aggregate demand and supply analysis

Copyright 2011 
Pearson Canada Inc.
24 -
1
Chapter 24
Aggregate Demand and Supply Analysis
Copyright 2011 
Pearson Canada Inc.
24 -
2
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
Y
AD
= C + I + G + NX
Copyright 2011 
Pearson Canada Inc.
24 -

3
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
Multiplying both sides by M we derive the equation of exchange
which relates money supply to aggregate spending
M x V = P x Y
Changes in aggregate spending are determined primarily by
changes in the money supply
M
YxP
V =
Copyright 2011 
Pearson Canada Inc.
24 -
4
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.
Copyright 2011 
Pearson Canada Inc.
24 -
5
Aggregate Demand Curve
Copyright 2011 
Pearson Canada Inc.
24 -
6
Behaviour of Aggregate Demand’s
Component Parts
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 ↓ → Y
AD
↑
Copyright 2011 
Pearson Canada Inc.
24 -
7
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
Copyright 2011 
Pearson Canada Inc.
24 -
8
Factors That Shift the Aggregate Demand
Curve I
Copyright 2011 
Pearson Canada Inc.
24 -
9
Factors That Shift the Aggregate Demand
Curve II
Copyright 2011 
Pearson Canada Inc.
24 -
10
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
Copyright 2011 
Pearson Canada Inc.
24 -
11
Long Run Aggregate Supply
Copyright 2011 
Pearson Canada Inc.
24 -
12
Short Run Aggregate Supply
Copyright 2011 
Pearson Canada Inc.
24 -
13
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)
Copyright 2011 
Pearson Canada Inc.
24 -
14
Factors that Shift Short Run Aggregate Supply II
Copyright 2011 
Pearson Canada Inc.
24 -
15
Equilibrium of AS and AD in the Short Run
Copyright 2011 
Pearson Canada Inc.
24 -
16
Equilibrium of AS and AD in the Long Run I
Copyright 2011 
Pearson Canada Inc.
24 -
17
Equilibrium of AS and AD in the Long Run II
Insert Figure 24-5 panel (b)
Copyright 2011 
Pearson Canada Inc.
24 -

18
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
Copyright 2011 
Pearson Canada Inc.
24 -
19
Response of Output and the Price Level to a
Shift in the AD Curve
Copyright 2011 
Pearson Canada Inc.
24 -
20
Response of Output and the Price Level to a
Shift in the AS Curve
Copyright 2011 

Pearson Canada Inc.
24 -
21
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
Copyright 2011 
Pearson Canada Inc.
24 -
22
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
Copyright 2011 
Pearson Canada Inc.
24 -
23
Unemployment and Inflation in the United
States 1964 -1970
Copyright 2011 
Pearson Canada Inc.
24 -
24
Unemployment and Inflation in Canada
1973-75 and 1978-80
Copyright 2011 
Pearson Canada Inc.
24 -
25
Negative Supply Shocks In Canada: 2007- 2008