© 2008 Pearson Education Canada24.1 Chapter 24 Aggregate Demand and Supply Analysis.

© 2008 Pearson Education Canada24.1

Chapter 24Chapter 24Aggregate Demand and Supply Analysis


Aggregate DemandAggregate Demand

• 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


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

V P Y

MMultiplying both sides by M we derive the

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

Quantity Theory of Money Approach to Quantity Theory of Money Approach to Aggregate DemandAggregate Demand


Deriving the Aggregate Deriving the Aggregate Demand CurveDemand Curve

• Changes in the price level induce changes in the aggregate output demanded and hence movement along the AD curve (points A, B, and C in Figure 24-1)

• In the quantity theory, changes in the money supply are the primary source of changes in aggregate spending and thus shifts the AD curve.


Aggregate Demand CurveAggregate Demand Curve


The aggregate demand curve is downward sloping because

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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 Behavior of Aggregate Demand’s Component PartsDemand’s Component Parts


Factors that Shift Aggregate Factors that Shift Aggregate DemandDemand

• 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


Factors That Shift the Factors That Shift the Aggregate Demand CurveAggregate Demand Curve


Aggregate SupplyAggregate Supply

• Long-run aggregate supply curve (LRAS)

– 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 (SRAS)– Wages and prices are sticky– Generates an upward sloping SRAS as firms

attempt to take advantage of short-run profitability when price level rises


Long Run Aggregate SupplyLong Run Aggregate Supply


Short Run Aggregate SupplyShort Run Aggregate Supply


Factors that Shift Short Run Factors that Shift Short Run Aggregate SupplyAggregate Supply

• Costs of production– Tightness of the labor market– Expected price level– Wage push– Change in production costs unrelated to wages

(supply shocks)


Factors that Shift Short Run Factors that Shift Short Run Aggregate Supply Aggregate Supply (Cont’d)(Cont’d)


Equilibrium of AS and AD in Equilibrium of AS and AD in the Short Runthe Short Run


Equilibrium of AS and AD in Equilibrium of AS and AD in the Long Runthe Long Run


Self-Correcting MechanismSelf-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


Response of Output and the Price Response of Output and the Price Level to a Shift in the AD CurveLevel to a Shift in the AD Curve


Response of Output and the Price Response of Output and the Price Level to a Shift in the AS CurveLevel to a Shift in the AS Curve


Shifts in Long-Run Shifts in Long-Run Aggregate SupplyAggregate 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


ConclusionsConclusions

• Shifts in aggregate demand affects output only in the short run and has no effect in the long run

• When shifts in aggregate demand occur, the initial change in the price level is less in the short run than it is in the long run when AS has fully adjusted


• Shifts 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


Unemployment and Inflation in the Unemployment and Inflation in the United States 1964 -1970United States 1964 -1970


Unemployment and Inflation in the Unemployment and Inflation in the United States 2000-2004United States 2000-2004

© 2008 Pearson Education Canada24.1 Chapter 24 Aggregate Demand and Supply Analysis.

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Transcript of © 2008 Pearson Education Canada24.1 Chapter 24 Aggregate Demand and Supply Analysis.