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25
PREVIEW
Aggregate Demand and
Supply Analysis
In earlier chapters, we focused considerable attention on monetary policy, because it
touches our everyday lives by affecting the prices of the goods we buy and the quantity of available jobs. In this chapter, we develop a basic tool, aggregate demand and
supply analysis, that will enable us to study the effects of money on output and prices.
Aggregate demand is the total quantity of an economy’s final goods and services
demanded at different price levels. Aggregate supply is the total quantity of final
goods and services that firms in the economy want to sell at different price levels. As
with other supply and demand analyses, the actual quantity of output and the price
level are determined by equating aggregate demand and aggregate supply.
Aggregate demand and supply analysis will enable us to explore how aggregate
output and the price level are determined. (The “Following the Financial News” box
indicates when data on aggregate output and the price level are published.) Not only
will the analysis help us interpret recent episodes in the business cycle, but it will also
enable us to understand the debates on how economic policy should be conducted.
Aggregate Demand
The first building block of aggregate supply and demand analysis is the aggregate
demand curve, which describes the relationship between the quantity of aggregate
output demanded and the price level when all other variables are held constant.
Monetarists (led by Milton Friedman) view the aggregate demand curve as downwardsloping with one primary factor that causes it to shift—changes in the quantity of
money. Keynesians (followers of Keynes) also view the aggregate demand curve as
downward-sloping, but they believe that changes in government spending and taxes
or in consumer and business willingness to spend can also cause it to shift.
Monetarist View
of Aggregate
Demand
582
The monetarist view of aggregate demand links the quantity of money M with total
nominal spending on goods and services P Y (P price level and Y aggregate
real output or, equivalently, aggregate real income). To do this it uses the concept of
the velocity of money: the average number of times per year that a dollar is spent on
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Aggregate Demand and Supply Analysis
583
Following the Financial News
Aggregate Output, Unemployment, and the Price Level
Newspapers and Internet sites periodically report
data that provide information on the level of aggregate output, unemployment, and the price level. Here
is a list of the relevant data series, their frequency, and
when they are published.
Aggregate Output and Unemployment
Real GDP: Quarterly (January–March, April–June,
July–September, October–December); published
three to four weeks after the end of a quarter.
Industrial production: Monthly. Industrial production
is not as comprehensive a measure of aggregate
output as real GDP, because it measures only
manufacturing output; the estimate for the previous month is reported in the middle of the following month.
Unemployment rate: Monthly; previous month’s figure is usually published on the Friday of the first
week of the following month.
www.bls.gov/data/home.htm
The home page of the Bureau
of Labor Statistics lists
information on unemployment
and price levels.
Price Level
GDP deflator: Quarterly. This comprehensive measure of the price level (described in the appendix
to Chapter 1) is published at the same time as
the real GDP data.
Consumer price index (CPI): Monthly. The CPI is a
measure of the price level for consumers (also
described in the appendix to Chapter 1); the
value for the previous month is published in the
third or fourth week of the following month.
Producer price index (PPI): Monthly. The PPI is a
measure of the average level of wholesale prices
charged by producers and is published at the
same time as industrial production data.
final goods and services. More formally, velocity V is calculated by dividing nominal
spending P Y by the money supply M:
V
PY
M
Suppose that the total nominal spending in a year was $2 trillion and the money supply was $1 trillion; velocity would then be $2 trillion/$1 trillion 2. On average, the
money supply supports a level of transactions associated with 2 times its value in final
goods and services in the course of a year. By multiplying both sides by M, we obtain
the equation of exchange, which relates the money supply to aggregate spending:
MVPY
(1)
At this point, the equation of exchange is nothing more than an identity; that is,
it is true by definition. It does not tell us that when M rises, aggregate spending will
rise as well. For example, the rise in M could be offset by a fall in V, with the result
that M V does not rise. However, Friedman’s analysis of the demand for money (discussed in detail in Chapter 22) suggests that velocity varies over time in a predictable
manner unrelated to changes in the money supply. With this analysis, the equation of
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Monetary Theory
exchange is transformed into a theory of how aggregate spending is determined and
is called the modern quantity theory of money.
To see how the theory works, let’s look at an example. If velocity is predicted to
be 2 and the money supply is $1 trillion, the equation of exchange tells us that aggregate spending will be $2 trillion (2 $1 trillion). If the money supply doubles to
$2 trillion, Friedman’s analysis suggests that velocity will continue to be 2 and aggregate spending will double to $4 trillion (2 $2 trillion). Thus Friedman’s modern
quantity theory of money concludes that changes in aggregate spending are determined primarily by changes in the money supply.
Deriving the Aggregate Demand Curve. To learn how the modern quantity theory of
money generates the aggregate demand curve, let’s look at an example in which we
measure aggregate output in trillions of 1996 dollars, with the price level in 1996 having a value of 1.0. As just shown, with a predicted velocity of 2 and a money supply
of $1 trillion, aggregate spending will be $2 trillion. If the price level is given at 2.0,
the quantity of aggregate output demanded is $1 trillion because aggregate spending
P Y then continues to equal 2.0 $1 trillion $2 trillion, the value of M V. This
combination of a price level of 2.0 and aggregate output of 1 is marked as point A
in Figure 1. If the price level is given as 1.0 instead, aggregate output demanded is
$2 trillion (point B), so aggregate spending continues to equal $2 trillion ( 1.0 2 trillion). Similarly, at an even lower price level of 0.5, the quantity of output
demanded rises to $4 trillion, shown by point C. The curve connecting these points,
marked AD1, is the aggregate demand curve, given a money supply of $1 trillion. As
you can see, it has the usual downward slope of a demand curve, indicating that as the
price level falls (everything else held constant), the quantity of output demanded rises.
Shifts in the Aggregate Demand Curve. In Friedman’s modern quantity theory, changes
in the money supply are the primary source of the changes in aggregate spending and
shifts in the aggregate demand curve. To see how a change in the money supply shifts
the aggregate demand curve in Figure 1, let’s look at what happens when the money supply increases to $2 trillion. Now aggregate spending rises to 2 $2 trillion $4 trillion,
F I G U R E 1 Aggregate Demand
Curve
An aggregate demand curve is
drawn for a fixed level of the
money supply. A rise in the money
supply from $1 trillion to $2 trillion leads to a shift in the aggregate demand curve from AD1 to
AD2 .
