Introduction to the Aggregate Demand–Aggregate Supply Model

This photograph shows a new house under construction.
 New Home Construction. At 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 work by Tim Pierce/Flickr Creative Commons)

From Housing Bubble to Housing Bust

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 1 shows how new single family home sales peaked in 2005 at 107,000 units.

The figure shows that single family house sales were highest in 2005 (to over 12,000 thousand) before plummeting drastically. In 2014, housing sales were over 400 thousand.
Figure 1. New 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. By 2014, the number of new houses sold had begun to climb back up, but the levels are still lower than those of 1990. (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. 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.

Introduction to the Aggregate Supply–Aggregate Demand Model

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 and Aggregate Demand
  • How the AD–AS Model Incorporates Growth, Unemployment, and Inflation
  • The Labor Market and Full Employment Equilibrium
  • The Loanable Funds Market

A key part of macroeconomics is the use of models to analyze issues and problems. How is the rate of economic growth connected to changes in the unemployment rate? 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 two chapters take up this task. This chapter introduces the standard orthodox 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 looks at the macroeconomy from a different, heterodox perspective, where aggregate demand plays a crucial role.

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Principles of Economics: Scarcity and Social Provisioning (2nd Ed.) Copyright © 2020 by Rice University; Dean, Elardo, Green, Wilson, Berger is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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