Introduction

FIGURE 11.1New Home ConstructionAt the peak of the housing bubble, many people across the country were able to secure the loans necessary to build new houses. (Credit: modification of "our house! Again!" by Tim Pierce/ Flickr Creative Commons, CC BY 2.0)

In this chapter, you will learn about:

• Macroeconomic Perspectives on Demand and Supply
• Building a Model of Aggregate Supply and Aggregate Demand
• Shifts in Aggregate Supply
• Shifts in Aggregate Demand
• How the AS–AD Model Incorporates Growth, Unemployment, and Inflation
• Keynes’ Law and Say’s Law in the AS–AD Model

BRING IT HOME From Housing Bubble to Housing Bust The United States experienced rising home ownership rates for most of the last two decades. Between 1990 and 2006, the U.S. housing market grew. Homeownership rates grew from 64% to a high of over 69% between 2004 and 2005. For many people, this was a period in which they could either buy first homes or buy a larger and more expensive home. During this time mortgage values tripled. Housing became more accessible to Americans and was considered to be a safe financial investment. Figure 11.2 shows how new single family home sales peaked in 2005 at 1,279,000 units.

FIGURE 11.2New Single Family Houses Sold From the early 1990s up through 2005, the number of new single family houses sold rose steadily. In 2006, the number dropped dramatically and this dramatic decline continued through 2011. Beginning in 2012, the number of new houses sold began to climb back up. (Source: U.S. Census Bureau) The housing bubble began to show signs of bursting in 2005, as delinquency and late payments began to grow and an oversupply of new homes on the market became apparent. Dropping home values contributed to a decrease in the overall wealth of the household sector and caused homeowners to pull back on spending. Several mortgage lenders were forced to file for bankruptcy because homeowners were not making their payments, and by 2008 the problem had spread throughout the financial markets. Lenders clamped down on credit and the housing bubble burst. Financial markets were now in crisis and unable or unwilling to even extend credit to credit-worthy customers. The housing bubble and the crisis in the financial markets were major contributors to the Great Recession that led to unemployment rates over 10% and falling GDP. While the United States is still recovering from the impact of the Great Recession, it has made substantial progress in restoring financial market stability through implementing aggressive fiscal and monetary policy. The economic history of the United States is cyclical in nature with recessions and expansions. Some of these fluctuations are severe, such as the economic downturn that occurred during the Great Depression in the 1930s which lasted several years. Why does the economy grow at different rates in different years? What are the causes of the cyclical behavior of the economy? This chapter will introduce an important model, the aggregate demand–aggregate supply model, to begin our understanding of why economies expand and contract over time. Access multimedia content (http://openstax.org/books/principles-macroeconomics-3e/pages/11-introduction- to-the-aggregate-supply-aggregate-demand-model) New One-Family Houses Sold in the United States. A key part of macroeconomics is the use of models to analyze macro issues and problems. How is the rate of economic growth connected to changes in the unemployment rate? Is there a reason why unemployment and inflation seem to move in opposite directions: lower unemployment and higher inflation from 1997 to 2000, higher unemployment and lower inflation in the early 2000s, lower unemployment and higher inflation in the mid-2000s, and then higher unemployment and lower inflation in 2009? Why did the current account deficit rise so high, but then decline in 2009? To analyze questions like these, we must move beyond discussing macroeconomic issues one at a time, and begin building economic models that will capture the relationships and interconnections between them. The next three chapters take up this task. This chapter introduces the macroeconomic model of aggregate supply and aggregate demand, how the two interact to reach a macroeconomic equilibrium, and how shifts in aggregate demand or aggregate supply will affect that equilibrium. This chapter also relates the model of aggregate supply and aggregate demand to the three goals of economic policy (growth, unemployment, and inflation), and provides a framework for thinking about many of the connections and tradeoffs between these goals. The chapter on The Keynesian Perspective focuses on the macroeconomy in the short run, where aggregate demand plays a crucial role. The chapter on The Neoclassical Perspective explores the macroeconomy in the long run, where aggregate supply plays a crucial role.

11.1 Macroeconomic Perspectives on Demand and Supply

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain Say’s Law and understand why it primarily applies in the long run
• Explain Keynes’ Law and understand why it primarily applies in the short run

Macroeconomists over the last two centuries have often divided into two groups: those who argue that supply is the most important determinant of the size of the macroeconomy while demand just tags along, and those who argue that demand is the most important factor in the size of the macroeconomy while supply just tags along.

Say’s Law and the Macroeconomics of Supply

Those economists who emphasize the role of supply in the macroeconomy often refer to the work of a famous early nineteenth century French economist named Jean-Baptiste Say (1767–1832). Say’s law is: “Supply creates its own demand.” As a matter of historical accuracy, it seems clear that Say never actually wrote down this law and that it oversimplifies his beliefs, but the law lives on as useful shorthand for summarizing a point of view. The intuition behind Say’s law is that each time a good or service is produced and sold, it generates income that is earned for someone: a worker, a manager, an owner, or those who are workers, managers, and owners at firms that supply inputs along the chain of production. We alluded to this earlier in our discussion of the National Income approach to measuring GDP. The forces of supply and demand in individual markets will cause prices to rise and fall. The bottom line remains, however, that every sale represents income to someone, and so, Say’s law argues, a given value of supply must create an equivalent value of demand somewhere else in the economy. Because Jean-Baptiste Say, Adam Smith, and other economists writing around the turn of the nineteenth century who discussed this view were known as “classical” economists, modern economists who generally subscribe to the Say’s law view on the importance of supply for determining the size of the macroeconomy are called neoclassical economists. If supply always creates exactly enough demand at the macroeconomic level, then (as Say himself recognized) it is hard to understand why periods of recession and high unemployment should ever occur. To be sure, even if total supply always creates an equal amount of total demand, the economy could still experience a situation of some firms earning profits while other firms suffer losses. Nevertheless, a recession is not a situation where all business failures are exactly counterbalanced by an offsetting number of successes. A recession is a situation in which the economy as a whole is shrinking in size, business failures outnumber the remaining success stories, and many firms end up suffering losses and laying off workers. Say’s law that supply creates its own demand does seem a good approximation for the long run. Over periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace. However, over shorter time horizons of a few months or even years, recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.

Keynes’ Law and the Macroeconomics of Demand

The alternative to Say’s law, with its emphasis on supply, is Keynes’ law: “Demand creates its own supply.” As a matter of historical accuracy, just as Jean-Baptiste Say never wrote down anything as simpleminded as Say’s law, John Maynard Keynes never wrote down Keynes’ law, but the law is a useful simplification that conveys a