Aggregate Price
Level, P (1996 = 1.0 )
2.0
A
A
B
1.0
C
0.5
0.0
B
C
AD2
AD1
2
4
6
8
Aggregate Output, Y ($ trillions, 1996)
CHAPTER 25
Aggregate Demand and Supply Analysis
585
and at a price level of 2.0, the quantity of aggregate output demanded will rise to $2
trillion so that 2.0 2 trillion $4 trillion. Therefore, at a price level of 2.0, the
aggregate demand curve moves from point A to A. At a price level of 1.0, the quantity of output demanded rises from $2 to $4 trillion (from point B to B), and at a price
level of 0.5, output demanded rises from $4 to $8 trillion (from point C to C). The
result is that the rise in the money supply to $2 trillion shifts the aggregate demand
curve outward to AD2.
Similar reasoning indicates that a decline in the money supply lowers aggregate
spending proportionally and reduces the quantity of aggregate output demanded at
each price level. Thus a decline in the money supply shifts the aggregate demand
curve to the left.
Keynesian View of
Aggregate
Demand
Rather than determining aggregate demand from the equation of exchange, Keynesians
analyze aggregate demand in terms of its four component parts: consumer expenditure, the total demand for consumer goods and services; planned investment spending,1 the total planned spending by business firms on new machines, factories, and
other inputs to production, plus planned spending on new homes; government
spending, spending by all levels of government (federal, state, and local) on goods
and services (paper clips, computers, computer programming, missiles, government
workers, and so on); and net exports, the net foreign spending on domestic goods
and services, equal to exports minus imports. Using the symbols C for consumer
expenditure, I for planned investment spending, G for government spending, and NX
for net exports, we can write the following expression for aggregate demand Y ad:
Y ad C I G NX
(2)
Deriving the Aggregate Demand Curve. Keynesian analysis, like monetarist analysis,
suggests that the aggregate demand curve is downward-sloping because a lower price
level (P↓), holding the nominal quantity of money (M) constant, leads to a larger
quantity of money in real terms (in terms of the goods and services that it can buy,
M/P ↑). The larger quantity of money in real terms (M/P ↑) that results from the lower
price level causes interest rates to fall (i↓), as suggested in Chapter 5 and 24. The
resulting lower cost of financing purchases of new physical capital makes investment
more profitable and stimulates planned investment spending (I↑). Because, as shown
in Equation 2, the increase in planned investment spending adds directly to aggregate
demand (Y ad ↑), the lower price level leads to a higher level of aggregate demand (P↓
⇒ Y ad↑). Schematically, we can write the mechanism just described as follows:
P↓ ⇒ M/P↑ ⇒ i↓ ⇒ I↑ ⇒ Y ad ↑
Another mechanism that generates a downward-sloping aggregate demand curve
operates through international trade. Because a lower price level (P↓) leads to a larger
quantity of money in real terms (M/P↑) and lower interest rates (i↓), U.S. dollar bank
deposits become less attractive relative to deposits denominated in foreign currencies,
thereby causing a fall in the value of dollar deposits relative to other currency deposits
1
Recall that economists restrict use of the word investment to the purchase of new physical capital, such as a new
machine or a new house, that adds to expenditure.
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Monetary Theory
(a decline in the exchange rate, denoted by E↓). The lower value of the dollar, which
makes domestic goods cheaper relative to foreign goods, then causes net exports to
rise, which in turn increases aggregate demand:
P↓ ⇒ M/P ↑ ⇒ i↓ ⇒ E↓ ⇒ NX↑ ⇒ Y ad ↑
Shifts in the Aggregate Demand Curve. The mechanisms described also indicate why
Keynesian analysis suggests that changes in the money supply shift the aggregate
demand curve. For a given price level, a rise in the money supply causes the real
money supply to increase (M/P ↑), which leads to an increase in aggregate demand,
as shown. Thus an increase in the money supply shifts the aggregate demand curve
to the right (as in Figure 1), because it lowers interest rates and stimulates planned
investment spending and net exports. Similarly, a decline in the money supply shifts
the aggregate demand curve to the left.2
In contrast to monetarists, Keynesians believe that other factors (manipulation of
government spending and taxes, changes in net exports, and changes in consumer and
business spending) are also important causes of shifts in the aggregate demand curve.
For instance, if the government spends more (G ↑) or net exports increase (NX↑),
aggregate demand rises, and the aggregate demand curve shifts to the right. A decrease
in government taxes (T↓) leaves consumers with more income to spend, so consumer
expenditure rises (C ↑). Aggregate demand also rises, and the aggregate demand curve
shifts to the right. Finally, if consumer and business optimism increases, consumer
expenditure and planned investment spending rise (C ↑, I↑), again shifting the aggregate demand curve to the right. Keynes described these waves of optimism and pessimism as “animal spirits” and considered them a major factor affecting the aggregate
demand curve and an important source of business cycle fluctuations.
The Crowding-Out
Debate
You have seen that both monetarists and Keynesians agree that the aggregate demand
curve is downward-sloping and shifts in response to changes in the money supply.
However, monetarists see only one important source of movements in the aggregate
demand curve—changes in the money supply—while Keynesians suggest that other
factors—fiscal policy, net exports, and “animal spirits”—are equally important sources
of shifts in the aggregate demand curve.
Because aggregate demand can be written as the sum of C I G NX, it might
appear that any factor affecting one of its components must cause aggregate demand
to change. Then it would seem that a fiscal policy change such as a rise in government spending (holding the money supply constant) would necessarily shift the
aggregate demand curve. Because monetarists view changes in the money supply as
the only important source of shifts in the aggregate demand curve, they must be able
to explain why the foregoing reasoning is invalid.
Monetarists agree that an increase in government spending will raise aggregate
demand if the other components of aggregate demand—C, I, and NX—remained
unchanged after the government spending rise. They contend, however, that the
increase in government spending will crowd out private spending (C, I, and NX ),
which will fall by exactly the amount of the government spending increase. For example, an increase of $50 billion in government spending might be offset by a decline of
$30 billion in consumer expenditure, $10 billion in investment spending, and $10
2
A complete demonstration of the Keynesian analysis of the aggregate demand curve is given in Chapters 23 and 24.
