Chapter 22
Aggregate Demand and
Supply Analysis
Aggregate Demand
• Aggregate demand is made up of four component parts:
– C = consumption expenditure, the total demand for consumer goods and services
– I = planned investment spending, the total planned spending by business firms on
new machines, factories, and other capital goods, plus planned spending on new
homes
– G = government purchases , spending by all levels of government (federal, state,
and local) on goods and services
– NX = net exports, the net foreign spending on domestic goods and services
Y ad  C  I  G  NX
Aggregate Demand
•
The Quantity Theory of Money (QTM) implies the aggregate demand curve is
downward sloping.
•
The QTM results when velocity is assumed to be constant in the equation of
exchange:
PL  Y  M  V
•
A constant money supply implies constant nominal aggregate spending
•
A decrease in the price level is matched with an increase in real GDP.
•
Recall that inflation is defined as follows:
PLis  PLwas
p
100
PLwas
•
Hence, a rise in real GDP is associated with a decline in PLis, which causes p to fall
for a given value of PLwas.
Aggregate Demand
QTM:
• The quantity of real GDP
demanded decreases in p.
p
p  b  Y ad  C  I  NX  G  T  r  f
AD
Y
Aggregate Demand
QTM:
• The quantity of real GDP
demanded decreases in p.
• AD increases when
o 𝐶 increases
o 𝐼 increases
p
AD
o 𝑁𝑋 increases
o 𝐺 is increased
o 𝑇 is cut
o 𝑟 decreases
o Financial friction 𝑓 decreases
p  b  Y ad  C  I  NX  G  T  r  f
Y
Aggregate Demand
Aggregate Demand
p  b  Y ad  C  I  NX  G  T  r  f
Aggregate Demand
Aggregate Demand
p  b  Y ad  C  I  NX  G  T  r  f

The Congress and President are in charge of fiscal policy.
Expansionary fiscal policy involves a cut in T and/or increase in G
Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policy
Expansionary monetary policy involves lowering the federal funds interest rate
Restrictive monetary policy involves raising the federal funds interest rate
Aggregate Demand
Aggregate Demand
p  b  Y ad  C  I  NX  G  T  r  f

The Congress and President are in charge of fiscal policy.
 Expansionary fiscal policy involves a cut in T and/or increase in G
Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policylves raising the
federal funds interest rate
Aggregate Demand
Aggregate Demand
p  b  Y ad  C  I  NX  G  T  r  f

The Congress and President are in charge of fiscal policy.
 Expansionary fiscal policy involves a cut in T and/or increase in G
Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policy
 Expansionary monetary policy involves lowering the federal funds interest rate
Restrictive monetary policy involves raising the federal funds interest rate
Aggregate Demand
Aggregate Demand
p  b  Y ad  C  I  NX  G  T  r  f

The Congress and President are in charge of fiscal policy.
 Expansionary fiscal policy involves a cut in T and/or increase in G
 Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policy
 Expansionary monetary policy involves lowering the federal funds interest rate
Aggregate Demand
Aggregate Demand
p  b  Y ad  C  I  NX  G  T  r  f

The Congress and President are in charge of fiscal policy.
 Expansionary fiscal policy involves a cut in T and/or increase in G
 Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policy
 Expansionary monetary policy involves lowering the federal funds interest rate
 Restrictive monetary policy involves raising the federal funds interest rate
Long Run Aggregate Supply
Simulated LRAS

Example: Suppose the economy’s production function shows the volume of output that
can be produced by its labor force (L) given its physical capital (K), land and natural
resources (R), and technology and entrepreneurial talent (Z).
Y  Z K RL
Suppose R = 0.4 (trillion dollars of land, oil, coal, natural gas…), K = 2.5 (trillion dollars
of physical capital like machines, roads, networks…) and z = 1.25 (percent of all
knowledge in the universe is known on Earth).
1.
What is the economy’s short-run production function?
Y  1.25 0.4  2.5  L
Y  1.25 L
Long Run Aggregate Supply
Simulated LRAS

Example (continued):
2. Graph the economy’s short-run production function.
Y  1.25 L
L
Y
0
0
50
8.839
100
12.500
150
15.309
L
Long Run Aggregate Supply
Simulated LRAS

