THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 654

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PA R T V I I Monetary Theory
increase in the quantity of aggregate demand (Yad c), shifting the aggregate
demand curve to the right from AD1 to AD2.2
In contrast to the quantity theory, the components approach suggests 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 c) or net exports increase (NX c), the quantity of aggregate output demanded at
each price level 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 c). The quantity of aggregate output demanded
at each price level 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 c, I c), again shifting the aggregate demand
curve to the right. John Maynard 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.

Summary

You have seen that both the quantity theory and components approaches to aggregate demand agree that the aggregate demand curve slopes downward and shifts
in response to changes in the money supply. However, in the quantity theory
approach there is only one important source of movements in the aggregate
demand curve changes in the money supply. The components approach suggests that other factors fiscal policy, net exports, and animal spirits are
equally important sources of shifts in the aggregate demand curve. Our discussion
of quantity theory and components approaches indicates that six factors can shift
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 (often referred to as demand shocks) is summarized in Table 24-1.

AG GRE G AT E SU P PLY
To complete our analysis we need to derive an aggregate supply curve, the relationship between the quantity of output supplied and the price level. In the typical
supply and demand analysis, we have only one supply curve, but because prices
and wages take time to adjust to their long-run level, the aggregate supply curve
differs in the short and the long runs. First, we examine the long-run aggregate supply curve. We then derive the short-run aggregate supply curve and see how it shifts
over time as the economy moves from the short run to the long run.

Long-Run
Aggregate
Supply Curve

The amount of output that can be produced in the economy in the long run is
determined by the amount of capital in the economy, the amount of labour supplied
at full employment, and the available technology. As discussed in Chapter 18,
some unemployment cannot be helped because it is either frictional or structural. Thus
full employment is not at zero, but is rather at a level above zero at which the demand
for labour equals the supply of labour. This natural rate of unemployment is

2

A complete demonstration of the components approach to the aggregate demand curve is given in
Chapters 22 and 23.