CHAPTER 25
Aggregate Demand and Supply Analysis
587
billion in net exports. This phenomenon of an exactly offsetting movement of private
spending to an expansionary fiscal policy, such as a rise in government spending, is
called complete crowding out.
How might complete crowding out occur? When government spending increases
(G ↑), the government has to finance this spending by competing with private borrowers for funds in the credit market. Interest rates will rise (i↑), increasing the cost of
financing purchases of both physical capital and consumer goods and lowering net
exports. The result is that private spending will fall (C↓, I↓, NX↓), and so aggregate
demand may remain unchanged. This chain of reasoning can be summarized as follows:
G↑ ⇒ i↑ ⇒ C↓, I↓, NX↓
Therefore, C I G NX Y ad is unchanged.
Keynesians do not deny the validity of the first set of steps. They agree that an
increase in government spending raises interest rates, which in turn lowers private
spending; indeed, this is a feature of the Keynesian analysis of aggregate demand (see
Chapters 23 and 24). However, they contend that in the short run only partial
crowding out occurs—some decline in private spending that does not completely offset the rise in government spending.
The Keynesian crowding-out picture suggests that when government spending
rises, aggregate demand does increase, and the aggregate demand curve shifts to the
right. The extent to which crowding out occurs is the issue that separates monetarist
and Keynesian views of the aggregate demand curve. We will discuss the evidence on
this issue in Chapter 26.
Aggregate Supply
The key feature of aggregate supply is that as the price level increases, the quantity of
output supplied increases in the short run. Figure 2 illustrates the positive relationship
between quantity of output supplied and price level. Suppose that initially the quantity
F I G U R E 2 Aggregate Supply
Curve in the Short Run
A rise in the costs of production
shifts the supply curve leftward
from AS1 to AS2 .
Aggregate Price
Level, P (1996 = 1.0 )
AS2
B
2.0
1.0
0.0
A
AS1
B
A
2
4
6
8
Aggregate Output, Y ($ trillions, 1996)
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PART VI
Monetary Theory
of output supplied at a price level of 1.0 is $4 trillion, represented by point A. A rise
in the price level to 2.0 leads, in the short run, to an increase to $6 trillion in the
quantity of output supplied (point B). The line AS1 connecting points A and B
describes the relationship between the quantity of output supplied in the short run
and the price level and is called the aggregate supply curve; as you can see, it is
upward-sloping.
To understand why the aggregate supply curve slopes upward, we have to look at
the factors that cause the quantity of output supplied to change. Because the goal of
business is to maximize profits, the quantity of output supplied is determined by the
profit made on each unit of output. If profit rises, more output will be produced, and
the quantity of output supplied will increase; if it falls, less output will be produced,
and the quantity of output supplied will fall.
Profit on a unit of output equals the price for the unit minus the costs of producing it. In the short run, costs of many factors that go into producing goods and
services are fixed; wages, for example, are often fixed for periods of time by labor contracts (sometimes as long as three years), and raw materials are often bought by firms
under long-term contracts that fix the price. Because these costs of production are
fixed in the short run, when the overall price level rises, the price for a unit of output
will be rising relative to the costs of producing it, and the profit per unit will rise.
Because the higher price level results in higher profits in the short run, firms increase
production, and the quantity of aggregate output supplied rises, resulting in an
upward-sloping aggregate supply curve.
Frequent mention of the short run in the preceding paragraph hints that the
aggregate supply curve (AS 1 in Figure 2) may not remain fixed as time passes. To see
what happens over time, we need to understand what makes the aggregate supply
curve shift.3
Shifts in the
Aggregate Supply
Curve
We have seen that the profit on a unit of output determines the quantity of output
supplied. If the cost of producing a unit of output rises, profit on a unit of output falls,
and the quantity of output supplied falls. To learn what this implies for the position
of the aggregate supply curve, let’s consider what happens at a price level of 1.0 when
the costs of production increase. Now that firms are earning a lower profit per unit of
output, they reduce production, and the quantity of aggregate output supplied falls
from $4 (point A) to $2 trillion (point A). Applying the same reasoning at point B
indicates that aggregate output supplied falls to point B. What we see is that the
aggregate supply curve shifts to the left when costs of production increase and to the
right when costs decrease.
Equilibrium in Aggregate Supply and Demand Analysis
http://hadm.sph.sc.edu
/Courses/Econ/SD/SD.html
An interactive lecture on
aggregate supply and demand.
The equilibrium level of aggregate output and the price level will occur at the point
where the quantity of aggregate output demanded equals the quantity of aggregate
output supplied. However, in the context of aggregate supply and demand analysis,
there are two types of equilibrium: short-run and long-run.
3
The aggregate supply curve is closely linked to the Phillips curve discussed in Chapter 18. More information on
the Phillips and aggregate supply curve can be found in an appendix to this chapter, which is on this book’s web
site at www.aw.com/mishkin.
CHAPTER 25
Aggregate Demand and Supply Analysis
589
Equilibrium in
the Short Run
Figure 3 illustrates an equilibrium in the short run in which the quantity of aggregate
output demanded equals the quantity of output supplied; that is, where the aggregate
demand curve AD and the aggregate supply curve AS intersect at point E. The equilibrium level of aggregate output equals Y *, and the equilibrium price level equals P *.
As in our earlier supply and demand analyses, equilibrium is a useful concept
only if there is a tendency for the economy to head toward it. We can see that the
economy heads toward the equilibrium at point E by first looking at what happens
when we are at a price level above the equilibrium price level P *. If the price level is
at P, the quantity of aggregate output supplied at point D is greater than the quantity of aggregate output demanded at point A. Because people want to sell more goods
and services than others want to buy (a condition of excess supply) , the prices of goods
and services will fall, and the aggregate price level will drop, as shown by the downward arrow. This decline in the price level will continue until it has reached its equilibrium level of P * at point E.
When the price level is below the equilibrium price level, say at P, the quantity
of output demanded is greater than the quantity of output supplied. Now the price
level will rise, as shown by the upward arrow, because people want to buy more goods
than others want to sell (a condition of excess demand) . This rise in the price level will
continue until it has again reached its equilibrium level of P * at point E.
