THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 653

CHAPTER 24

Aggregate Demand and Supply Analysis

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demanded (P* + Yad c), and so the aggregate demand curve slopes down as in
Figure 24-1. Schematically, we can write the mechanism just described as follows:
P * + M/P c + i * + I c + Y ad

c

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 c) and lower interest rates (i *),
Canadian-dollar assets become less attractive relative to assets denominated in foreign currencies, thereby causing a fall in the value of dollar assets relative to other
currency assets (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 (NX c), which in turn increases aggregate demand (Y ad c):
P * + M/P c + i * + E * + NX c +Y ad

c

The fact that the aggregate demand curve is downward sloping can also be
derived from the quantity theory of money analysis in Chapter 21. The equation
of exchange, MV = PY, indicates that if velocity stays constant, a constant money
supply (M) implies that nominal aggregate spending (PY) is also constant. When
the price level falls (P *), aggregate demand must necessarily rise (Yad c) to keep
aggregate spending at the same level.

Factors That

Shift the
Aggregate
Demand
Curve

The quantity theory analysis shows that an increase in the money supply (M c)
shifts the demand curve to the right, because with velocity constant the higher
money supply raises nominal aggregate spending (PY c) and hence at a given price
level the quantity of aggregate demand increases (Yad c). An increase in the quantity of money increases the quantity of aggregate demand at each price level and
shifts the aggregate demand curve to the right from AD1 to AD2 in Figure 24-1. A
components approach to aggregate demand also indicates that changes in the
money supply cause the aggregate demand curve to shift via the two mechanisms
shown in the schematics above. For a given price level, a rise in the money supply causes the real money supply to increase (M/P c), which leads to a decline in
interest rates (i *), an increase in investment and net exports (I, NX c), and an

Aggregate
Price Level, P

AD1

AD2
Aggregate Output, Y

FIGURE 24-1

Aggregate Demand Curve

A decrease in taxes (T *) or an increase in the money supply (M c), government expenditure
(G c), net exports (NX c), or business or consumer optimism (C c, I c) increases aggregate
demand at each aggregate price level and shifts the aggregate demand curve from AD1 to AD2