CHAPTER 23

BUSINESS FLUCTUATIONS AND THE THEORY OF

AGGREGATE DEMAND

I. CHAPTER OVERVIEW

Chapter 23 explores business cycles and one of the main economic variables that they influence—aggregate
demand. Throughout its economic history the United States and other nations have been subject to
fluctuations—upturns and downturns—in economic growth. One of the critical issues facing the economics
profession is whether economic policy can be designed to adequately control the adverse effects of the business
cycle. Or should policy makers be satisfied with being able to simply dampen the amplitude of cyclical
swings?
Aggregate Demand, which can be influenced greatly by business cycle activity, can also have a powerful
impact on output, employment, and prices—especially in the short run. This chapter reviews the components
of aggregate demand and discusses the overall shape of the aggregate demand curve. In addition, there is a
discussion of the factors that can cause the aggregate demand curve to shift. As always, be careful to
distinguish between movements along the curve and shifts in the curve.

II. LEARNING OBJECTIVES

After you have read Chapter 23 in your text and completed the exercises in this Study Guide chapter, you
should be able to:
1. Outline the business-cycle experience of the United States and the causes behind it.
2. Understand the successive phases of the business cycle.
3. Describe the business-cycle theories that lie behind aggregate supply and aggregate demand.
4. Appreciate the use of econometric modeling in forecasting business-cycle behavior.
5. Explain why the economy’s aggregate demand curve is downward-sloping.
6. Understand the differences between microeconomic and macroeconomic demand.
7. Provide reasons for shifts in the aggregate demand curve.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.
A B
__ Business cycle 1. Rapid output growth stimulates investment which in turn, stimulates further
economic growth.
__ Recession 2. Variables outside the AS-AD framework.
__ Depression 3. Nominal money supply divided by the price level.
__ Business-cycle 4. Swings in total national output usually lasting between 2 and 10 years and
phases marked by widespread expansion or contraction in the economy.
__ Expansion 5. Rooted in the Keynesian tradition, but is more pragmatic in its explanation of
movements in aggregate supply and demand.
__ Multiplier- 6. Fiscal and monetary decisions made by the government to shift aggregate
accelerator theory demand.
__ Demand-induced 7. Phase of the business cycle characterized by economic growth.
cycles
__ Aggregate demand 8. A decline in real GDP for at least two consecutive quarters.
__ Real money 9 Concentrate primarily on monetary forces in analyzing movements in AD and
supply AS in the economy.
__ Policy variables 10. Business cycles caused by shocks to AD.
__ Exogenous variables 11. Prolonged, cumulative slump in real GDP.
__ Monetarists 12. Total quantity of output that is willingly bought at a given level of prices, other
things held constant.
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__ Keynesian 13. Peak, trough, expansion, and contraction.

macroeconomics

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. Business Fluctuations
1. Business cycles are all different—and all the same. Each one has its own cause, its own length of time, its
own degree of severity, and its own trajectory. Despite all these differences, though, they all seem to follow
the same general pattern: decline into recession (contraction); bottom out (trough); climb into recovery and
continue into boom (expansion); reach an apex (peak); and start all over. The differences are confounding, but
the similarities suggest the possibility that some general pattern of policy might reduce the severity of the
cycle.
2. There are many possible explanations for the sources of business cycles, but it may be helpful to classify
them into two categories: external and internal. External sources include changes that occur outside the
economic system. There are many possibilities here: natural disasters, wars, new discoveries. Internal
mechanisms include the multiplier-accelerator theory and demand-induced cycles. Recall from Chapter 22 that
the accelerator theory describes a relationship between the rate of (real) GDP growth and investment spending.
The multiplier-accelerator theory adds to the accelerator the relationship between investment and GDP. In a
nutshell, GDP growth generates investment (accelerator), which in turn, contributes to further GDP growth
(multiplier). As Samuelson and Nordhaus indicate, the multiplier will be explained in greater detail in the next
chapter. Hang in there! The main point behind demand-induced business cycles is to realize that economic
growth or decline can be caused by rightward and leftward shifts in the aggregate demand curve.
3. Economists do not fully understand the roots and causes of business cycles. Appropriately, many different
theories have been developed. Some work better than others; some work better under different circumstances.
Samuelson and Nordhaus review six different theories. Problem number 6 in section VII, below, reviews these
theories.

