To this point in the course we have covered some basic economic concepts and definitions. We have used the production possibilities frontier to help describe the attributes and choices facing an economy. We expanded to allow for international trade and examined the benefits of an open system. Product, labor and capital markets were developed to show how equilibrium is determined in each of these markets. Critical macroeconomic indicators such as the unemployment rate, inflation and economic growth were studied.
The section expands on our knowledge to cover the business cycle. Aggregate demand and supply are introduced to help explain business cycles. When we combine all markets for individual goods and services, we look at the aggregate for the entire economy. Aggregate demand is the sum of total economy-wide demand for goods and services. Aggregate demand is equivalent to GDP, or the sum of all consumption, investment, government spending and net exports in the economy. Aggregate supply is the supply side of the economy. It represents the productive capacity available in the economy to produce goods and services. Aggregate supply is represented by the country's production possibilities frontier. The same factors that expand the economy's PPF, such as an increase in labor, resources or worker productivity, also increases a country's aggregate supply (be sure to review the material on supply side economic growth in Section 3 if necessary).
The last point is worth emphasizing again:
Aggregate demand is represented by GDP and aggregate supply by the PPF. Changes in GDP will shift the aggregate demand curve, and an expansion of the PPF will result in an outward shift of the aggregate supply curve.
In this section we will cover a business cycle. A business cycle covers periods of alternating economic growth and recession or negative economic growth as measured by changes in real GDP. Business cycles are represented in this section by a change in aggregate demand. Aggregate supply will expand at a constant rate from year-to-year, but aggregate demand will not. Sometimes the rate of change of aggregate demand will be much greater than the change in aggregate supply, and in some cases this will lead to higher inflation. Or aggregate demand growth may turn negative, leading to an inward shift in the economy's aggregate demand curve.
The duration and magnitude of a business cycle varies from one to the next. To date, all economic expansions have eventually resulted in higher inflation rates due to aggregate demand growth increasing at a sustained rate faster than aggregate supply. Increased inflation eventually triggers counter-cyclical fiscal and monetary policy (covered in later sections) and a possible recession. In general, greater levels of inflation require stronger counter measures, leading to more severe recessions as measured by the drop in GDP and the rise in the unemployment rate.
One of the major uncertainties in economic measurements today is the typical annual increase in aggregate supply or the economy's supply side growth rate. Currently, annual supply side economic growth is estimated to be about 3.0%, resulting from the combination of labor force increases and improvements in worker productivity. Measuring changes in the labor force is no problem, but there are no certain measures of the gains in worker productivity.
Improvements in worker productivity result from a combination of gains in worker skills and knowledge, increases in the capital stock and advances in technology. Measures of all three are uncertain and may actually be greater that statistical numbers indicate. If increases in worker productivity are actually higher than official estimates, then annual supply side growth (also known as non-inflationary growth) would be proportionately higher as well.
LINK TO MAIN SECTION OF UNIT 7 - BUSINESS CYCLES, AD AND AS