Equilibrium in
the Long Run
Usually in supply and demand analysis, once we find the equilibrium at which the
quantity demanded equals the quantity supplied, there is no need for additional discussion. In aggregate supply and demand analysis, however, that is not the case. Even
when the quantity of aggregate output demanded equals the quantity supplied, forces
operate that can cause the equilibrium to move over time. To understand why, we must
remember that if costs of production change, the aggregate supply curve will shift.
The most important component of production costs is wages (approximately 70%
of production costs), which are determined in the labor market. If the economy is
booming, employers will find that they have difficulty hiring qualified workers and
may even have a hard time keeping their present employees. In this case, the labor
F I G U R E 3 Equilibrium in the
Short Run
Equilibrium occurs at point E at
the intersection of the aggregate
demand curve AD and the aggregate supply curve AS.
Aggregate
Price Level, P
AS
D
A
P
P
P
E
C
B
AD
Y
Aggregate Output, Y
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PART VI
Monetary Theory
market is tight, because the demand for labor exceeds the supply; employers will raise
wages to attract needed workers, and this raises the costs of production. The higher
costs of production lower the profits per unit of output at each price level, and the
aggregate supply curve shifts to the left (see Figure 2).
By contrast, if the economy enters a recession and the labor market is slack,
because demand for labor is less than supply, workers who cannot find jobs will be
willing to work for lower wages. In addition, employed workers may be willing to
make wage concessions to keep from losing their jobs. Therefore, in a slack labor market in which the quantity of labor demanded is less than the quantity supplied, wages
and hence costs of production will fall, profits per unit of output will rise, and the
aggregate supply curve will shift to the right.
Our analysis suggests that the aggregate supply curve will shift depending on
whether the labor market is tight or slack. How do we decide which it is? One helpful concept is the natural rate of unemployment, the rate of unemployment to
which the economy gravitates in the long run at which demand for labor equals supply. (A related concept is the NAIRU, the nonaccelerating inflation rate of unemployment, the rate of unemployment at which there is no tendency for inflation to
change.) Many economists believe that the rate is currently around 5%. When unemployment is at, say, 4%, below the natural rate of unemployment of 5%, the labor
market is tight; wages will rise, and the aggregate supply curve will shift leftward.
When unemployment is at, say, 8%, above the natural rate of unemployment, the
labor market is slack; wages will fall, and the aggregate supply curve will shift rightward. Only when unemployment is at the natural rate will no pressure exist from the
labor market for wages to rise or fall, so the aggregate supply need not shift.
The level of aggregate output produced at the natural rate of unemployment is
called the natural rate level of output. Because, as we have seen, the aggregate supply curve will not remain stationary when unemployment and aggregate output differ
from their natural rate levels, we need to look at how the short-run equilibrium
changes over time in response to two situations: when equilibrium is initially below
the natural rate level and when it is initially above the natural rate level.
In panel (a) of Figure 4, the initial equilibrium occurs at point 1, the intersection
of the aggregate demand curve AD and the initial aggregate supply curve AS1. Because
the level of equilibrium output Y1 is greater than the natural rate level Yn, unemployment is less than the natural rate, and excessive tightness exists in the labor market.
This tightness drives wages up, raises production costs, and shifts the aggregate supply curve to AS2. The equilibrium is now at point 2, and output falls to Y2. Because
aggregate output Y2 is still above the natural rate level, Yn, wages continue to be driven
up, eventually shifting the aggregate supply curve to AS3. The equilibrium reached at
point 3 is on the vertical line at Yn and is a long-run equilibrium. Because output is
at the natural rate level, there is no further pressure on wages to rise and thus no further tendency for the aggregate supply curve to shift.
The movements in panel (a) indicate that the economy will not remain at a level
of output higher than the natural rate level because the aggregate supply curve will
shift to the left, raise the price level, and cause the economy to slide upward along the
aggregate demand curve until it comes to rest at a point on the vertical line through
the natural rate level of output Yn. Because the vertical line through Yn is the only
place at which the aggregate supply curve comes to rest, this vertical line indicates the
quantity of output supplied in the long run for any given price level. We can characterize this as the long-run aggregate supply curve.
CHAPTER 25
591
AS3
Aggregate
Price Level, P
AS2
P3
3
AS1
↑
2
P2
↑
F I G U R E 4 Adjustment to LongRun Equilibrium in Aggregate Supply
and Demand Analysis
In both panels, the initial equilibrium is at point 1 at the intersection of AD and AS 1 . In panel (a),
Y1 Yn , so the aggregate supply
curve keeps shifting to the left
until it reaches AS 3 , where output
has returned to Yn . In panel (b),
Y1 Yn , so the aggregate supply
curve keeps shifting to the right
until output is again returned to
Yn . Hence in both cases, the economy displays a self-correcting
mechanism that returns it to the
natural rate level of output.
Aggregate Demand and Supply Analysis
1
P1
AD
Yn
Y2
Y1
Aggregate Output, Y
(a) Initial equilibrium in which Y > Yn
Aggregate
Price Level, P
AS1
AS2
AS3
1
↑
P1
↑
2
P2
3
P3
AD
Y1
Y2
Yn
Aggregate Output, Y
(b) Initial equilibrium in which Y < Yn
A characteristic of the
economy that causes
output to return
eventually to the
natural rate level
regardless of where it
is initially.
In panel (b), the initial equilibrium at point 1 is one at which output Y1 is below
the natural rate level. Because unemployment is higher than the natural rate, wages
begin to fall, shifting the aggregate supply curve rightward until it comes to rest at
AS 3. The economy slides downward along the aggregate demand curve until it
reaches the long-run equilibrium point 3, the intersection of the aggregate demand
curve AD and the long-run aggregate supply curve at Yn. Here, as in panel (a), the
economy comes to rest when output has again returned to the natural rate level.
A striking feature of both panels of Figure 4 is that regardless of where output is
initially, it returns eventually to the natural rate level. This feature is described by saying that the economy has a self-correcting mechanism.
An important issue for policymakers is how rapidly this self-correcting mechanism works. Many economists, particularly Keynesians, believe that the self-correcting
mechanism takes a long time, so the approach to long-run equilibrium is slow. This
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Monetary Theory
view is reflected in Keynes’s often quoted remark, “In the long run, we are all dead.”