Example (continued):
3. Suppose there are 9 million workers that are frictionally or structurally unemployed, and
135 million of the 144 million in the labor force are employed. Compute u, un, uc, real
GDP, and Yp.
un 
Un
9

 6.25%
L f 144
Yp  1.25 L f  1.25 144  15
u
Lf  E
Lf

15
144  135
 6.25%
144
uc  u  un  6.25  6.25  0%
Y  1.25 E  U n  1.25 135 + 9  15
L
144
Long Run Aggregate Supply
Simulated LRAS

Example (continued):
Yp  Z K  R  L f
4. Graph LRAS.
Yp  15
LRAS
PL
30
20
10
0
15
Y
Long Run Aggregate Supply
Simulated LRAS

Example (continued):
4. Suppose there are 9 million workers that are frictionally or structurally unemployed, and
112 million of the 144 million in the labor force are employed. Compute u, un, uc, real
GDP, and Yp.
un 
Un
9

 6.25%
L f 144
Yp  1.25 L f  1.25 144  15
15
13.75
Unemployment
is too high
u
Lf  E
Lf

144  112
 22.22%
144
uc  u  un  22.22  6.25  15.97%
Y  1.25 E  U n  1.25 112 + 9  13.75
GDP is lower
than what it
should be
L
121
144
Long Run Aggregate Supply
Simulated LRAS

Example (continued):
5. Suppose there are 9 million workers that are frictionally or structurally unemployed, and
140 million of the 144 million in the labor force are employed. Compute u, un, uc, real
GDP, and Yp.
un 
Un
9

 6.25%
L f 144
Yp  1.25 L f  1.25 144  15
15.26
15
Unemployment
is too low
u
Lf  E
Lf

144  140
 2.78%
144
uc  u  un  2.78  6.25  3.47%
Y  1.25 E  U n  1.25 140 + 9  15.26
GDP is higher
than what it
should be
L
144149
Long Run Aggregate Supply
Simulated LRAS

Example: With the labor force equal to 144 million workers, show what happens if
•
Resources rises by 0.5 trillion dollars
•
Physical capital increases by 0.5 trillion dollars
•
The number of laborers falls by 12 million
•
Nominal wage rates rise by 1 dollar per hour
•
Nominal prices of other inputs increases by 1 dollar per hour
•
Supply side taxes are cut by 1 percentage point.
What is monetary policy, and who conducts it?
What is fiscal policy, and who conducts it?
Short Run Aggregate Supply
SRAS is the relationship between the quantity of real GDP supplied and p when all
other influences on production plans remain the same

SRAS shifts upward (decreases) when
 Expected inflation rises
o Workers expecting the PL to rise will demand one-for-one adjustments in w
Dp e = Dw



o In the short-run, w is the most important factor to producing products
o Inflation increases one-for-one in expected inflation
a price shock (up) occurs due to the nominal price of a resource like energy ( r).
Government permanently changes the supply-side tax rate (t )
Output gap Y – Yp widens
o workers are being offered higher w and better benefits due to u being too low
o In the short-run, it is believed this pushes inflation higher due to firms raising their
prices.
o This makes SRAS upward sloping.
p = p e + r +t + g (Y – Yp)
p = g Y + p e + r +t – g Y p
Short Run Aggregate Supply

Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of
machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or
structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity
of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the
supply-side tax rate is 6 (percent).
1.
Graph the potential GDP you computed in part (3) with AD
Yp = 15
p = g Y + p e + r +t – g Y p
Short Run Aggregate Supply

Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of
machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or
structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity
of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the
supply-side tax rate is 6 (percent).
1.
Graph the potential GDP you computed in part (3) with AD
Yp = 15
p = g Y + p e + r +t – g 15
Short Run Aggregate Supply

Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of
machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or
structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity
of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the
supply-side tax rate is 6 (percent).
1.
Graph the potential GDP you computed in part (3) with AD
Yp = 15
p = 0.5Y + p e + r +t – 7.5
Short Run Aggregate Supply

Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of
machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or
structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity
of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the
supply-side tax rate is 6 (percent).
1.
Graph the potential GDP you computed in part (3) with AD
Yp = 15
p = 0.5Y + 1.5 + r +t – 7.5
Short Run Aggregate Supply

Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of
machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or
structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity
of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the
supply-side tax rate is 6 (percent).
1.
Graph the potential GDP you computed in part (3) with AD
Yp = 15
p = 0.5Y + 1.5 + 0 +t – 7.5
Short Run Aggregate Supply

Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of
machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or
structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity
of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the
supply-side tax rate is 6 (percent).
1.
Graph the potential GDP you computed in part (3) with AD
Yp = 15
p = 0.5Y + 1.5 + 0 + 6 – 7.5
Short Run Aggregate Supply

Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of
machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or
structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity
of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the
supply-side tax rate is 5 (percent).
1.
Graph the potential GDP you computed in part (3) with AD
Yp = 15
p = 0.5Y
Short Run Aggregate Supply

Example (continued):
2.
Graph SRAS:
p = 0.5Y
p
SRAS
7.5
15
Y
Short Run Aggregate Supply

Example (continued):
3.
What happens if government cuts supply-side taxes by 1 percentage point?
p
p = 0.5Y + 1.5 + 0 + 5
6 – 7.5
SRAS
SRAS’
Supply-side tax cuts
increase SRAS.
7.5
-1
15 17
Y
Short Run Aggregate Supply
p = g Y + p e + r +t – g Y p
Short Run Aggregate Supply
p = g Y + p e + r +t – g Y p

The Congress and President are in charge of fiscal policy.
 Expansionary supply-side fiscal policy involves cutting t
Restrictive supply-side fiscal policy involves raising t

The Federal Reserve (our central bank) is in charge of monetary policy


Expansionary monetary policy lowers the federal funds interest rate
Restrictive monetary policy raises the federal funds interest rate
Short Run Aggregate Supply
p = g Y + p e + r +t – g Y p

The Congress and President are in charge of fiscal policy.
 Expansionary supply-side fiscal policy involves cutting t
 Restrictive supply-side fiscal policy involves raising t

The Federal Reserve (our central bank) is in charge of monetary policy


Expansionary monetary policy lowers the federal funds interest rate
Restrictive monetary policy raises the federal funds interest rate
Aggregate Market Model
Equilibrium

Example (continued):
4.
Graph LRAS with SRAS:
p
p = 0.5Y
Yp = 15
LRAS
SRAS
7.5
15
Y
Aggregate Market Model
Equilibrium

Example (continued):
5.
Suppose the labor force increases by 25 million workers. Show the effect of this on
LRAS and SRAS.
p
LRAS LRAS’
Y  1.25 0.4  2.5  169
144
SRAS
Yp = 16.25 (trillion $)
7.5
15 16.25
Y
Aggregate Market Model
Equilibrium

Example (continued):
5.
Suppose the labor force increases by 25 million workers. Show the effect of this on
LRAS and SRAS.
p
LRAS LRAS’
SRAS
SRAS’
Yp = 16.25 (trillion $)
7.5
16.25
p = 0.5Y + 1.5 + 0 + 6 – 0.5 ·15
p = 0.5Y – 0.625
-0.625
15 16.25
Y
Aggregate Market Model
Equilibrium

Example (continued):
6.
Graph LRAS, AD & SRAS:
p
Yp = 15
p = 0.5Y
p = 15 – 0.5 Y
LRAS
SRAS
7.5
AD
15
Y
Aggregate Market Model
Equilibrium

Example (continued):
7.
Graph LRAS, AD & SRAS:
p
Yp = 15
p = 0.5Y
p = 14 – 0.5 Y
LRAS
SRAS
7
AD
14 15
Y
Aggregate Market Model
Equilibrium

Example (continued):
7.
Graph LRAS, AD & SRAS:
Yp = 15
p = 0.5Y
p = 14 – 0.5 Y
p = g Y + p e + r +t – g Y p
p
LRAS
SRAS
7
AD
14 15
Y
Aggregate Market Model
Equilibrium

