Understanding Aggregate Demand and Supply Analysis

1. Chapter 22 Aggregate Demand and Supply Analysis

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

3. Aggregate Demand (cont’d)

4. FIGURE 1 Shifts in the Aggregate Demand Curve

5. 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.

6. 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

7. Summary Table 1 Factors That Shift the Aggregate Demand Curve

8. 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

9. FIGURE 2 Long-Run Aggregate Supply Curve

10. FIGURE 3 Aggregate Supply Curve in the Short Run

11. 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)

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

13. FIGURE 4 Equilibrium in the Short Run

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

15. 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

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

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

18. 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

19. 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

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

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

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

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

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