THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 665

CHAPTER 24

Aggregate Demand and Supply Analysis

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rises because of a reduction of aggregate demand that shifts the AD curve inward,
the natural rate of unemployment is viewed as rising above the full employment
level. This could occur because the unemployed become discouraged and fail to
look hard for work or because employers may be reluctant to hire workers who
have been unemployed for a long time, seeing it as a signal that the worker is
undesirable. The outcome is that the natural rate of unemployment shifts upward
after unemployment has become high, and Yn falls below the full employment
level. In this situation, the self-correcting mechanism will be able to return the
economy only to the natural rate levels of output and unemployment, not to the
full employment level. Only with expansionary policy to shift the aggregate
demand curve to the right and raise aggregate output can the natural rate of
unemployment be lowered (Yn raised) to the full employment level. Proponents
of hysteresis are thus more likely to promote governmemnt intervention and
expansionary policies to restore the economy to full employment.

Conclusions

Aggregate demand and supply analysis yields the following conclusions (under the
usual assumption that the natural rate level of output is unaffected by aggregate
demand and supply shocks):
1. A shift in the aggregate demand curve which can be caused by changes in
monetary policy (the money supply), fiscal policy (government spending or
taxes), international trade (net exports), or animal spirits (business and consumer optimism) affects output only in the short run and has no effect in the
long run. Furthermore, the initial change in the price level is less than is
achieved in the long run, when the aggregate supply curve has fully adjusted.

2. A shift in the aggregate supply curve which can be caused by changes in
expected inflation, workers attempts to push up real wages, or a supply
shock affects output and prices only in the short run and has no effect in the
long run (holding the aggregate demand curve constant).
3. The economy has a self-correcting mechanism, which will return it to the
natural rate levels of unemployment and aggregate output over time.

A PP LI CATI O N

Explaining Past Business Cycle Episodes
Aggregate supply and demand analysis is an extremely useful tool for analyzing
aggregate economic activity; we will apply it to several business cycle episodes.
To simplify our analysis, we always assume that aggregate output is initially at the
natural rate level.

The United
States During
the Vietnam
War Buildup,
1964 1970

America s involvement in Vietnam began to escalate in the early 1960s, and after
1964, the United States was fighting a full-scale war. Beginning in 1965, the resulting increases in military expenditure raised government spending, while at the
same time the Federal Reserve increased the rate of money growth in an attempt
to keep interest rates from rising. What does aggregate supply and demand analysis suggest should have happened to aggregate output and the price level in the
United States as a result of the Vietnam War buildup?
The rise in government spending and the higher rate of money growth would
shift the aggregate demand curve to the right (shown in Figure 24-6 on page 631).