens to the real interest rate in 

the short run and in the long run? (Hint:

Use the model of the real interest rate in

Chapter 3 to see what happens when

output changes.)

3.

Let’s examine how the goals of the Fed

influence its response to shocks. Suppose Fed A

cares only about keeping the price level stable

and Fed B cares only about keeping output and

employment at their natural levels. Explain how

each Fed would respond to the following.

1.

An economy begins in long-run equilibrium,

and then a change in government regulations

allows banks to start paying interest on 

checking accounts. Recall that the money

stock is the sum of currency and demand

deposits, including checking accounts, so this

regulatory change makes holding money 

more attractive.

a. How does this change affect the demand for

money?

b. What happens to the velocity of money?

c. If the Fed keeps the money supply constant,

what will happen to output and prices in the

short run and in the long run?

d. If the goal of the Fed is to stabilize the

price level, should the Fed keep the 

money supply constant in response to this

regulatory change? If not, what should it

do? Why?

e. If the goal of the Fed is to stabilize output,

how would your answer to part (d) change?

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Business Cycle Theory: The Economy in the Short Run

a. An exogenous decrease in the velocity of

money.

b. An exogenous increase in the price of oil.

4.

The official arbiter of when recessions begin

and end is the National Bureau of Economic

Research, a nonprofit economics research

group. Go to the NBER’s Web site

(www.nber.org) and find the latest turning

point in the business cycle. When did it occur?

Was this a switch from expansion to

contraction or the other way around? List all

the recessions (contractions) that have occurred

during your lifetime and the dates when they

began and ended.

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Aggregate Demand I: 

Building the 

IS–LM Model

I shall argue that the postulates of the classical theory are applicable to a special

case only and not to the general case. . . . Moreover, the characteristics of the

special case assumed by the classical theory happen not to be those of the

economic society in which we actually live, with the result that its teaching is

misleading and disastrous if we attempt to apply it to the facts of experience.

—John Maynard Keynes, The General Theory

10

C H A P T E R

O

f all the economic fluctuations in world history, the one that stands out

as particularly large, painful, and intellectually significant is the Great

Depression of the 1930s. During this time, the United States and many

other countries experienced massive unemployment and greatly reduced

incomes. In the worst year, 1933, one-fourth of the U.S. labor force was unem-

ployed, and real GDP was 30 percent below its 1929 level.

This devastating episode caused many economists to question the validity of

classical economic theory—the theory we examined in Chapters 3 through 6.

Classical theory seemed incapable of explaining the Depression. According to

that theory, national income depends on factor supplies and the available tech-

nology, neither of which changed substantially from 1929 to 1933. After the

onset of the Depression, many economists believed that a new model was need-

ed to explain such a large and sudden economic downturn and to suggest gov-

ernment policies that might reduce the economic hardship so many people faced.

In 1936 the British economist John Maynard Keynes revolutionized eco-

nomics with his book The General Theory of Employment, Interest, and Money.

Keynes proposed a new way to analyze the economy, which he presented as an

alternative to classical theory. His vision of how the economy works quickly

became a center of controversy. Yet, as economists debated The General Theory, a

new understanding of economic fluctuations gradually developed.

Keynes proposed that low aggregate demand is responsible for the low

income and high unemployment that characterize economic downturns. He

criticized classical theory for assuming that aggregate supply alone—capital,

labor, and technology—determines national income. Economists today reconcile

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Business Cycle Theory: The Economy in the Short Run

these two views with the model of aggregate demand and aggregate supply

introduced in Chapter 9. In the long run, prices are flexible, and aggregate sup-

ply determines income. But in the short run, prices are sticky, so changes in

aggregate demand influence income. In 2008 and 2009, as the United States and

Europe descended into a recession, the Keynesian theory of the business cycle

was often in the news. Policymakers around the world debated how best to

increase aggregate demand and put their economies on the road to recovery.

In this chapter and the next, we continue our study of economic fluctuations

by looking more closely at aggregate demand. Our goal is to identify the vari-

ables that shift the aggregate demand curve, causing fluctuations in national

income. We also examine more fully the tools policymakers can use to influence

aggregate demand. In Chapter 9 we derived the aggregate demand curve from

the quantity theory of money, and we showed that monetary policy can shift the

aggregate demand curve. In this chapter we see that the government can influ-

ence aggregate demand with both monetary and fiscal policy.

The model of aggregate demand developed in this chapter, called the IS–LM

model,

is the leading interpretation of Keynes’s theory. The goal of the model

is to show what determines national income for a given price level. There are

two ways to interpret this exercise. We can view the IS –LM model as showing

what causes income to change in the short run when the price level is fixed

because all prices are sticky. Or we can view the model as showing what causes

the aggregate demand curve to shift. These two interpretations of the model are

equivalent: as Figure 10-1 shows, in the short run when the price level is fixed,

shifts in the aggregate demand curve lead to changes in the equilibrium level of

national income.