B. Foundations of Aggregate Demand

1. Aggregate demand (AD) includes all the desired spending by the different sectors in the economy:
consumption (C), private domestic investment (I), government purchases of goods and services (G), and net
exports (X).
2. The primary reason for the downward slope of the AD curve is the money-supply effect. As prices in the
economy increase, other things held constant, the real money supply decreases. The real money supply is
defined as the nominal money supply divided by the price level. The supply of real money becomes relatively
scarce or tight, and therefore, the price of obtaining money, or the rate of interest, goes up. All types of
spending that rely on borrowed funds—consumption items, investment, even net exports—decline. Hence, we
observe that higher price levels lead to a decrease in the aggregate demand for goods and services, or a
movement up and along the aggregate demand curve.
3. There are some important differences between microeconomic and macroeconomic demand curves. In
micro, the focus is on a particular market for a particular good. When we construct the demand curve, we allow
the price of the good to vary, while all other prices and consumer incomes are held constant. In macro, we
attempt to get a picture of the entire economy, not just one market. The general price level varies along the
vertical axis, and total output and real incomes change as we move along the aggregate demand curve. The
primary reason for the negative slope of the aggregate demand curve is the money-supply effect; the main reason
for the downward slope of the single market demand curve is the substitution effect.
4. There are numerous reasons why the aggregate demand curve might shift. The two main categories of shift
variables are policy variables and exogenous variables. Policy variables include changes in either monetary or
fiscal policy.
Exogenous variables are variables determined outside the framework of the model, or beyond the control of
policymakers. Examples of exogenous variables include changes in foreign countries (oil-production decisions,
growth rates abroad), advances in technology, and movements in the stock market. We are not implying here
that the economy and government policies have no bearing on these “outside” variables, only that it is possible
for changes to originate in these areas and that such changes can have an effect on the level of spending (i.e.,
aggregate demand) in the economy.
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Whether change is due to policy variables or exogenous variables, the aggregate demand curve will shift
(right or left) in response to these “shocks.” There is not universal agreement among economists about the
relative importance of these factors. Those economists who stress the importance of the role of the money
supply are called monetarists. Other economists focus more on the influence of exogenous variables and fiscal
policy. The mainstream of economic thinking today includes aspects of both the Keynesian and monetarist
points of view.

V. HELPFUL HINTS

1. Several different theories of business cycles are presented in this chapter. You should realize that there are
many unsolved economic problems, and economics cannot always provide exact and clearly defined answers or
solutions. What economic analysis does provide in these circumstances, is a structure and framework for
investigating and learning about the economic problem at hand. Once informed, you can argue for, or against,
particular theories.
2. Do not forget: The G in aggregate demand measures the government’s purchases of goods and services.
This is not the same thing as the government’s budget expenditures which also include transfer payments and
interest on the debt.
3. The phrase “other things held constant” is important. In order to clarify specific economic relationships it
is desirable to change just one variable at a time. When two or more variables change at once (which in reality
happens all the time), it becomes very difficult to isolate causes from effects. For example, when we construct
the aggregate demand curve, we vary the price level and hold all other things—including the money
supply—constant. And when we analyze the effect of policy or exogenous variables on AD, we change just one
variable at a time and hold everything else constant.
4. Models that explain simple economic relationships may teach us a great deal, but may at times, seem
removed from the helter-skelter activity of the real world. The price we pay for realism in economic models is
complication. Recall Samuelson and Nordhaus’ discussion of business-cycle models that contain systems of
equations and thousands of variables.
5. Remember, we use models to understand and explain how the economy functions. You should always be
aware of the simplifying assumptions being made.

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.

