chapter 22 aggregate demand and supply analysis. copyright © 2007 pearson addison-wesley. all...
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Chapter 22
Aggregate Demand and Supply Analysis
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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
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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
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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
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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
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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
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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)
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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
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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
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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
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