Chapter 24: Aggregate Demand and Supply Analysis

In chapter 24, we build a model that links monetary policy to changes in prices and output. From Principles of Macroeconomics you should recognize the basic of the aggregate demand and supply analysis that we use here.

I.  Aggregate Demand

The aggregate demand (AD) curve is the relationship between the overall price level and aggregate output (real GDP) in the economy, holding other factors constant. Both Monetarists and Keynesians view the AD curve as downward-sloping:

However, Monetarists and Keynesians have different opinions on how AD responds to changes in other factors.

Monetarist View

Recall the quantity theory of money relationship: MV = PY
So for a given M and V, higher levels of P must be associated with lower levels of Y, and vice versa. Thus, the AD curve is downward sloping.
If M rises, then the same output Y is associated with a higher price P:

So an increase in the money supply shifts AD right, while a decrease in the money supply shifts AD left.

Keynesian View

Keynesians analyze AD in terms of its components:

So Y = C + I + G + NX
When P rises, real balances (M/P) fall, causing interest rates to rise. Higher interest rates discourage consumption and investment spending, leading to a lower Y. Similarly, lower prices lead to a higher Y:

Thus, the AD curve is downward sloping.

Keynesians believe any changes in C, I, G, NX that are NOT caused by price changes will shift the AD curve.
Keynesians also believe that money supply shifts the aggregate demand curve, but for a different reason than the Monetarists. Changes in the money supply alter the interest rate, which affects consumption and investment expenditures and shift AD:

Crowding Out

Both Monetarist and Keynesian believe that the AD curve is downward sloping and that changes in the money supply shift the AD curve. So how is it that Keynesians believe changes in G shift AD while Monetarists do not? The answer lies in the extent of crowding out that occurs with increases in government spending (or any other spending). As G rises and the government increases its borrowing, interest rates rise. These higher interest rates discourage or CROWD OUT private spending on consumption, investment, and net exports:

Monetarists believe this crowding out is complete, i.e. that the increase in G is totally offset by the fall in C, I , and NX. Thus, changes in spending do not shift the AD curve.

Keynesians believe this crowding out is only partial, i.e. that the increase in G is larger than the resulting fall in C, I, and NX. So overall, changes in spending do shift the AD curve.

II.  Aggregate Supply

The aggregate supply (AS) curve is upward sloping in the short run: higher prices levels are associated with a high quantity of output supplied.

Why? The reason lies in profits. In the short-run many costs are fixed: rent, salaries, supplier contracts. If prices rise, then suppliers get an increase in the price they receive, but their costs do not increase by the same amount. This causes profits to rise, so suppliers increase output. If prices fall, profits fall, and suppliers decrease output.

The AS curve shifts due to changes in the cost of production, such as higher wages or a rise in the price of raw materials. Higher production costs shift the AS left, lower production costs shift AS curve right.

III.  Equilibrium

There are two types of equilibrium: short-run and long-run.

Short-Run

Short-run equilibrium occurs when the AS and AD curves intersect:

The equilibrium level of output is Y* and the equilibrium price level is P*.

Long-Run

In the long run, the costs of production will change. However a given AS curve holds the costs of production constant. So in the long run, changes in the cost of production many shift the AS curve. So what is an equilibrium in the short run may not be an equilibrium in the long run.

If the economy is booming, the labor market will be tight. That is, firms will have a hard time finding and keeping workers. This shortage in the labor market will push wages up. Higher wages mean higher production costs, and the AS curve will decrease or shift left. Equilibrium output will fall and price level will rise:

If the economy is in recession, there is a surplus of labor, and workers will accept lower wages to keep or find a job. Lower wages will shift the AS curve right. Equilibrium output will rise and price level will fall:

So where is the labor market just right? Recall that the natural rate of unemployment is the long-run unemployment level in the economy. When the unemployment rate is higher than the natural rate, there will be downward pressure on wages. When the unemployment rate is lower than the natural rate, there will be upward pressure on wages. The level of output corresponding to the natural rate of unemployment is called the natural rate level of output, or Yn in the graphs above.

When AD and AS intersect at Yn, then we are at a long run equilibrium. Otherwise, forces in the labor market will shift the AS curve until we reach Yn. So the vertical line at Yn can be considered the long run aggregate supply curve:

Note that forces always return us to a natural rate level of output in our model. In other words, the economy has a self-correcting mechanism that pulls us out of recessions or slows down the economy during a boom.

With a self-correcting mechanism, why should the government do anything to interfere with the economy? Well, the question remains as to how long it takes the economy to self-correct. 6 months? 1 year? 10 years?

Keynesians tend to believe that self-correction takes a long time because wages are somewhat inflexible and do not fall quickly when unemployment is high. They advocate activist policies where the government uses monetary or fiscal policy to shift the AD curve to return to Yn.

Monetarists believe that wages adjust rapidly so the self-correction occurs relatively quickly. They advocate nonactivist policies where the government does not actively try to shift the AD curve.

Changes in AD/AS
Shifts in AD will result in a new short-run equilibrium (table 1 on page 624 summarizes the factors that shift the AD curve). However, if the new equilibrium is not at Yn, the economy will eventually return to its long run equilibrium. For example, suppose we are at a long-run equilibrium and an increase in the money supply shifts AD right:

Initially both price level and output rise. However, now output is above its natural level. The shortage of labor pushes up wages and the AS shifts left:

So in the long-run, the increase in AD only results in a higher price level, with no change in output.

We know the AS will shift due to changes in the labor market, but other factors shift AS as well (summarized in table 2, page 626):

As with shifts in AD, shifts in AS will affect the short-run equilibrium, but output will return to Yn in the long-run.

Over time, we would expect improvements in technology and productivity and economic growth to increase Yn, shifting the long-run aggregate supply curve to the right.

Examples
Our AD/AS model can be used to explain past business cycles in the U.S. economy.

Vietnam War Expansion, 1964-1970
Increases in military expenditures and President Johnson's War on Poverty both increased government spending. As the same time, the Fed was committed to keeping interest rates low and thus increased the money supply.
Our model would predict that AD would shift right, output would rise, unemployment would fall, and prices would rise. In the long run, output would revert to its natural level. The data in table 3 follow this prediction. Unemployment falls and inflation rises from 1964-69. Then in 1970 we see unemployment rise back towards its natural rate.

Supply Shocks, 1973-75
1973 was not a good year for the U.S. economy. Trouble in the Middle East between Arab nations and Israel led to an oil embargo against the U.S. (who supported Israel). At the same time the OPEC oil cartel restricted production and the price of crude oil quadrupled. Bad harvests all over the world in 1973 led to rising food prices. Food and energy are pretty essential so large increase in the price of these items significantly increase the cost of production in the U.S. economy. Our model predicts a large leftward shift for the AS curve with falling output, rising unemployment and rising prices. The data in table 4 follow this prediction. Unemployment and inflation increase dramatically between 1973 and 1975.