5: Output, business cycles, growth and employment

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Many economic events seem simple and limited in their effects on rates of growth of output, rates of inflation and rates of unemployment. A housing market collapse in the US in 2008 was seen, at first as just a collapse in prices in an overheated market. A sharp drop in crude oil prices in early 2015 was seen as a benefit to households that would reduce their driving costs and allow for higher expenditure in other areas. Fiscal austerity aimed at achieving balance government budgets in Europe seemed an obvious way to reduce high government debt to GDP ratios. But none of these initial judgements worked out. In each case, ignoring the complexity of the macro economy led to large errors in early forecasts and persistent, widespread problems with economic performance.

An aggregate demand and aggregate supply model is the workhorse of macroeconomics. It integrates the effects of economic disturbances, economic decisions, relationships and linkages that determine real GDP and the GDP deflator. Analyzing events like financial shocks, commodity price shocks and government policy shifts using a full macroeconomic model provides a better understanding of their effects on rates of growth of GDP, rates of unemployment and rates of inflation. In this chapter we introduce a basic concepts of an aggregate demand and supply model and use it to illustrate the causes and effects of business cycle fluctuations in real output and prices. The objective is to provide the framework for the economic theory on which aggregate demand and supply are based.