These economists view the self-correcting mechanism as slow, because wages are
inflexible, particularly in the downward direction when unemployment is high. The
resulting slow wage and price adjustments mean that the aggregate supply curve
does not move quickly to restore the economy to the natural rate of unemployment.
Hence when unemployment is high, these economists (called activists) are more
likely to see the need for active government policy to restore the economy to full
employment.
Other economists, particularly monetarists, believe that wages are sufficiently
flexible that the wage and price adjustment process is reasonably rapid. As a result of
this flexibility, adjustment of the aggregate supply curve to its long-run position and
the economy’s return to the natural rate levels of output and unemployment will
occur quickly. Thus these economists (called nonactivists) see much less need for
active government policy to restore the economy to the natural rate levels of output
and unemployment when unemployment is high. Indeed, monetarists advocate the
use of a rule whereby the money supply or the monetary base grows at a constant rate
so as to minimize fluctuations in aggregate demand that might lead to output fluctuations. We will return in Chapter 27 to the debate about whether active government
policy to keep the economy near full employment is beneficial.
http://ecedweb.unomaha.edu
/Dem_Sup/demand.htm
An interactive tutorial on
demand and how various
factors cause changes in the
demand curve.
F I G U R E 5 Response of Output
and the Price Level to a Shift in the
Aggregate Demand Curve
A shift in the aggregate demand
curve from AD1 to AD2 moves the
economy from point 1 to point 1.
Because Y1 Yn , the aggregate
supply curve begins to shift leftward, eventually reaching AS2 ,
where output returns to Yn and the
price level has risen to P2.
You are now ready to analyze what happens when the aggregate demand curve shifts.
Our discussion of the Keynesian and monetarist views of aggregate demand indicates
that six factors can affect the aggregate demand curve: the money supply, government
spending, net exports, taxes, consumer optimism, and business optimism—the last
two (“animal spirits”) affecting willingness to spend. The possible effect on the aggregate demand curve of these six factors is summarized in Table 1.
Figure 5 depicts the effect of a rightward shift in the aggregate demand curve
caused by an increase in the money supply (M↑), an increase in government spending (G↑), an increase in net exports (NX ↑), a decrease in taxes (T↓), or an increase
in the willingness of consumers and businesses to spend because they become more
Aggregate
Price Level, P
AS2
AS1
P2
2
↑
Shifts in
Aggregate
Demand
1
P1
↑
P1
AD2
1
AD1
Yn
Y1'
Aggregate Output, Y
CHAPTER 25
SUMMARY
Aggregate Demand and Supply Analysis
593
Table 1 Factors That Shift the Aggregate Demand Curve
Factor
Money supply M
Change
↑
Shift in the Aggregate
Demand Curve
P
←
AD1
AD2
Y
Government spending G
↑
P
←
AD1
AD2
Y
Taxes T
↑
P
←
AD2 AD1
Y
↑
P
←
Net exports NX
AD1
AD2
Y
↑
P
←
Consumer optimism C
AD1
AD2
Y
↑
P
←
Business optimism I
AD1
AD2
Y
Note: Only increases (↑) in the factors are shown. The effect of decreases in the factors would be the
opposite of those indicated in the “Shift” column. Note that monetarists view only the money supply
as an important cause of shifts in the aggregate demand curve.
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PART VI
Monetary Theory
optimistic (C↑, I↑). The figure has been drawn so that initially the economy is in
long-run equilibrium at point 1, where the initial aggregate demand curve AD1 intersects the aggregate supply AS1 curve at Yn. When the aggregate demand curve shifts
rightward to AD2, the economy moves to point 1, and both output and the price level
rise. However, the economy will not remain at point 1, because output at Y 1 is above
the natural rate level. Wages will rise, eventually shifting the aggregate supply curve
leftward to AS2, where it finally comes to rest. The economy thus slides up the aggregate demand curve from point 1 to point 2, which is the point of long-run equilibrium at the intersection of AD2 and Yn. Although the initial short-run effect of the
rightward shift in the aggregate demand curve is a rise in both the price level and
output, the ultimate long-run effect is only a rise in the price level.
Shifts in
Aggregate Supply
www.census.gov/statab/www/
Statistics on the U.S.
economy in an easy-tounderstand format.
Not only can shifts in aggregate demand be a source of fluctuations in aggregate output (the business cycle), but so can shifts in aggregate supply. Factors that cause the
aggregate supply curve to shift are the ones that affect the costs of production: (1)
tightness of the labor market, (2) expectations of inflation, (3) workers’ attempts to
push up their real wages, and (4) changes in the production costs that are unrelated
to wages (such as energy costs). The first three factors shift the aggregate supply curve
by affecting wage costs; the fourth affects other costs of production.
Tightness of the Labor Market. Our analysis of the approach to long-run equilibrium
has shown us that when the labor market is tight (Y Yn ) , wages and hence production costs rise, and when the labor market is slack (Y Yn ) , wages and production costs fall. The effects on the aggregate supply curve are as follows: When
aggregate output is above the natural rate level, the aggregate supply curve shifts
to the left; when aggregate output is below the natural rate level, the aggregate supply curve shifts to the right.
Expected Price Level. Workers and firms care about wages in real terms; that is, in
terms of the goods and services that wages can buy. When the price level increases, a
worker earning the same nominal wage will be able to buy fewer goods and services.
A worker who expects the price level to rise will thus demand a higher nominal wage
in order to keep the real wage from falling. For example, if Chuck the Construction
Worker expects prices to increase by 5%, he will want a wage increase of at least 5%
(more if he thinks he deserves an increase in real wages). Similarly, if Chuck’s
employer knows that the houses he is building will rise in value at the same rate as
inflation (5%), his employer will be willing to pay Chuck 5% more. An increase in the
expected price level leads to higher wages, which in turn raise the costs of production, lower the profit per unit of output at each price level, and shift the aggregate
supply curve to the left (see Figure 2). Therefore, a rise in the expected price level
causes the aggregate supply curve to shift to the left; the greater the expected
increase in price level (that is, the higher the expected inflation), the larger the shift.
Wage Push. Suppose that Chuck and his fellow construction workers decide to strike
and succeed in obtaining higher real wages. This wage push will then raise the costs
of production, and the aggregate supply curve will shift leftward. A successful wage
push by workers will cause the aggregate supply curve to shift to the left.
