Aggregate Demand and Supply
Linking Monetary Policy to Price
and Output
Aggregate Demand
• Define aggregate demand as the total demand for an
economy’s output (production of goods and services)
over a given period of time.
• Demand may come from households (consumption),
firms (investment), the public sector (government
spending) or foreign households, firms, or governments
(net exports).
– YAD = C + I + G + NX
• We assume an inverse relationship between price and
aggregate demand
Aggregate Demand Rises as Price Falls
• Suppose aggregate prices in the economy fell
• This would cause the demand for money to shift in, causing interest
rates to decline
– Alternatively, the real money supply (M/P) rises, causing interest rates
to fall.
• With lower interest rates, the opportunity cost of consumption is
lower:
– P↓  Md↓  i↓  C↑
• With lower interest rates, the direct cost of investment falls:
– P↓  Md↓  i↓  I↑
• With lower interest rates a country’s currency will depreciate. A
weaker currency makes exports cheaper and imports more
expensive
– P↓  Md↓  i↓  Exchange Rate↓  NX↑
The Aggregate Demand Curve
P
2
1
AD
100
180
Y
Factors that Shift the AD Curve
• Anything (other than price!) that causes C, I, G, or NX to increase
will shift the AD curve to the right.
• C increases when…
– There is an increase in consumer confidence, leading to more current
consumption and less current savings
– Taxes are cut leaving consumers with more income to spend (assuming
Ricardian Equivalence doesn’t hold!)
• I increases when…
– Business confidence rises, prompting firms to invest more for the future.
• G increases when…
– Government spending increases
• NX increases when…
– There is increased preference for domestically produced goods.
• An increase in the money supply will cause AD to shift right
– Interest rates are lower, so C and I rise. The currency weakens, so NX
increases.
Increasing the Money Supply
P
2
1
AD2
80
140
AD1
200
Y
Long Run Aggregate Supply
• In the long run, money is neutral
– Any changes in the money supply will be met by a proportionate change
in prices
– Increasing the money supply will not affect the economy’s output in the
long run.
• Long run output is determined entirely by an economy’s productive
capacity
– Production Function: YP = A*F(K,L,H,N)
• Only changes in real variables can affect potential output.
– Price does not have any effect on YP
• In the long run, all resources are being efficiently utilized such that
unemployment equals the natural rate
Long Run Aggregate Supply
LRAS
P
2
1
YP = 140
Y
Short Run Aggregate Supply
• In the short run, money is not neutral
– An increase in the money supply need not trigger an immediate
increase in price.
– Prices are sticky due to uncertainty, menu costs, and long-term
contracts.
• Suppose output prices across the economy rise.
– Wage and input contracts do not immediately adjust to higher
output prices.
– Profit per unit rise, leading to an increase in production.
– Eventually, these contracts will readjust to factor in the higher
cost of living, erasing the increased profits and returning output
back to YP
Short Run Supply Shocks
• Tightness in the labor market.
– Suppose that because of a big economic expansion, the economy is
producing at an output level Y that is greater than YP.
– This suggests that the economy is using more labor than it normally
does.
– To get people to work longer hours, you have to pay them more.
– This increase in labor costs will shift the SRAS curve left, as profit per
output falls when labor costs rise.
• Expectations about inflation
– If workers expect inflation to be higher in the future, they will demand
higher wages in anticipation of this increase in the cost of living.
– Higher wages reduce firm profit and shift SRAS left
• Supply shocks to critical raw materials
– Suppose a war broke out between the US and Iran. Oil prices would
rise dramatically
– Since oil is such a pervasive part of nearly everything we produce,
production costs would rise significantly.
– The SRAS curve would shift left as the return on production fell.
Lower Expected Inflation
LRAS1
SRAS1
P
SRAS2
1
YP = 140
200
Y
Short Run Equilibrium
P
SRAS
PH
Surplus
P*
Shortage
PL
AD
Y*
Y
Long Run Equilibrium
LRAS
P
SRAS2
SRAS1
P*
PL
AD
YP
Y
Over-employment  Wages must rise!
Y
The Self-Correcting Economy
• Suppose that a decrease in consumer confidence causes the
aggregate demand curve to shift left.
• At current prices, there will be a surplus of production as consumers
demand fewer goods and services
• Firms will cut both their prices and their production until the surplus
inventory is sold.
• Output and prices fall in the short run, resulting in a recession.
• Eventually, lower output prices and less demand for labor will induce
a fall in production costs.
• The SRAS curve will shift right until full employment output is
restored at a lower price (assuming consumer confidence never
recovered).
• The economy will always return to full-employment output, but how
long does this adjustment process take?
A Drop in Consumer Confidence
LRAS
P
SRAS1
SRAS2
P1
P2
P3
AD2
Y
YP
Unemployment  Wages must fall!
AD1
Y
Keynesians vs. Monetarists
• If you believe that prices and wages are very slow to adjust, then
would you advocate an active or passive role for economic policy?
• In the last example, the economy suffered a recession as a result of
the drop in consumer confidence.
– The duration of the recession was entirely dependant on the amount of
time it took for price and wage contracts to readjust and shift the SRAS
curve out to the right.
– If this happened quickly, then the recession was brief.
• What if in response to the drop in consumer confidence, the Fed
decided to buy bonds from the public?
– This would expand the monetary base, and assuming no significant
drops in the money multiplier, an increase in the money supply.
– In the short run (at least) this will cause interest rates to fall and shift AD
out to the right.
– By compensating for the drop in consumer confidence with easy
liquidity, the Fed can hasten the end of the recession, albeit at the cost
of higher prices.
Central Bank Intervention
LRAS
P
SRAS1
P1
P2
P3
AD2
Y
YP
AD1 = AD3
Y
Conclusions
• Shift in aggregate demand affects output
only in the short run and has no effect in the long
run
• Shifts in aggregate demand affects only price
level in the long run
• Shift 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
• The pace of self-correction may justify policy
intervention.
Vietnam War Buildup
LRAS
P
SRAS2
SRAS1
P3
P2
P1
AD2
AD1
YP
Y
Y
OPEC Oil Shocks
LRAS
P
SRAS2
SRAS1
P2
P1
AD1
Y
YP
Y
The 1990’s Tech Boom
LRAS
P
SRAS1
SRAS2
P1
P2
AD1
YP
Y
Y
The Current Situation
LRAS
SRAS2
P
SRAS1
Rising oil prices
raise production
costs
P2
P1
Housing market crash
lowers consumer
confidence
AD2
Y
YP
AD1
Y