The Economics of Money, Banking, and

Financial Markets
Thirteenth Edition

Chapter 22
Aggregate Demand and
Supply Analysis

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Preview
• This chapter develops the aggregate demand-aggregate
supply framework, which will allow for an examination of
the effects of monetary policy on output and prices.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Learning Objectives (1 of 2)
22.1 Summarize and illustrate the aggregate demand curve
and the factors that shift it.
22.2 Illustrate and interpret the short-run and long-run
aggregate supply curves.
22.3 Illustrate and interpret shifts in the short-run and long-
run aggregate supply curves.
22.4 Illustrate and interpret the short-run and long-run
equilibria, and the role of the self-correcting mechanism.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Learning Objectives (2 of 2)
22.5 Illustrate and interpret the short-run an long-run
effects of a shock to aggregate demand.
22.6 Illustrate and interpret the short-run and long-run
effects of temporary and permanent supply shocks.
22.7 Explain business cycle fluctuations in major
economies during the 2007–2009 financial crisis.
22.8 Summarize the conclusions from aggregate demand
and supply analysis.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Business Cycle and Inflation
• Aggregate demand and supply analysis attempts to
explain the business cycle and inflation
– Expansions
– Recessions
– Potential output
– Output gap
– Unemployment
– Inflation

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Following the Financial News
• Among the more important data collected on business
cycle variables are
– Real GDP
– Industrial Production
– Unemployment Rate
– The rate of inflation
▪ GDP deflator
▪ CPI
▪ PCE deflator
▪ PPI

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Aggregate Demand (1 of 3)
• Aggregate demand is made up of four component parts:
– consumption expenditure: the total demand for
consumer goods and services
– planned investment spending: the total planned
spending by business firms on new machines, factories,
and other capital goods, plus planned spending on new
homes
– government purchases: spending by all levels of
government (federal, state, and local) on goods and
services
– net exports: the net foreign spending on domestic goods
and services

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Aggregate Demand (2 of 3)

Y ad = C + I + G + NX

The aggregate demand curve is downward sloping

because

P  M / P  i  I  Y ad 
and
P  M / P  i  E  NX  Y ad 

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Aggregate Demand (3 of 3)
• The fact that the aggregate demand curve is downward
sloping can also be derived from the quantity theory of
money analysis.
• If velocity stays constant, a constant money supply
implies constant nominal aggregate spending, and a
decrease in the price level is matched with an increase
in aggregate demand.
• Meaning of the term autonomous.
• Now let’s look at the factors that can shift the AD curve

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 4 Leftward Shift in the Aggregate
Demand Curve

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 5 Rightward Shift in the Aggregate
Demand Curve

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Factors That Shift the Aggregate Demand
Curve
• An increase in the money supply shifts AD to the right:
holding velocity constant, an increase in the money
supply increases the quantity of aggregate demand at
each price level.
• An increase in spending from any of the components
C, I, G, NX will also shift AD to the right.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Summary Table 1 Factors That Shift the
Aggregate Demand Curve

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Aggregate Supply
• Long-run aggregate supply curve:
– Determined by the amount of capital and labor and
the available technology
– Vertical at the natural rate of output generated by the
natural rate of unemployment
• Short-run aggregate supply curve:
– Wages and prices are sticky
– Generates an upward sloping SRAS as firms attempt
to take advantage of short-run profitability when price
level rises

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 6 Long- and Short-Run Aggregate
Supply Curves

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Shifts in Aggregate Supply Curves
• Shifts in the long-run aggregate supply curve
– The long-run aggregate supply curve shifts to the right
from when there is

1. An increase in the total amount of capital in the economy

2. An increase in the total amount of labor supplied in the
economy
3. An increase in the available technology, or
4. A decline in the natural rate of unemployment

– An opposite movement in these variables shifts the LRAS

curve to the left.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 7 Shift in the Long-Run Aggregate
Supply Curve

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Shifts in the Short-Run Aggregate Supply
Curve
• There are three factors that can shift the short-run
aggregate supply curve:

