Tying It Together

Our analysis in this chapter is all about one big idea: Aggregate expenditure is a major factor shaping macroeconomic outcomes. It matters because if people don’t want to buy much stuff, then businesses won’t produce much stuff. As a result, the economy can get stuck in the sort of depressed low-spending, low-production equilibrium that led to the Great Depression.

Fortunately, there’s also a happier outcome in which people buy a lot of stuff, and so businesses produce a lot of stuff, leading to a high-output equilibrium in which there are jobs for everyone. There are also many other possible outcomes between these extremes of depression and full employment.

Aggregate expenditure focuses on the demand side of the economy.

The more stuff people demand, the more stuff the economy will produce … and deliver.

The key lesson of our analysis is that the demand side of the economy—that is, aggregate expenditure—really matters. Moreover, the multiplier effect reinforces this point. When the effects of any change in consumption, planned investment, government purchases, or net exports have multiplied effects on GDP, the economy is susceptible to being knocked off course. As a result, even modest changes in aggregate expenditure can lead to economic booms and busts. The same insights suggest that government policy really matters because changes in government purchases can help push the economy back on course.

These ideas are all important. And indeed, each of them has been built into the foundations of the modern frameworks economists use to understand the economy. Equally, it’s worth emphasizing that our analysis of aggregate expenditure doesn’t yield a complete account of the macroeconomy. Income is not the only driver of aggregate expenditure—interest rates also play a major role. And that, in turn, suggests a more complete analysis needs to also account for the role of the financial sector in shaping interest rates and therefore spending decisions.

The supply side is important when the economy is close to capacity.

Our focus on the role that buyers and the demand side of the economy play means that we’ve yet to say much about the sellers and the supply side of the economy. Implicitly, we’ve been assuming that when the demand for stuff rises, businesses are willing to supply more of that stuff at the current price. This is why extra spending translates into extra production, rather than shortages or higher prices.

But when the economy is close to full capacity, businesses cannot easily increase production, or they wouldn’t want to do so without raising their prices. Perhaps their production lines are already overloaded, or maybe key inputs like skilled workers are hard to come by. When these supply-side constraints are binding—which can occur when output exceeds potential output—it’s no longer appropriate to assume that extra spending will translate into extra production. Rather, it may spark higher prices and inflation. This suggests that it’s important to integrate this chapter’s demand-side emphasis on aggregate expenditure with an understanding of how supply constraints can lead inflation to emerge.

Economists emphasize demand in the short run and supply in the long run.

Finally, this distinction between demand- and supply-side analysis can help you integrate your understanding of the determinants of the state of the economy in the short and long run. In Chapter 22, we analyzed the long-run determinants of the level of potential GDP, emphasizing that it reflects the number of workers, their skill levels, the number of machines they have to work with, and the technology for combining them. This emphasis on the supply side—the quantity and quality of inputs to production—is appropriate for analyzing the economy’s potential output, which is the level that occurs when all resources are fully employed.

But in the short run, the economy may fail to meet this potential. Indeed, a shortfall in aggregate expenditure will lead the economy to produce below its full-employment potential. This explains why economists tend to emphasize demand factors in the short run and supply factors in the long run. Fluctuations in demand are the source of many of the short-run disruptions that make up the business cycle, while supply factors determine the economy’s long-run potential. Of course, in the real world, distinctions are never quite as sharp as in textbooks. Sometimes changes on the supply side can also cause short-run disruptions. And sometimes short-run demand disruptions—like the Great Depression, or the global financial crisis that began in 2008—can last for so long and do so much damage that they have long-run consequences.