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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 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 YAD = C + I + G + NX
Chapter 24 Aggregate Demand and Supply Analysis 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 YAD = C + I + G + NX Quantity Theory of Money Approach to Aggregate Demand M =quantity of money P= price level Y= aggregate real output (real income) P x Y = total nominal spending on goods and services V = the average number of time per year that a dollar is spent V= P xY M Multiplying both sides by M we derive the equation of exchange which relates money supply to aggregate spending MxV=PxY Changes in aggregate spending are determined primarily by changes in the money supply Deriving the Aggregate Demand 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 Curve Behaviour of Aggregate Demand’s Component Parts YAD = C + I + G + NX The aggregate demand curve is downward sloping because P ↓ → M/P ↑ →i ↓ → I ↑ → YAD ↑ and P ↓ → M/P ↑ →i ↓ → E ↓ → YAD ↑ 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 Factors That Shift the Aggregate Demand Curve I Factors That Shift the Aggregate Demand Curve II Aggregate 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 Supply Short Run Aggregate Supply Factors that Shift Short Run Aggregate Supply I • 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 Aggregate Supply II Equilibrium of AS and AD in the Short Run Equilibrium of AS and AD in the Long Run I Equilibrium of AS and AD in the Long Run II Insert Figure 24-5 panel (b) 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 Response of Output and the Price Level to a Shift in the AD Curve Response of Output and the Price Level to a Shift in the AS Curve 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 Conclusions • 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 United States 1964 -1970 Unemployment and Inflation in Canada 1973-75 and 1978-80 Negative Supply Shocks In Canada: 2007- 2008 ... Shift the Aggregate Demand Curve I Factors That Shift the Aggregate Demand Curve II Aggregate Supply • Long-run aggregate supply curve (LRAS) – Determined by amount of capital and labor and the.. .Aggregate Demand • Aggregate Demand - The relationship between the quantity of aggregate output demanded and the price level when all other variables... in aggregate spending are determined primarily by changes in the money supply Deriving the Aggregate Demand Curve • Changes in the price level induce changes in the aggregate output demanded and