Changes in Production Costs Unrelated to Wages. Changes in technology and in the supply of raw materials (called supply shocks) can also shift the aggregate supply curve.
A negative supply shock, such as a reduction in the availability of raw materials (like
CHAPTER 25
Aggregate Demand and Supply Analysis
595
oil), which raises their price, increases production costs and shifts the aggregate supply
curve leftward. A positive supply shock, such as unusually good weather that leads to a
bountiful harvest and lowers the cost of food, will reduce production costs and shift the
aggregate supply curve rightward. Similarly, the development of a new technology that
lowers production costs, perhaps by raising worker productivity, can also be considered
a positive supply shock that shifts the aggregate supply curve to the right.
The effect on the aggregate supply curve of changes in production costs unrelated
to wages can be summarized as follows: A negative supply shock that raises production costs shifts the aggregate supply curve to the left; a positive supply shock that
lowers production costs shifts the aggregate supply curve to the right.4
Study Guide
SUMMARY
As a study aid, factors that shift the aggregate supply curve are listed in Table 2.
Table 2 Factors That Shift the Aggregate Supply Curve
Shifts in
the Aggregate
Supply Curve
Factor
Y Yn
P
←
Factor
AS2
AS1
Wage push
Shifts in
the Aggregate
Supply Curve
P
←
Y
Y
AS1
AS2
P
Positive supply shock
AS1
AS2
P
←
Y Yn
←
Y
Y
Rise in expected
price level
P
←
AS2
AS1
Y
4
AS2
AS1
Negative supply shock
P
←
AS2
AS1
Y
Developments in the foreign exchange market can also shift the aggregate supply curve by changing domestic
production costs. As discussed in more detail in Chapter 19, an increase in the value of the dollar makes foreign
goods cheaper in the United States. The decline in prices of foreign goods and hence foreign factors of production lowers U.S. production costs and thus raises the profit per unit of output at each price level in the United
States. An increase in the value of the dollar therefore shifts the aggregate supply curve to the right. Conversely,
a decline in the value of the dollar, which makes foreign factors of production more expensive, shifts the aggregate supply curve to the left.
596
PART VI
Monetary Theory
Now that we know what factors can affect the aggregate supply curve, we can
examine what occurs when they cause the aggregate supply curve to shift leftward, as
in Figure 6. Suppose that the economy is initially at the natural rate level of output at
point 1 when the aggregate supply curve shifts from AS1 to AS2 because of a negative
supply shock (a sharp rise in energy prices, for example). The economy will move
from point 1 to point 2, where the price level rises but aggregate output falls. A situation of a rising price level but a falling level of aggregate output, as pictured in Figure
6, has been labeled stagflation (a combination of words stagnation and inflation). At
point 2, output is below the natural rate level, so wages fall and shift the aggregate
supply curve back to where it was initially at AS1. The result is that the economy
slides down the aggregate demand curve AD1 (assuming that the aggregate demand
curve remains in the same position), and the economy returns to the long-run equilibrium at point 1. Although a leftward shift in the aggregate supply curve initially
raises the price level and lowers output, the ultimate effect is that output and price
level are unchanged (holding the aggregate demand curve constant).
www.fgn.unisg.ch/eumacro
/IntrTutor/SGEadas.html
Work with an animated
interactive AD/AS graph.
F I G U R E 6 Response of Output
and the Price Level to a Shift in
Aggregate Supply
A shift in the aggregate supply
curve from AS1 to AS2 moves the
economy from point 1 to point 2.
Because Y2 Yn , the aggregate
supply curve begins to shift back
to the right, eventually returning
to AS1, where the economy is
again at point 1.
To this point, we have assumed that the natural rate level of output Yn and hence the
long-run aggregate supply curve (the vertical line through Yn ) are given. However,
over time, the natural rate level of output increases as a result of economic growth.
If the productive capacity of the economy is growing at a steady rate of 3% per year,
for example, this means that every year, Yn will grow by 3% and the long-run aggregate supply curve at Yn will shift to the right by 3%. To simplify the analysis when
Yn grows at a steady rate, Yn and the long-run aggregate supply curve are drawn as
fixed in the aggregate demand and supply diagrams. Keep in mind, however, that the
level of aggregate output pictured in these diagrams is actually best thought of as the level
of aggregate output relative to its normal rate of growth (trend).
The usual assumption when conducting aggregate demand and supply analysis is
that shifts in either the aggregate demand or aggregate supply curve have no effect on
the natural rate level of output (which grows at a steady rate). Movements of aggregate output around the Yn level in the diagram then describe short-run (business
cycle) fluctuations in aggregate output. However, some economists take issue with the
assumption that Yn is unaffected by aggregate demand and supply shocks.
Aggregate
Price Level, P
AS2
AS1
2
P2
←
Shifts in the
Long-Run
Aggregate Supply
Curve: Real
Business Cycle
Theory and
Hysteresis
P1
1
AD1
Y2
Yn
Aggregate Output, Y
CHAPTER 25
www.whitehouse.gov/fsbr
/esbr.html
The White House sponsors an
economic statistics briefing
room that reports a wide variety
of interesting data dealing with
the state of the economy.
Study Guide
Conclusions
Aggregate Demand and Supply Analysis
597
One group, led by Edward Prescott of the University of Minnesota, has developed
a theory of aggregate economic fluctuations called real business cycle theory, in
which aggregate supply (real) shocks do affect the natural rate level of output Yn. This
theory views shocks to tastes (workers’ willingness to work, for example) and technology (productivity) as the major driving forces behind short-run fluctuations in the
business cycle, because these shocks lead to substantial short-run fluctuations in Yn.
Shifts in the aggregate demand curve, perhaps as a result of changes in monetary policy, by contrast are not viewed as being particularly important to aggregate output
fluctuations. Because real business cycle theory views most business cycle fluctuations
as resulting from fluctuations in the natural rate level of output, it does not see much
need for activist policy to eliminate high unemployment. Real business cycle theory
is highly controversial and is the subject of intensive research.5
Another group of economists disagrees with the assumption that the natural rate
level of output Yn is unaffected by aggregate demand shocks. These economists contend that the natural rate level of unemployment and output are subject to hysteresis, a departure from full employment levels as a result of past high unemployment.6
When unemployment rises because of a reduction of aggregate demand that shifts the
AD curve inward, the natural rate of unemployment is viewed as rising above the full
employment level. This could occur because the unemployed become discouraged
and fail to look hard for work or because employers may be reluctant to hire workers
who have been unemployed for a long time, seeing it as a signal that the worker is
undesirable. The outcome is that the natural rate of unemployment shifts upward
after unemployment has become high, and Yn falls below the full employment level.