A. Business Fluctuations
1. Business cycles seem to be caused:
a. exclusively by external factors.
b. exclusively by internal factors.
c. by factors of any type that mostly influence aggregate demand.
d. by factors that only influence aggregate supply.
e. all the above.
2. Which of the following would you not expect to see during a period of recession?
a. Lower business investment in durable equipment.
b. Lower stock prices and lower demand for labor.
c. Lower tax receipts from corporations and individuals.
d. Lower corporate profits.
e. Lower unemployment compensation payments.
3. Which of the following time frames was marked by the most severe period of recession?
a. 1969-1970.
b. 1982-1983.
c. 1974-1975.
d. 1960-1961.
e. 1953-1954.
4. Which of the following time frames was marked by the most energetic period of economic boom?
a. 1983-1984.
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b. 1973-1974.
c. 1938-1939.
d. 1955-1956.
e. 1967-1968.
5. The implication of the theory of political business cycles is that:
a. anti-inflationary medicine is generally administered early in an administration.
b. the year after an election is frequently a year of austerity.
c. the year of an election is frequently a year of growth and prosperity.
d. the timing of elections can dictate the timing of the business cycle.
e. all the above are correct.
6. If we look to any particular kind of spending as a key factor in accounting for the business cycle, we find it
in:
a. net investment, specifically spending on inventories.
b. net investment, specifically spending on durable goods.
c. consumer spending.
d. variations in spending by state and local governments.
e. none of the above, the point stressed being that no single type of spending plays any key role.
7. The role of consumer spending in the business cycle, according to U.S. experience, is best understood by
noting that:
a. changes in consumer durable purchases may occasionally set off an upswing or downturn, and changes
in consumer spending will intensify the effect of any disturbance originating outside the consumer sphere,
via the multiplier.
b. consumer spending and investment seem to have approximately equal parts to play in the cycle,
although the two are so intermixed that it is difficult to separate one from the other and to analyze the role
of either.
c. changes in consumer spending on nondurables most commonly initiate the downturn in a major
business cycle, whereas increases in consumer durable purchases are most likely to start the upturn as
replacement of worn-out durable items becomes necessary.
d. changes in consumer spending are most often the initial disturbing factor, and the impact then spreads
to investment, thus intensifying the original disturbance.
e. consumer spending has no part to play in the cycle, which (except for wartime disturbances) is almost
entirely due to changes in investment.
8. Statistically, the widest swings between peak and bottom of the business cycle are to be found in:
a. the supply of consumer services.
b. the production of inventories.
c. the production of durables and capital goods.
d. wholesale rather than retail goods.
e. export and import goods.
9. The multiplier-accelerator theory focuses on the relationship between:
a. taxes, consumer spending, and GDP.
b. monetary policy, interest rates, and investment.
c. GDP and investment spending.
d. GDP and any component of aggregate demand.
e. exogenous and policy variables.
10. Which of the following would be considered as a supply shock to the economy?
a. a sharp increase in foreign oil prices.
b. weather-related crop failures.
c. a reorganization of the domestic health care industry.
d. all of the above.
e. none of the above.
11. The index of leading indicators is best described as:
a. a combination of several statistics that generally give an accurate indication of the direction of
economic growth ahead.
b. a combination of data on boxcar loadings and steel production.
c. a type of econometric forecasting model.
d. all of the above.
e. choices a and c only.
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12. Which of the following are typical characteristics of a recession?

a. Consumer purchases decline sharply.
b. Business inventories of durable goods increase unexpectedly.
c. The demand for labor falls.
d. All of the above.
e. A and B only.
13. The multiplies-accelerator theory:
a. suggests that business cycles may be self-generating.
b. is an external theory of business cycles.
c. is related primarily to fluctuations in the automobile industry.
d. follows from shocks to aggregate demand curve.
e. is one of the political theories of the business cycle.

