copyright © 2010 pearson addison-wesley. all rights reserved. chapter 23 aggregate demand and...

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 23

Aggregate Demand and Supply Analysis

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.23-2

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• To understand the effect of monetary policy on output and prices– Need to study how output and prices are

determined, i.e, the relationship between aggregate demand and aggregate supply

– Aggregate demand: total quantity, final goods and services, demanded @ different price levels

– Aggregate supply: total quantity, final goods and services, want to sell @ different price levels


Aggregate Demand Curve

• The relationship between – the quantity of aggregate output demanded

– the price level when all other variables are held constant.

• Aggregate demand is made up of four component parts:1. Consumer expenditure ( C )

2. Planned investment spending ( I )

3. Government spending (G )

4. Net export ( NX )


Aggregate Demand (cont’ d)


Aggregate Demand Curve (cont’ d)

• The fact that the aggregate demand curve is downward sloping can also be derived from the quantity theory of money analysis.

MV=PY

• If velocity stays constant, a constant money supply implies constant nominal aggregate spending, and a decrease in the price level is matched with an increase in aggregate demand.


Factors that Shift Aggregate Demand

• An increase in the money supply shifts AD to the right: holding velocity constant, an increase in the money supply increases the quantity of aggregate demand at each price level [quantity theory]

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


Factors that Shift Aggregate Demand

• Component approach implication:– Other factors (C, I, G, NX) as well as money

supply affect aggregate demand


FIGURE 1 Shifts in the Aggregate Demand Curve


Summary Table 1 Factors That Shift the Aggregate Demand Curve


Aggregate Supply Curve

• Long-run aggregate supply curve– Determined by 1 ） amount of capital ； 2 ） labor

supplied @ full employment ； 3 ） 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 of materials are sticky in short run– upward sloping as firms attempt to take advantage

of short-run profitability when price level rises


FIGURE 2 Long-Run Aggregate Supply Curve


FIGURE 3 Aggregate Supply Curve in the Short Run


Factors that Shift Short-Run Aggregate Supply

• Costs of production– Tightness of the labor market

– Expected inflation

– Higher wage push

– Change in production costs unrelated to wages (supply shocks)


Summary Table 2 Factors That Shift the Short-Run Aggregate Supply Curve


FIGURE 4 Equilibrium in the Short Run


FIGURE 5 Adjustment to Long-Run Equilibrium in Aggregate Supply and Demand Analysis


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


FIGURE 6 Response of Output and the Price Level to a Shift in the Aggregate Demand Curve


FIGURE 7 Response of Output and the Price Level to a Shift in Short-Run Aggregate Supply


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 (holding the aggregate demand constant)

• The economy has a self-correcting mechanism


Table 3 Unemployment and Inflation During the Vietnam War Buildup, 1964–1970


Table 4 Unemployment and Inflation During the Negative Supply Shocks Periods, 1973–1975 and 1978–1980


Table 5 Unemployment and Inflation During the Favorable Supply Shocks Period, 1995–1999


Table 6 Unemployment and Inflation During the Negative Demand Shocks Period, 2000–2004


Table 7 Unemployment and Inflation During the Perfect Storm of 2007–2008

copyright © 2010 pearson addison-wesley. all rights reserved. chapter 23 aggregate demand and...

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