In this situation, the self-correcting mechanism will be able to return the economy
only to the natural rate levels of output and unemployment, not to the full employment level. Only with expansionary policy to shift the aggregate demand curve to the
right and raise aggregate output can the natural rate of unemployment be lowered (Yn
raised) to the full employment level. Proponents of hysteresis are thus more likely to
promote activist, expansionary policies to restore the economy to full employment.
Aggregate supply and demand analysis are best learned by practicing applications. In
this section, we have traced out what happens to aggregate output when there is an
increase in the money supply or a negative supply shock. Make sure you can also
draw the appropriate shifts in the aggregate demand and supply curves and analyze
what happens when other variables such as taxes or the expected price level change.
Aggregate demand and supply analysis yields the following conclusions (under the
usual assumption that the natural rate level of output is unaffected by aggregate
demand and supply shocks):
1. A shift in the aggregate demand curve—which can be caused by changes in
monetary policy (the money supply), fiscal policy (government spending or taxes),
5
See Charles Plosser, “Understanding Real Business Cycles,” Journal of Economic Perspectives (1989): 51–77, for a
nontechnical discussion of real business cycle theory.
6
For a further discussion of hysteresis, see Olivier Blanchard and Lawrence Summers, “Hysteresis in the European
Unemployment Problem,” NBER Macroeconomics Annual, 1986, 1, ed. Stanley Fischer (Cambridge, Mass.: M.I.T.
Press, 1986), pp. 15–78.
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PART VI
Monetary Theory
international trade (net exports), or “animal spirits” (business and consumer optimism)—
affects output only in the short run and has no effect in the long run. Furthermore,
the initial change in the price level is less than is achieved in the long run, when the
aggregate supply curve has fully adjusted.
2. A shift in the aggregate supply curve—which can be caused by changes in
expected inflation, workers’ attempts to push up real wages, or a supply shock—
affects output and prices only in the short run and has no effect in the long run (holding the aggregate demand curve constant).
3. The economy has a self-correcting mechanism, which will return it to the natural rate levels of unemployment and aggregate output over time.
Application
Explaining Past Business Cycle Episodes
Aggregate supply and demand analysis is an extremely useful tool for analyzing aggregate economic activity; we will apply it to several business cycle
episodes. To simplify our analysis, we always assume in all three examples
that aggregate output is initially at the natural rate level.
Vietnam War
Buildup,
1964–1970
America’s involvement in Vietnam began to escalate in the early 1960s, and
after 1964, the United States was fighting a full-scale war. Beginning in 1965,
the resulting increases in military expenditure raised government spending,
while at the same time the Federal Reserve increased the rate of money
growth in an attempt to keep interest rates from rising. What does aggregate
supply and demand analysis suggest should have happened to aggregate output and the price level as a result of the Vietnam War buildup?
The rise in government spending and the higher rate of money growth
would shift the aggregate demand curve to the right (shown in Figure 5). As
a result, aggregate output would rise, unemployment would fall, and the
price level would rise. Table 3 demonstrates that this is exactly what happened: The unemployment rate fell steadily from 1964 to 1969, remaining
well below what economists now think was the natural rate of unemployment during that period (around 5%), and inflation began to rise. As Figure
5 predicts, unemployment would eventually begin to return to the natural
rate level because of the economy’s self-correcting mechanism. This is exactly
what we saw occurring in 1970, when the inflation rate rose even higher and
unemployment increased.
Negative Supply
Shocks, 1973–1975
and 1978–1980
In 1973, the U.S. economy was hit by a series of negative supply shocks. As a
result of the oil embargo stemming from the Arab-Israeli war of 1973, the
Organization of Petroleum Exporting Countries (OPEC) was able to engineer
a quadrupling of oil prices by restricting oil production. In addition, a series
of crop failures throughout the world led to a sharp increase in food prices.
Another factor was the termination of wage and price controls in 1973 and
1974, which led to a push by workers to obtain wage increases that had been
prevented by the controls. The triple thrust of these events caused the aggregate supply curve to shift sharply leftward, and as the aggregate demand and
CHAPTER 25
Aggregate Demand and Supply Analysis
Table 3 Unemployment and Inflation During the Vietnam War Buildup,
1964–1970
Year
Unemployment Rate (%)
Inflation (Year to Year) (%)
1964
1965
1966
1967
1968
1969
1970
5.0
4.4
3.7
3.7
3.5
3.4
4.8
1.3
1.6
2.9
3.1
4.2
5.5
5.7
Source: Economic Report of the President.
supply diagram in Figure 6 predicts, both the price level and unemployment
began to rise dramatically (see Table 4).
The 1978–1980 period was almost an exact replay of the 1973–1975
period. By 1978, the economy had just about fully recovered from the
1973–1974 supply shocks, when poor harvests and a doubling of oil prices
(as a result of the overthrow of the Shah of Iran) again led to another sharp
leftward shift of the aggregate supply curve. The pattern predicted by Figure
6 played itself out again—inflation and unemployment both shot upward
(see Table 4).
Favorable
Supply Shocks,
1995–1999
In February 1994, the Federal Reserve began to raise interest rates, because
it believed the economy would be reaching the natural rate of output and
unemployment in 1995 and might become overheated thereafter. As we can
see in Table 5, however, the economy continued to grow rapidly, with unem-
Table 4 Unemployment and Inflation During the Negative Supply Shock Periods, 1973–1975 and
1978–1980
Year
Unemployment
Rate (%)
Inflation
(Year to Year) (%)
Year
Unemployment
Rate (%)
Inflation
(Year to Year) (%)
1973
1974
1975
4.8
5.5
8.3
6.2
11.0
9.1
1978
1979
1980
6.0
5.8
7.0
7.6
11.3
13.5
Source: Economic Report of the President.
