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Lecture #1

chapter 24

Aggregate Demand and Supply Analysis

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Monetarist View of AD

P Y 2000V = ——— = —–— = 2

M 1000

Modern Quantity Theory of Money

M V = P Y

Implication: M determines P Y

Deriving AD Curve

M = 1000, V = 2 P Y = 2000

Point A: P = 2 Y = 1000 PY = 21000Point B: P = 1 Y = 2000 PY = 12000Point C: P = .5 Y = 4000 PY =.54000

Conclusion: P Y , downward sloping AD

Shift in AD Curve

M : PY , so at given P, Y AD shifts right

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The AD Curve

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Keynesian View of AD

Yad = C + I + G + NX

Downward Sloping AD

P , M/P , i , I , NX , Yad

Shift in AD

M , M/P , i , I , NX , Yad AD shifts right

C or G or T or NX : Yad AD shifts right

Complete Crowding Out

G , i C , I , NX C + I + G + NX = Yad unchanged

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

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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 Y shifts right

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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 the Long-Run

Panel (a): Y > Yn

Wages : at given P, profits , Y produced AS shifts in until Y = Yn at long-run ASPanel (b): Y < Yn

Wages : at given P, profits , Y produced AS shifts out until Y = Yn at long-run ASActivist sees movement to long-run AS (self-correcting mechanism) as slow; nonactivist sees as fast

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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 = Yn

Conclusion: 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

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Shifts in Long-Run Supply

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

Real Business Cycle Theory

1. Yn fluctuates a lot due to aggregate supply (real) shocks

2. Shifts in AD small

3. Conclusion: Business cycles due to real shocks

4. Supports nonactivism

Hysteresis

1. AD shifts in, natural rate of unemployment , Yn shifts in

2. Unemployment stays high

3. Supports activism

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Vietnam War Buildup: 1964–70

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Negative Supply Shocks: 1973–75 and 1978–80

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Phillips Curve and AS

Phillips Curve

w/w = – h (U – Un)

Implication: When U > Un, i.e., Y < Yn w , AS shifts in

Expectations Augmented Phillips Curve

w/w – e = – h (U – Un)

or

w/w = – h (U – Un) + e

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Phillips Curve

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Implications of ExpectationsAugmented Phillips Curve

1. When e , Phillips Curve shifts up

2. U deviates from Un only when there are surprises about inflation

Solving above for U

U = Un – (w/w – e)/h

substituted for w/w cause move together

U = Un – ( – e)/h

3. Can’t buy U permanently below Un by higher

In long-run = e: so from eq. above, U = Un