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Chapter 22

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 (contd)

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 (contd)


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, 19641970

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Table 4 Unemployment and Inflation During the


Negative Supply Shocks Periods, 19731975 and
19781980

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Table 5 Unemployment and Inflation During the


Favorable Supply Shocks Period, 19951999

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Table 6 Unemployment and Inflation During the


Negative Demand Shocks Period, 20002004

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Table 7 Unemployment and Inflation During the


Perfect Storm of 20072008

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