Example (continued):
7.
Graph LRAS, AD & SRAS:
Yp = 15
p = 0.5Y
p = 14 – 0.5 Y
p = g Y + p e + r +t – g Y p
p
LRAS
SRAS
7
6.5
AD
14 15
Y
Aggregate Market Model
Equilibrium

Example (continued):
7.
Graph LRAS, AD & SRAS:
Yp = 15
p = 0.5Y
p = 14 – 0.5 Y
p = g Y + p e + r +t – g Y p
p
LRAS
SRAS
But wages are inflexible…
…need active government policy
7
6.5
AD
14 15
Y
Aggregate Market Model
Equilibrium

Example (continued):
8.
Graph LRAS, AD & SRAS:
p
Yp = 15
p = 0.5Y
p = 16 – 0.5 Y
LRAS
SRAS
8
AD
15
16
Y
Aggregate Market Model
Equilibrium

Example (continued):
8.
Graph LRAS, AD & SRAS:
Yp = 15
p = 0.5Y
p = 16 – 0.5 Y
p = g Y + p e + r +t – g Y p
p
LRAS
SRAS
8
AD
15
16
Y
Aggregate Market Model
Equilibrium

Example (continued):
8.
Graph LRAS, AD & SRAS:
Yp = 15
p = 0.5Y
p = 16 – 0.5 Y
p = g Y + p e + r +t – g Y p
p
LRAS
SRAS
8.5
8
AD
15
16
Y
Aggregate Market Model
Equilibrium

Example (continued):
8.
Graph LRAS, AD & SRAS:
Yp = 15
p = 0.5Y
p = 16 – 0.5 Y
p = g Y + p e + r +t – g Y p
p
LRAS
SRAS
8.5
Wages and prices are
flexible
AD
15
Y
Positive Demand Shock
AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift
Positive Demand Shock
AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift
p
LRAS
SRAS
3
2
AD
12
13
Y
Positive Demand Shock
AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift
p
LRAS
SRAS
3.5
3
2
AD
12
13
Y
Negative Demand Shock
AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift
p
LRAS
SRAS
2
1.5
AD
11 12
Y
Negative Demand Shock
AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift
p
LRAS
SRAS
2
1.5
1.25
AD
11 12
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
AD
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
AD
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
6.2
AD
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
6.2
AD
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
6.2
AD
3.2
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
6.2
AD
4.3
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
6.2
AD
3.6
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
6.2
AD
3.6
1.9
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
13.5
10.3
6.2
AD
3.6
1.9
Yp
Y
Negative Demand Shock
The Volcker Disinflation
p
LRAS
1.9
AD
Yp
Y
Negative Demand Shock
2001-2004
p
LRAS
SRAS
4.5
3.1
AD
11 12
Y
Negative Demand Shock
2001-2004
p
LRAS
SRAS
4.5
3.1
1.6
AD
11 12
Source: Economic Report of the President.
Y
Supply Shock
•
Temporary supply shock
– SRAS shifts
– LRAS does not shift
•
Permanent supply shock
– SRAS shifts
– LRAS shifts
– E.g., permanent negative supply shock occurs when ill-advised regulations that cause the
economy to be less efficient are adopted
– Real business cycle theory (Edward Prescott of ASU) says that business cycle
fluctuations result from permanent supply shocks
Temporary Negative Supply Shock
1973-1980
p
LRAS
SRAS
6
5
AD
11
12
Y
Permanent Positive Supply Shock
1995–1999
p
LRAS
SRAS
5
4
AD
12
13
Y
Negative Demand and Supply Shocks
2007–2009
LRAS
p
SRAS
4
3
0
AD
11
12
Y
Negative Demand and Supply Shocks
2007–2009
LRAS
p
SRAS
4
3
0
-1
AD
11 11
12
Y
Conclusions
Aggregate demand and supply analysis yields the following conclusions:
1. A shift in the aggregate demand curve affects output only in the short run and has
no effect in the long run
2. A temporary supply shock affects output and inflation only in the short run and has
no effect in the long run (holding the aggregate demand curve constant)
3. A permanent supply shock affects output and inflation both in the short and the long
run
4. The economy has a self-correcting mechanism that returns it to potential output and
the natural rate of unemployment over time
5. Monetary policy has a short-run affect on AD only