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Economics 3rd ch08


By John B. Taylor
Stanford University

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Chapter 23 (Macro 10)
The Nature and
Causes of Economic
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This chapter develops an initial explanation of
economic fluctuations that is based on changes in
aggregate demand. To illustrate the concept that
changes in aggregate demand lead to short-run
fluctuations in real GDP, a description of how real
GDP is forecast is included. Unconditional and
conditional forecasts are used to introduce the
aggregate expenditures' dependence, via the
consumption function, on income. The spending
balance is carefully developed in both graphical
and tabular form.

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Teaching Objectives
• Introduce an explanation of how and why
economic fluctuations occur.
• Introduce the simple consumption function and
discuss its properties.
• Develop an Aggregate Expenditures (AE) -income
spending balance relationship in which only
consumption depends on income.

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1. Changes in Aggregate Demand First Lead to Changes in Output

1a. Figure 23.1 places the problem of economic
fluctuations in the familiar setting of the previous
chapters. In Figure 23.2 the distinction between
potential GDP and real GDP at a point in the
business cycle is used to emphasize that changes
in aggregate demand explain economic

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Figure 23.1
(Macro 10)
Narrowing the Focus on
Economic Fluctuations

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Figure 23.2
(Macro 10)
The First Step of an Economic Fluctuation

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1. Changes in Aggregate Demand…. (cont.)
1b. The decisions of individual firms depend on
capacity utilization. Firms generally increase or
decrease production, not prices, in the short run or
over the business cycle.
Firms have the ability to vary production over a range
of utilization, for example, between 70 and 90 percent.
High utilization rates in factories and unemployment
below the natural rate occur during booms, while the
opposite occurs in recessions.
Firms respond to changes in demand through changes
in production in all areas, not just in manufacturing.
For example, construction employment is quite
sensitive to changes in demand.

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1. Changes in Aggregate Demand…. (cont.)
• 1c. The explanation of why changes in demand
result in changes in production relies on two factors.
• 1c.1 Firms operate with limited information,
uncertain about whether an increase in demand is
permanent or temporary. Firms are often reluctant to
raise prices because of uncertainty and an implicit
contract with customers. Similar arrangements with
workers lead to nominal wage rigidities.

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1. Changes in Aggregate Demand…. (cont.)
• 1c.2 The response of the typical firm is illustrated
in Figure 23.3. Demand is uncertain: It can be
high, medium, or low. The flexible price
assumption views the firm as adjusting price;
under the sticky price assumption, the firm adjusts
quantity. If demand becomes certain or is viewed
as permanent, a firm is more likely to adjust price
than quantity.

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Figure 23.3 (Macro 10)
Alternative Short-Run Responses of a Typical Firm to a Change in Demand

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1. Changes in Aggregate Demand…. (cont.)
• 1d. Another explanation of economic fluctuations
is the real business cycle theory. Under this
explanation, the source of economic fluctuations is
found in frequent shifts in potential GDP. This
would mean that the determinants of aggregate
supply (labor, capital, and technology) must shift
frequently. However, these determinants tend to
change slowly over time.

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2. Forecasting Real GDP
• 2a. The case for viewing shifts in aggregate
demand as the source of economic fluctuations
can be seen as a forecasting problem. To forecast
real GDP, a forecast of each component is made
and then added together using the GDP identity: Y
= C + I + G + X . As the underlying factors for
each spending component change, the value in the
forecast changes.

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2. Forecasting Real GDP (cont.)
• 2b. Another approach is to make a conditional
forecast, one in which alternative assumptions
about the value of an underlying factor or the
value of one of the spending components is made.
This approach to forecasting real GDP makes clear
that it is changes in the spending components, or
aggregate demand, that are responsible for
economic fluctuations

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3. The Response of Consumption to Income
• 3a. The consumption function describes how
consumption depends on income. This relationship
is illustrated by Table 25.1. From this data we are
able to determine the marginal propensity to
consume (MPC). Figure 23.4 graphs the
consumption-income relation.

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Figure 23.4
(Macro 10)
The Consumption Function

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3. The Response of Consumption to Income
• 3a.1 The measure of income used, whether real
GDP, income, or disposable income, depends in
part on the purpose of the analysis. However,
because taxes and transfer payments tend to be a
constant proportion of income, the measures bear
essentially the same relation to consumption, as in
Figure 23.5.

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Figure 23.5
(Macro 10)
Consumption versus Aggregate

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3. The Response of Consumption to Income (cont.)
• 3b. Other influences, such as the interest rate and
wealth, are less important in the short run and so
are ignored in the initial explanation.

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4. Finding Real GDP When Consumption and Income
Move Together
• 4a. There are now two income-related parts to the
determination of aggregate demand or spending:
the GDP identity and the consumption function.
Taken together they determine GDP for a given
forecast change.
4b. The 45-degree line in Figure 23.6 is used to
determine the income-spending equality.

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Figure 23.6
(Macro 10)
The 45-Degree Line

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4. Finding Real GDP… (cont.)
• 4c. The aggregate expenditure ( AE ) line results
from adding up the spending components
successively, as in Figure 23.7.
• 4c.1 The slope of the AE line depends at this point
on the consumption-income relation and is the

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Figure 23.7 (Macro 10)
The Expenditure Line

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4. Finding Real GDP… (cont.)
• 4c.2 Changes in any autonomous spending
component shift the AE line. For example, an
increase in I will shift the AE line up, as in Figure

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Figure 23.8
(Macro 10)
Shifts in the Expenditure Line

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