CHAPTER 7
AGGREGATE DEMAND, AGGREGATE SUPPLY, AND THE INFLUENCE OF MONETARY AND
FISCAL POLICY ON AGGREGATE DEMAND
• Economic activity fluctuates from year to year.
• Recession is a period of declining real incomes and rising unemployment and depression is
a severe recession.
• Three key facts about economic fluctuations :
1. Economic fluctuations are irregular and unpredictable
2. Most Macroeconomic quantities fluctuate together
3. As output falls, unemployment rises
• Explaining short-run economic fluctuations:
1. The assumptions of classical economics
2. The reality of short-run fluctuations
3. The model of aggregate demand and aggregate supply
• THE MODEL OF AGGREGATE DEMAND AND AGGREGATE SUPPLY is the model that most
economists use to explain short-run fluctuations in economic activity around its long-run
trend
Aggregate Demand
• Aggregate demand curve is a curve that shows the quantity of goods and services that
households, firms, the government, and customers abroad want to buy at each price level.
• The four components contributes to the aggregate demand are GDP (Y) is the sum of its
consumption (C), investment (I), government purchases (G), and net exports (NX).
• Why the aggregate demand curve slopes downward:
1. The wealth effect: The price level and consumptions.
2. The interest-rate effect: The price level and investment.
3. The exchange-rate effect: The price level and net exports.
• Why the aggregate demand curve might shift:
1. Shifts arising from changes in consumption
2. Shifts arising from changes in investment
3. Shifts arising from changes in government purchases
4. Shifts arising from changes in net exports
Aggregate Supply
• The aggregate-supply curve tells us the total quantity of goods and services that firms
produce and sell at any given price level.
• Why the aggregate supply curve slopes upward in the short run :
1. The sticky-wage theory
2. The sticky-price theory
3. The misperceptions theory
• In the long run, the quantity of output supplied depends on the economy’s quantities of labor,
capital, and natural resources and on the technology for turning these inputs into output.
Because the quantity supplied does not depend on the overall price level, the long-run
aggregate-supply curve is vertical at the natural level of output or full-employment
output.
• Natural level of output or full-employment output is the production of goods and services that
an economy achieves in the long run when unemployment is at its normal rate.
• Why might the short run and long run aggregate supply curve shift:
1. Shifts arising from changes in labor
2. Shifts arising from changes in capital
3. Shifts arising from changes in natural resources
4. Shifts arising from changes in technology
5. Shifts arising from changes in the expected price level (short run)
• Two causes of Economic Fluctuations:
1. The effects of a shift in aggregate demand
2. The effects of a shift in aggregate supply
• In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of
goods and services. In the long run, shifts in aggregate demand affect the overall price level
but do not affect output.
• Shifts in aggregate supply can cause stagflation, a period of falling output and rising prices
(combination of recession and inflation).
• Policymakers who can influence aggregate demand can potentially mitigate the adverse
impact on output but only at the cost of exacerbating the problem of inflation.
• Four steps to analyzing economic fluctuations:
1. Decide whether the event shifts the aggregate-demand curve or the aggregate-
supply curve (or perhaps both).
2. Decide the direction in which the curve shifts.
3. Use the diagram of aggregate demand and aggregate supply to determine the
impact on output and the price level in the short run.
4. Use the diagram of aggregate demand and aggregate supply to analyze how the
economy moves from its new short-run equilibrium to its new long-run
equilibrium.
• How Monetary policy influences aggregate demand:
1. Theory of liquidity preference tells Keynes’s theory that the interest rate adjust to
bring money supply and money demand into balance.
2. The aggregate demand curve slopes downward is caused of three reason : the
wealth effect, the interest rate effect, the exchange rate effect.
3. Change in money supply.
4. The role of interest-rate targets in fed policy.
5. The zero lower bound.
• How fiscal policy influences aggregate demand:
1. Change in government purchase.
▪ The multiplier effect, is an additional shifts in aggregate demand that
result when expansionary fiscal policy increases income and thereby
increase consumer spending Multiplier = 1 / (1 – MPC)
▪ The crowding out effect, is the offset aggregate demand that results when
expansionary fiscal policy raises the interest rate and thereby reduces
investment spending.
2. Change in taxes.
A tax increase depresses consumer spending and
shifts aggregate demand curve the the left and vice
versa.
• Using policy to stabilize the economy:
• The case for active stabilization policy
Monetary policy can offset any changes in fiscal policy if done correctly
• The case against active stabilization policy
Monetary policy lags in its effect on the economy
• Automatic Stabilizer
Changes in fiscal policy that stimulate aggregate demand when the economy goes into
a recession without policymakers having to take any deliberate action.