1. Expected inflation
2. Output gap
3. Inflation (supply) shocks

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Summary Table 2 Factors That Shift the
Short-Run Aggregate Supply Curve

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 8 Shift in the Short-Run Aggregate Supply
Curve from Changes in Expected Inflation and Supply
(Inflation) Shocks

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 9 Shift in the Short-Run Aggregate Supply
Curve From a Persistent Positive Output Gap

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Equilibrium in Aggregate Demand and
Supply Analysis
• We can now put the aggregate demand and supply
curves together to describe macroeconomic or general
equilibrium in the economy, when all markets are
simultaneously in equilibrium at the point where the
quantity of aggregate output demanded equals the
quantity of aggregate output supplied.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Short-Run Equilibrium
• Figure 7 illustrates a short-run equilibrium in which the
quantity of aggregate output demanded equals the
quantity of output supplied.
• In Figure 8, the short-run aggregate demand curve AD
and the short-run aggregate supply curve AS intersect at
point E with an equilibrium level of aggregate output at
Y * and an equilibrium inflation rate at  *.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 10 Short-Run Equilibrium

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 12 Adjustment to Long-Run Equilibrium
in Aggregate Supply and Demand Analysis

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Self-Correcting Mechanism
• Regardless of where output is initially, it returns
eventually to the natural rate.
• Slow:
– Wages are inflexible, particularly downward
– Need for active government policy
• Rapid:
– Wages and prices are flexible
– Less need for government intervention

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Changes in Equilibrium: Aggregate
Demand Shocks
• With an understanding of the distinction between the
short-run and long-run equilibria, you are now ready to
analyze what happens when there are demand shocks,
shocks that cause the aggregate demand curve to shift.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 13 Positive Demand Shock

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 14 The Volcker Disinflation

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Changes in Equilibrium: Aggregate
Supply (Price) Shocks (1 of 2)
• The aggregate supply curve can shift from temporary
supply (price) shocks in which the long-run aggregate
supply curve does not shift, or from permanent supply
shocks in which the long-run aggregate supply curve
does shift.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Changes in Equilibrium: Aggregate
Supply (Price) Shocks (2 of 2)
• Temporary Supply Shocks:
– When the temporary shock involves a restriction in
supply, we refer to this type of supply shock as a
negative (or unfavorable) supply shock, and it results
in a rise in commodity prices.
– A temporary positive supply shock shifts the short-run
aggregate supply curve downward and to the right,
leading initially to a fall in inflation and a rise in output.
In the long run, however, output and inflation will be
unchanged (holding the aggregate demand curve
constant).

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 15 Negative Supply Shock

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 16 Negative Supply Shocks,
1973–1975

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Permanent Supply Shocks and Real
Business Cycle Theory
• A permanent negative supply shock—such as an increase in ill-
advised regulations that causes the economy to be less efficient,
thereby reducing supply—would decrease potential output and
shift the long-run aggregate supply curve to the left.
• Because the permanent supply shock will result in higher prices,
there will be an immediate rise in inflation and so the short-run
aggregate supply curve will shift up and to the left.
• One group of economists, led by Edward Prescott of Arizona
State University, believe that business cycle fluctuations result
from permanent supply shocks alone and their theory of
aggregate economic fluctuations is called real business cycle
theory.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Conclusions
• Aggregate demand and supply analysis yields the
following conclusions:
1. The economy has a self-correcting mechanism that
returns it to potential output and the natural rate of
unemployment over time.
2. A shift in the aggregate demand curve affects output
only in the short run and has no effect in the long run.
3. A temporary supply shock affects output and inflation
only in the short run and has no effect in the long run
(holding the aggregate demand curve constant).

