Download Aggregate 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
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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
P×Y
V=
M
Multiplying 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
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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 ↑
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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
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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
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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)
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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
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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
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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
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