Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 23 Aggregate Demand and Supply Analysis

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Chapter preview 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, different price levels –Aggregate supply: total quantity, final goods and services, want to different price levels

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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Aggregate Demand (cont’d)

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

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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Factors that Shift Aggregate Demand Component approach implication: –Other factors (C, I, G, NX) as well as money supply affect aggregate demand

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 1 Shifts in the Aggregate Demand Curve

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Summary Table 1 Factors That Shift the Aggregate Demand Curve

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Aggregate Supply Curve Long-run aggregate supply curve –Determined by 1 ） amount of capital ； 2 ） labor 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 2 Long-Run Aggregate Supply Curve

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 3 Aggregate Supply Curve in the Short Run

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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Summary Table 2 Factors That Shift the Short-Run Aggregate Supply Curve

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 4 Equilibrium in the Short Run

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 5 Adjustment to Long-Run Equilibrium in Aggregate Supply and Demand Analysis

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 6 Response of Output and the Price Level to a Shift in the Aggregate Demand Curve

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 7 Response of Output and the Price Level to a Shift in Short-Run Aggregate Supply

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 3 Unemployment and Inflation During the Vietnam War Buildup, 1964–1970

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 4 Unemployment and Inflation During the Negative Supply Shocks Periods, 1973–1975 and 1978–1980

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 5 Unemployment and Inflation During the Favorable Supply Shocks Period, 1995–1999

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 6 Unemployment and Inflation During the Negative Demand Shocks Period, 2000–2004

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 7 Unemployment and Inflation During the Perfect Storm of 2007–2008