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Chapter 22 Aggregate Demand and Supply Analysis 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-2 Quantity Theory of Money Approach M = quantity of money P = price level Y = aggregate real output (real income) P Y = total nominal spending on good and services V = the average number of time per year that a dollar is spent PY M Multiplying both sides by M we derive the V equation of exchange which relates the money supply to aggregate spending M V P Y Changes in aggregate spending are determined primarily by changes in the money supply Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-3 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-4 Behavior of Aggregate Demand’s Component Parts Y ad C I G NX The aggregate demand curve is downward sloping because P M / P i I Y ad and P M / P i E NX Y ad Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-5 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-6 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-7 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-8 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-9 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-10 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-11 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-12 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) Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-14 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-15 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-16 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 © 2007 Pearson Addison-Wesley. All rights reserved. 22-17 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-18 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-19 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 © 2007 Pearson Addison-Wesley. All rights reserved. 22-20 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 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-21 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-22 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-23 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-24 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 22-25