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Chapter 23
Aggregate
Demand and
Supply Analysis
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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
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Aggregate Demand (cont’d)
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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FIGURE 1 Shifts in the Aggregate
Demand Curve
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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.
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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
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Summary
Table 1
Factors That
Shift the
Aggregate
Demand Curve
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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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FIGURE 2 Long-Run Aggregate
Supply Curve
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FIGURE 3 Aggregate Supply Curve
in the Short Run
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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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Summary Table 2 Factors That Shift
the Short-Run Aggregate Supply Curve
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FIGURE 4 Equilibrium in the Short
Run
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FIGURE 5 Adjustment to Long-Run Equilibrium
in Aggregate Supply and Demand Analysis
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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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FIGURE 6 Response of Output and the
Price Level to a Shift in the Aggregate
Demand Curve
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FIGURE 7 Response of Output and the Price
Level to a Shift in Short-Run Aggregate Supply
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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 (holding the aggregate demand
constant)
• The economy has a self-correcting mechanism
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Table 3 Unemployment and Inflation During
the Vietnam War Buildup, 1964–1970
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Table 4 Unemployment and Inflation During
the Negative Supply Shocks Periods, 1973–1975
and 1978–1980
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Table 5 Unemployment and Inflation During
the Favorable Supply Shocks Period, 1995–1999
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Table 6 Unemployment and Inflation During
the Negative Demand Shocks Period, 2000–2004
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Table 7 Unemployment and Inflation During
the Perfect Storm of 2007–2008
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