B. Foundations of Aggregate Demand

14. Which of the terms below is not a component of aggregate demand?
a. consumption expenditure.
b. government expenditure.
c. net exports.
d. investment expenditure.
e. all of the above terms are part of AD.
15. Which of the following expressions best describes the money-supply effect?
a. As the money supply increases, so does inflation.
b. As the economy grows, the central bank increases the supply of money.
c. Aggregate demand and the money supply are positively related.
d. As prices increase, the decline in the real money supply will affect aggregate demand.
e. Money makes the world go round.
16. Which of the following is a reason why the aggregate demand curve should be drawn downward-sloping?
a. Higher prices reduce potential GDP by reducing labor force participation.
b. Higher prices cause interest rates to fall, thereby depressing investment.
c. Higher prices cause interest rates to rise, thereby depressing investment.
d. Higher prices inspire increased labor force participation and therefore increase consumption
expenditures.
e. None of the above makes any sense in explaining the negative slope of an aggregate demand curve.
17. One of the similarities between microeconomic and macroeconomic demand is that both:
a. hold income constant.
b. rely on the substitution effect to explain demand.
c. rely on the money-supply effect to explain demand.
d. vary inversely with price.
e. hold the prices of all other goods constant.
18. Which of the following should be expected to shift the aggregate demand curve to the left?
a. an increase in government spending.
b. a reduction in net exports.
c. a reduction in labor force participation.
d. the adoption of an improved production technology.
e. a reduction in the value of the dollar.
19. Which of the following should be expected to shift the aggregate demand curve to the right?
a. an increase in government spending.
b. a reduction in net exports.
c. a reduction in labor force participation.
d. an increase in taxes.
e. a decrease in the money supply.
20. According to the money-supply effect, which produces a downward-sloping aggregate demand curve, lower
prices in the context of a fixed real money supply should:
a. make credit more difficult to obtain.
b. increase interest rates and thereby reduce investment.
c. depress stock market values and thereby reduce consumption.
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d. all the above.

e. none of the above.
21. According to monetarists, the primary determinant of the total dollar of spending in the economy is:
a. interest rates.
b. the money supply.
c. taxes.
d. transfer payments.
e. the government debt.
22. Which of the following should be expected to shift the aggregate demand curve to the left?
a. An increase in government spending.
b. A reduction in net exports.
c. A reduction in labor force participation.
d. The adoption of an improved production technology.
e. A reduction in the value of the dollar.

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in the chapter.

A. Business Fluctuations
1. Record in the spaces provided the business-cycle phase during which you would expect to observe the
indicated events; denote contraction by (C) and expansion by (E):
___ a. Business investment increasing
___ b. Profits falling
___ c. Tax receipts climbing
___ d. Demand for labor rising
___ e. Stock prices falling
___ f. Inflation accelerating
___ g. Unemployment-insurance payments increasing
___ h. Interest rates falling
2. a. Recessions (or depressions) most commonly arise from a (drop / rise) in (consumption / investment
/ government spending).
b. This initial (drop / rise) has magnified consequences because of the multiplier effect; i.e., total
spending drops (even more / somewhat less) than the initial drop in (C / I / G) .
c. Among the following economic variables, the greatest cyclical fluctuation is typically found in
(wholesale prices / production of capital goods / production of basic materials such as petroleum /
expenditures on consumer goods).
3. Play a “what if” game to test your understanding of a few definitions.
a. If you were to believe that changes in the population were never caused by changes in economic
circumstance, then a theory that held that changes in total population caused the business cycle would be
(an external / an internal / a political) theory of the cycle.
b. Were you to go to the other extreme, holding that changes in population were exclusively the result of
changes in economic circumstance (e.g., you might think that depression increases the number of poor
people who cannot have children because they cannot support them), then a theory that proposed a causal
relationship between changes in total population and the business cycle would be (an external / an
internal / a political) theory of the cycle.
c. The notion that incumbent political parties use the policy tools at their disposal to time recovery and
boom for election years and recession and trough for off-election years is (an external / an internal / a
political) business-cycle theory.
4. Consider Figure 23-1. Suppose that an economic downturn is caused by a shift in aggregate demand.
a. Illustrate this on the diagram.
b. Give an example of a particular AD change that could cause this shift.
c. What sort of policy change would you recommend to move the economy out of this slump?
 387

Figure 23-1

5. Now look at Figure 23-2, which is identical to Figure 23-1. Suppose, this time, that an economic
downturn is caused by a shift in aggregate supply.

Figure 23-2

a. Illustrate this on the diagram in Figure 23-2.

b. Give an example of a particular AS change that could cause this shift.
c. What sort of policy change would you recommend to move the economy out of this slump?
d. Which type of economic downturn is worse, one caused by a shift in AD or one caused by a shift in
AS? Briefly justify your answer.
6. Samuelson and Nordhaus describe six different theories of the business cycle in this chapter. For each of
the theories listed below, match it with the number of its description and the letter of the economist(s) who
support it.

