Aggregate Demand and Supply Analysismchinn/wang_7dec05lecture.pdfAggregate Demand • Downward sloping – Monetarist: Money supply (monetary policy) is the most effective tool to

Chapter 25

Aggregate Demand and Supply Analysis

© 2006 Pearson Addison-Wesley. All rights reserved 25-2



Aggregate Demand and Supply

• How the aggregate output and price are determined.• How they are affected by the policies.


Aggregate Demand

• Downward sloping– Monetarist: Money supply (monetary policy) is the

most effective tool to shift the aggregate demand function.

– Keynesian view: Government spending and/or taxes (fiscal policy) is the most effective tool.

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Monetarist View of ADP × Y 2000

V = = = 2M 1000

Modern Quantity Theory of MoneyM × V = P × YImplication: M determines P × Y if V unrelated to ∆M

Deriving AD CurveM = 1000, V = 2 ⇒ P × Y = 2000

Point A: P = 2 Y = 1000 PY = 2 × 1000Point B: P = 1 Y = 2000 PY = 1 × 2000Point C: P = .5 Y = 4000 PY =.5 × 4000Conclusion: P ↓ Y ↑, downward sloping AD

Shift in AD CurveM ↑: P×Y ↑, so at given P, Y ↑ ⇒ AD shifts right


The AD Curve

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Keynesian View of ADYad = C + I + G + NX

Downward Sloping ADP ↓, M/P ↑, i ↓, I ↑, NX ↑, Yad ↑, Y ↑

Shift in ADM ↑, M/P ↑, i ↓, I ↑, NX ↑, Yad ↑, Y ↑⇒ AD shifts right

C ↑ or G ↑ or T ↓ or NX ↑: Yad ↑, Y ↑⇒ AD shifts right

Complete Crowding OutG ↑, i ↑ ⇒ C ↓, I ↓, NX ↓ ⇒ C + I + G + NX = Yad

unchangedPartial crowding out: private spending down, but not fully offsetting G ↑


Aggregate Demand

• AD is downward sloping.• Monetarist: Monetary policy is the most effect

way to shift aggregate demand.• Keynesian: Fiscal policy is the most effect

way to shift aggregate demand.


Aggregate Supply in Short Run

Upward slope of ASIn short-run production costs fixed ⇒ P ↑, profits ↑, Y produced ↑Shift in ASProduction costs ↑: At given P, profits ↓ , Y ↓⇒ AS shifts left


Equilibrium in Short Run

Equilibrium: AD = ASIf P > P*, AS > AD ⇒ P ↓ to P*If P < P*, AS < AD ⇒ P ↑ to P*

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Equilibrium in Long Run

Panel (a): Y > YnWages ↑: at given P, profits ↓, Yproduced ↓ ⇒ AS shifts in until Y = Yn at long-run AS

Panel (b): Y < YnWages ↓: at given P, profits ↑, Yproduced ↑ ⇒ AS shifts out until Y= Yn at long-run AS

Activist sees movement to long-run AS (self-correcting mechanism) as slow; nonactivistsees as fast


Summary: Factors that Shift AD

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Effect of Shift in AD on Y

1. AD shifts right: Y ↑ P ↑ to point 1'2. Y > Yn: wages ↑, AS shifts in until reach point 2, where Y = YnConclusion: AD shifts right, Y ↑ in short run only; in long run only P ↑

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Summary: Factors that Shift AS

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Effect of Shift in AS on Y

1. Negative supply shock: AS shifts in, Y ↓ P ↑ to point 22. Y < Yn: wages ↓, AS shifts out until return to point 1Conclusion: AS shifts in, Y ↓ P ↑ in short run, but in long run Y and P are unchanged


Vietnam War Buildup: 1964–70


Negative Supply Shocks: 1973–75 and 1978–80


Positive Supply Shocks 1995–99


What can monetary policy do?

• The self-correcting mechanism is slow. So exogenous shocks may keep the economy out of its long-run trend for prolonged periods.

• We can use the policy instrument to restore long-run output by shifting the aggregate demand.


Conduct of Monetary Policy

• Choice of monetary instrument– Monetary Aggregates, or– Interest Rate– Can you choose both?

• No! After you choose one, the other one is automatically determined by the market.

– Which monetary instrument is currently used by the central banks?• Interest rate


How to set the interest rate?

• Taylor rule (John Taylor, Stanford)it=i+α(πt- π)+β(yt-y)

it—interest rate of time t i—targeted long-run interest rate

πt—inflation rate of time t π—targeted long-run inflation rate

yt—output (GDP) of time t y—targeted long-run output (GDP)


How well the Taylor rule captures the monetary policy in U.S.?


How Taylor rule is followed in reality

• Countries explicitly follow “Taylor rule”– Australia, New Zealand, U.K.

• U.S.– Greenspan: No commitment to any “monetary

rule”.– Bernanke: Expected to follow the “rule” more

explicitly.


Debates on the Taylor Rule

• How much should the interest rate react to inflation and output?– What are the optimal values for α and β in the Taylor rule?

• What should be included in the Taylor rule?– Current inflation rate, lagged inflation rate or expected inflation

rate?– Is output stabilization necessary?– Should the exchange rate be included in an open economy?

• Should the central bank adjust interest rate gradually?– If the fed wants to increase interest rate by 1 percentage point,

should it increase the interest rate by 25 basis points each time during the next 4 months or increase the interest rate by 1 percent immediately.

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Shifts in Long-Run Supply

Yn grows over time, but is shown as fixed in AD/ASdiagram

Real Business Cycle Theory1. Yn fluctuates a lot due to aggregate supply (real) shocks2. Shifts in AD small3. Conclusion: Business cycles due to real shocks4. Supports nonactivism

Hysteresis1. AD shifts in, natural rate of unemployment ↑, Yn shifts in2. Unemployment stays high3. Supports activism

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