599
600
PART VI
Monetary Theory
Table 5 Unemployment and Inflation During the Favorable Supply Shock
Period, 1995–2000
Year
Unemployment Rate (%)
Inflation (Year to Year) (%)
1995
1996
1997
1998
1999
5.6
5.4
4.9
4.5
4.2
2.8
3.0
2.3
1.6
2.2
Source: Economic Report of the President; ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt.
ployment falling to below 5%, well below what many economists believed to
be the natural rate level, and yet inflation continued to fall, declining to
around 2%. Can aggregate demand and supply analysis explain what happened?
The answer is yes. Two favorable supply shocks hit the economy in the
late 1990s. First, changes in the health care industry, such as the movements
to health maintenance organizations (HMOs), reduced medical care costs
substantially relative to other goods and services. Second, the computer revolution finally began to have a favorable impact on productivity, raising the
potential growth rate of the economy (which journalists have dubbed the
“new economy”). The outcome was a rightward shift in the aggregate supply
curve, producing the opposite result depicted in Figure 6: Aggregate output
rose, and unemployment fell, while inflation also declined.
Summary
1. The aggregate demand curve indicates the quantity of
aggregate output demanded at each price level, and it is
downward-sloping. Monetarists view changes in the
money supply as the primary source of shifts in the
aggregate demand curve. Keynesians believe that not
only are changes in the money supply important to
shifts in the aggregate demand curve, but so are
changes in fiscal policy (government spending and
taxes), net exports, and the willingness of consumers
and businesses to spend (“animal spirits”).
2. In the short run, the aggregate supply curve slopes
upward, because a rise in the price level raises the profit
earned on each unit of production, and the quantity of
output supplied rises. Four factors can cause the
aggregate supply curve to shift: tightness of the labor
market as represented by unemployment relative to the
natural rate, expectations of inflation, workers’ attempts
to push up their real wages, and supply shocks unrelated
to wages that affect production costs.
3. Equilibrium in the short run occurs at the point where
the aggregate demand curve intersects the aggregate
supply curve. Although this is where the economy
heads temporarily, it has a self-correcting mechanism,
which leads it to settle permanently at the long-run
equilibrium where aggregate output is at its natural rate
level. Shifts in either the aggregate demand or the
aggregate supply curve can produce changes in
aggregate output and the price level.
CHAPTER 25
Aggregate Demand and Supply Analysis
601
Key Terms
hysteresis, p. 597
aggregate demand, p. 582
Keynesians, p. 582
aggregate demand curve, p. 582
long-run aggregate supply curve,
p. 590
nonactivists, p. 592
modern quantity theory of money,
p. 584
planned investment spending, p. 585
monetarists, p. 582
self-correcting mechanism, p. 591
natural rate level of output, p. 590
supply shocks, p. 594
natural rate of unemployment, p. 590
velocity of money, p. 582
aggregate supply, p. 582
aggregate supply curve, p. 588
“animal spirits,” p. 586
complete crowding out, p. 587
consumer expenditure, p. 585
equation of exchange, p. 583
government spending, p. 585
QUIZ
nonaccelerating inflation rate of
unemployment (NAIRU), p. 590
activists, p. 592
partial crowding out, p. 587
real business cycle theory, p. 597
net exports, p. 585
Questions and Problems
Questions marked with an asterisk are answered at the end
of the book in an appendix, “Answers to Selected Questions
and Problems.”
1. Given that a monetarist predicts velocity to be 5,
graph the aggregate demand curve that results if the
money supply is $400 billion. If the money supply
falls to $50 billion, what happens to the position of
the aggregate demand curve?
*2. Milton Friedman states, “Money is all that matters to
nominal income.” How is this statement built into the
aggregate demand curve in the monetarist framework?
3. Suppose that government spending is raised at the
same time that the money supply is lowered. What
will happen to the position of the Keynesian aggregate
demand curve? The monetarist aggregate demand
curve?
*4. Why does the Keynesian aggregate demand curve shift
when “animal spirits” change, but the monetarist
aggregate demand curve does not?
5. If the dollar increases in value relative to foreign currencies so that foreign goods become cheaper in the
United States, what will happen to the position of the
aggregate supply curve? The aggregate demand curve?
*6. “Profit-maximizing behavior on the part of firms
explains why the aggregate supply curve is upwardsloping.” Is this statement true, false, or uncertain?
Explain your answer.
7. If huge budget deficits cause the public to think that
there will be higher inflation in the future, what is
likely to happen to the aggregate supply curve when
budget deficits rise?
*8. If a pill were invented that made workers twice as productive but their wages did not change, what would
happen to the position of the aggregate supply curve?
9. When aggregate output is below the natural rate level,
what will happen to the price level over time if the
aggregate demand curve remains unchanged? Why?
*10. Show how aggregate supply and demand analysis can
explain why both aggregate output and the price level
fell sharply when investment spending collapsed during the Great Depression.
11. “An important difference between monetarists and
Keynesians rests on how long they think the long run
actually is.” Is this statement true, false, or uncertain?
Explain your answer.
Using Economic Analysis to Predict the Future
*12. Predict what will happen to aggregate output and the
price level if the Federal Reserve increases the money
supply at the same time that Congress implements an
income tax cut.
13. Suppose that the public believes that a newly
announced anti-inflation program will work and so
lowers its expectations of future inflation. What will
602
PART VI
Monetary Theory
happen to aggregate output and the price level in the
short run?
*14. Proposals have come before Congress that advocate
the implementation of a national sales tax. Predict the
effect of such a tax on both the aggregate supply and
demand curves and on aggregate output and the price
level.
15. When there is a decline in the value of the dollar,
some experts expect this to lead to a dramatic
improvement in the ability of American firms to compete abroad. Predict what would happen to output
and the price level in the United States as a result.
Web Exercises
1. As this book goes to press, the U.S. economy is still
suffering from slow growth and relatively high unemployment. Go to www.whitehouse.gov/fsbr/esbr.html
and follow the link to unemployment statistics. What
has happened to unemployment since the last
reported figure in Table 5?
2. As the economy stalled toward the end of 2002, Fed
policymakers were beginning to be concerned about
deflation. Go to www.whitehouse.gov/fsbr/esbr.html
and follow the link to prices. What has happened to
prices since the last reported figure in Table 5? Does
deflation still appear to be a threat?