__ __ Monetary 1. Business cycles a. W .Nordhaus

theories caused by shifts in and E. Tufte
aggregate supply
__ __ Multiplier- 2. Innovations and changes b. R. Lucas, R. Barro,
accelerator in productivity in one and T. Sargent
model sector can spread to the
rest of the economy.
__ __ Political 3. Misperceptions about c. J. Schumpeeter,
Theories prices and wages lead E. Prescott,
people tosupply little or P. Long, and
too much labor. This C. Plosser
leads to cycles in output.
 388

__ __ Equilibrium- 4. Output growth stimulates d. M. Friedman

business- investment which generates
cycle theories further growth in output.
__ __ Real 5. Cyclical swings caused by e. R. J. Gordon
business changes in the money supply
cycle and the availability
of credit.
__ __ Supply 6. Fluctuations in the f. P. Samuelson
shocks business cycle attributed
to politically-motivated
changes in fiscal and
monetary policy.

B. Foundations of Aggregate Demand

7. a. Aggregate demand is generally downward-sloping when drawn against a price index due, in large part,
to the (substitution effect / money-supply effect / income effect).
b. Higher prices, given a constant real money supply, can be expected to cause interest rates to (rise / fall
/ stay the same), cause stock market prices to (rise / fall / stay the same), (reduce / increase / have no
effect on) the international value of the dollar, and generally make credit (more difficult / easier) to obtain.
c. In light of these effects, use the spaces provided below to explain how the values of the components of
aggregate demand would change if prices were to fall:
1. Consumption:
2. Investment:
3. Government:
4. Net exports:

TABLE 23-1
(1) (2) (3) (4) (5)
Change AD Component Direction Panel Explanation
a. Increased population Consumption + (b) More people mean
enlarged consumption.
b. Reduced money supply ___ ___ ___ _________________
c. Increased personal income taxes ___ ___ ___ _________________
d. Severe recession abroad ___ ___ ___ _________________
e. Anticipated recession at home ___ ___ ___ _________________
f. Anticipated recession abroad ___ ___ ___ _________________
g. Rapid escalation in house prices ___ ___ ___ _________________
h. An October stock market crash ___ ___ ___ _________________
i. Diminished defense spending ___ ___ ___ _________________
j. Higher prices abroad ___ ___ ___ _________________

8. The first column of Table 23-1 records a series of changes in economic circumstance.
a. Indicate in column (2) the component of aggregate demand (C, I, G, or X) that would be most directly
affected by each change; then note the direction of the effect in column (3) (use + to designate an increase
and - to signify a reduction).
b. In column (4) identify whether panel (a), (b), or (c) of Figure 23-3 best illustrates the result graphically
as a shift from AD to AD’.
c. Use column (5) to explain your reasoning. The first row has been completed for you.
d. Look back at column (1) in the table. Circle the letter of those changes in which the effect was
generated by a change in a policy variable; place a star next to the changes in which the effect was generated
by a change in an exogenous variable.
9. There is a critical difference between the microeconomic construction of a demand curve for a specific
product and the macroeconomic construction of an aggregate demand curve. Indicate whether each of the
statements recorded below accurately describes a microeconomic demand curve for a specific product or a
macroeconomic aggregate demand curve; use the terms “micro” and “macro.”
a. The curve is drawn under the assumption that income is held constant.
b. Total incomes and output vary along this curve.
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c. The curve is downward-sloping because consumers can substitute into and out of the consumption of
various goods.
d. The curve is downward-sloping because the nominal money supply is fixed.
e. The curve is drawn against a price index even though relative prices may change within that index.
f. The curve is derived from individuals’ responses to changes in one price, other prices assumed
constant.

Figure 23-3

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

1. Figure 23-4 illustrates how different sectors of the economy were affected by three recessions in the United
States. Use the bar chart to discuss how the recessions affected different sectors of the economy in different
ways.
2. Figure 23-4 from the text is reproduced here on page 390 as Figure 23-5. Discuss several reasons why the
aggregate demand curve in the economy might shift to the left. For what reasons might policy makers want
aggregate demand to shift in this direction?

