chapter 23

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

Aggregate Demand

• The relationship between the quantity

of aggregate output demanded and the price level when all other variables are held constant.

• Aggregate demand is made up of four component parts


The aggregate demand curve is downward sloping because

/

and

/

ad

ad

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Y C I G NX

P M P i I Y

P M P i E NX Y

= + + +

↓⇒ ↑⇒ ↓⇒ ↑⇒ ↑

↓⇒ ↑⇒ ↓⇒ ↓⇒ ↑⇒ ↑

Aggregate Demand (cont’d)


FIGURE 1 Shifts in the Aggregate Demand Curve


Aggregate Demand (cont’d)

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

• 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

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


Summary Table 1 Factors That Shift the Aggregate Demand Curve


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


FIGURE 2 Long-Run Aggregate Supply Curve


FIGURE 3 Aggregate Supply Curve in the Short Run


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)


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

chapter 23

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