chapter 22 aggregate demand and supply analysis. copyright © 2007 pearson addison-wesley. all...

Chapter 22

Aggregate Demand and Supply Analysis

Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-2

Aggregate Demand

• The relationship between the quantity of aggregate output demanded and the price level when all other variables are held constant

• Based on the quantity theory of money Determined solely by the quantity of money

• Based on the components parts Consumption, investment, government spending

and net exports


M = quantity of money

P = price level

Y = aggregate real output (real income)

P × Y = total nominal spending on good and servicesV= the average number of time per year that a dollar is spent

V =P×YM

Multiplying both sides by M we derive the equation of exchange which relates the money supply to aggregate spending

M ×V =P×YChanges in aggregate spending are determined primarily by changes

in the money supply

Quantity Theory of Money Approach


The aggregate demand curve is downward sloping because

/

and

/

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Y C I G NX

P M P i I Y

P M P i E NX Y

= + + +

↓⇒ ↑⇒ ↓⇒ ↑⇒ ↑

↓⇒ ↑⇒ ↓⇒ ↓⇒ ↑⇒ ↑

Behavior of Aggregate Demand’s Component Parts


Factors that Shift Aggregate Demand

• An increase in the money supply shifts AD to the right because it lowers interest rates and stimulates investment spending

• An increase in spending from any of the components C, I, G, NX, will also shift AD to the right


Aggregate Supply

• Long-run aggregate supply curve Determined by amount of capital and labor and the

available technology Vertical at the natural rate of output generated by

the natural rate of unemployment

• Short-run aggregate supply curve Wages and prices are sticky Generates an upward sloping SRAS as firms

attempt to take advantage of short-run profitability when price level rises


Factors that Shift SRAS

• Costs of production Tightness of the labor market Expected price level Wage push Change in production costs unrelated to

wages (supply shocks)


Self-Correcting Mechanism

• Regardless of where output is initially, it returns eventually to the natural rate

• Slow Wages are inflexible, particularly downward Need for active government policy

• Rapid Wages and prices are flexible Less need for government intervention


Shifts in Long-Run Aggregate Supply

• Economic growth

• Real business cycle theory Real supply shocks drive short-run fluctuations in the natural

rate of output (shifts of LRAS) No need for government intervention

• Hysteresis Departure from full employment levels as a result of past

high unemployment Natural rate of unemployment shifts upward and natural rate

of output falls below full employment Expansionary policy needed to shift aggregate demand


Conclusions

• Shift in aggregate demand affects output only in the short run and has no effect in the long run

• Shifts in aggregate demand affects only price level in the long run

• Shift in short run aggregate supply affects output and price only in the short run and has no effect in the long run

• The economy has a self-correcting mechanism

chapter 22 aggregate demand and supply analysis. copyright © 2007 pearson addison-wesley. all...

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right slide

supply analysis slide

government intervention

net exports slide

aggregate supply curve

quantity of aggregate

money supply shifts