Figure 23-4
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Figure 23-5

IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Review of Key Concepts

4 Business cycle
8 Recession
11 Depression
13 Business-cycle phases
7 Expansion
1 Multiplier-accelerator theory
10 Demand-induced cycles
12 Aggregate demand
3 Real money supply
6 Policy variables
2 Exogenous variables
9 Monetarists
5 Keynesian macroeconomics

VI. Multiple Choice Questions

1. C 2. E 3. B 4. E 5. E 6. B
7. A 8. C 9. C 10. D 11. A 12. D
13. A 14. E 15. D 16. C 17. D 18. B
19. A 20. E 21. B 22. B

VII. Problem Solving

l. a. E
b. C
c. E
d. E
e. C
f. E
g. C
h. C
2. a. drop, investment
b. drop, even more, I
c. production of capital goods
3. a. an external
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b. an internal
c. a political
4. a. See Figure 23-1.

Figure 23-1

b. This shift could be caused by a reduction in consumption, investment, government spending, or net
exports. In reality, investment spending is the most volatile of these four possibilities.
c. Stimulative fiscal policy, either a tax cut or an increase in government spending, could be used to get
the economy out of the slump. Alternatively, the Fed could pursue an easy monetary policy.
5. a. See Figure 23-2.

Figure 23-2

b. The AS could shift to the left due to an increase in input prices or due to some external shock that
raises the price of a commodity that is vital to production in the economy. (The OPEC oil embargo comes
to mind.)
c. Usual fiscal or monetary policy measures would have to focus on either the inflation problem or the
unemployment problem. It is not possible to alleviate both problems at once. Ideally, the government
could use a supply-side policy to shift the aggregate supply curve back to the right.
d. The AS shift is worse since it creates both inflation and unemployment problems.
6. 5 d Monetary theories
4 f Multiplier-accelerator model
6 a Political theories
3 b Equilibrium-business-cycle theories
2 c Real business cycle
1 e Supply shocks
7. a. money-supply effect
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b. rise, fall, reduce, more difficult

c. 1. Spending would increase due to the increase in the real money supply. Consumers would be able
to purchase more goods and services with the same income.
2. Lower interest rates would increase investment spending.
3. Lower prices would allow the government to purchase more real goods and services with its
budget.
4. Lower prices would attract more foreign customers. Net exports would increase.
8. a., b., c.

TABLE 23-1
(2) (3) (4) (5)
b. Investment - (a) Higher interest rates lower investment.
c. Consumption - (a) Higher taxes reduce disposable income.
d. Net exports - (a) Recession abroad means less foreign demand for goods and services.
e. Investment - (a) The fear of lower profits
or or income reduces
Consumption spending.
f. Investment - (a) The fear of lower profits in export markets lowers investment.
g. Consumption + (b) Increase in consumer wealth increases spending.
h. Consumption - (a) Reduced consumer wealth
or and/or increased cost of
Investment raising funds lowers aggregate demand.
i. Government - (a) Reduced government spending lowers aggregate demand.
j. Net exports + (b) Imports are reduced, domestic spending increases.

d. Place a circle around b, c, and i.

Place a star next to the remaining changes.
9. a. micro
b. macro
c. micro
d. macro
e. macro
f. micro

VIII. Discussion Questions

1. The recession of 1973-1975 was the most severe for home construction, inventories, and investment. The
decline in inventories suggests that firms depleted their inventories rather than produce more products.
The 1981-1982 recession was also felt in the same three sectors, but to a lesser extent. Net foreign trade
declined more during this recession than during either of the other two recessions, and consumer spending
actually increased. The increased consumer spending may have contributed to the trade deficit. This was not a
bad recession for the consumer.
The 1990-1991 recession seems to have been less severe than the other two recessions, but it was the worst
one for consumers. It was also more evenly spread throughout the economy.
2. Aggregate demand will shift to the left whenever any of the components AD decrease. A decrease in
investment spending, an increase in taxes which causes a reduction in consumption spending, or a decrease in
net exports would all cause aggregate demand to shift to the left.
If the economy is growing too fast, policy makers, fearing inflation, may want to slow it down. In
general, policy makers may want AD to shift to the left when inflation is viewed as a problem in the economy.