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 17 First Phase of the Great
Recession

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Application: An AD/AS Analysis of the
Covid-19 Recession (1 of 4)
When the coronavirus began to spread exponentially in
March 2020 and lockdowns were implemented
throughout the United States, the economy declined at
the steepest rate in U.S. history.
The aggregate output index falling from 101.2 in the
fourth quarter of 2019 to 90.0 in the second quarter of
2020, the unemployment rate rose from 3.5% in the
fourth quarter of 2019 to 13% in the second quarter of
2020 and at the same time, the inflation rate fell from
2.0% to 0.4%.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 19 The Covid-19 Recession

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Application: An AD/AS Analysis of the
Covid-19 Recession (2 of 4)
What is unusual about the resulting Covid-19 recession is
that it was triggered by a massive aggregate supply shock
that induced a massive aggregate demand shock.
The lockdowns that began in March 2020 led to production
shutting down in many parts of the U.S. economy. The
result was that the short-run aggregate supply curve
shifted up and to the left from AS2019:Q4 to AS2020:Q2.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Application: An AD/AS Analysis of the
Covid-19 Recession (3 of 4)
Because the lockdowns meant that households were
unable to venture out to stores, they sharply cut back their
spending. In addition, because it was hard to know how
long the coronavirus pandemic would last and when the
economy might reopen, uncertainty increased greatly, so
businesses shelved a lot of their investment plans.
Uncertainty and the collapse in stock prices also further
reduced the willingness of consumers to spend. The result
was a large decline in the quantity of aggregate output
demanded at any given inflation rate, so the aggregate
demand curve shifted sharply to the left.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Application: An AD/AS Analysis of the
Covid-19 Recession (4 of 4)
The effects of the simultaneous supply and demand shifts
left unclear the effect on prices. However another event, a
price war between Saudi Arabia and Russia, which led to a
drop in the price of oil from around $60 a barrel to less than
$30 per barrel in the second quarter of 2020 led to a
precipitous drop in the price of oil. This acted as a positive
supply shock that offset some of the negative supply shock
from the pandemic. As a result, the short-run aggregate
supply curve shifted by less than the aggregate demand
curve, and the inflation rate fell from 2.0% in the fourth
quarter of 2019 to 0.4% in the second quarter of 2020.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Appendix to Chapter 22: The Phillips Curve
and the Short-Run Aggregate Supply Curve

• The Phillips Curve: the negative relationship between

unemployment and inflation.
• The idea behind the Phillips curve is intuitive: When labor
markets are tight—that is, the unemployment rate is
low—firms may have difficulty hiring qualified workers
and may even have a hard time keeping their present
employees. Because of the shortage of workers in the
labor market, firms will raise wages to attract needed
workers and raise their prices at a more rapid rate.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
 Figure 1 Inflation and Unemployment in the
United States, 1950–1969 and 1970–2019

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/UNRATE ;

https://fred.stlouisfed.org/series/CPIAUCSL

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Figure 2 The Short- and Long-Run
Phillips Curve

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Three Important Conclusions
1. There is no long-run trade off between unemployment
and inflation.
2. There is a short-run trade off between unemployment
and inflation.
3. There are two types of Phillips curves, long run and
short run.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
The Phillips Curve After the 1960s
• The expectations-augmented Phillips curve shows that the
negative correlation between unemployment and inflation
breaks down when the unemployment rate remains below
the natural rate of unemployment for any extended period
of time.
• Inflation jumped up sharply with the sharp rise in oil prices
in 1973 and 1979 and Phillips-curve theorists realized that
they had to add one more feature to the expectations-
augmented Phillips curve. Supply shocks are shocks to
supply that change the amount of output an economy can
produce from the same amount of capital and labor. These
supply shocks translate into inflation shocks.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
The Modern Phillips Curve with Adaptive
(Backward-Looking) Expectations
• To complete our analysis of the Phillips curve, we need
to understand how firms and households form
expectations about inflation. One simple model
assumes that they do so by looking at past inflation.
• This form of expectations is known as adaptive
expectations or backward-looking expectations
because expectations are formed by looking at the past
and therefore change only slowly over time.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
The Short-Run Aggregate Supply Curve

• To complete our aggregate demand and supply model, we

need to use our analysis of the Phillips curve to derive a
short-run aggregate supply curve, which represents the
relationship between the total quantity of output that firms
are willing to produce and the inflation rate.
• We can translate the modern Phillips curve into a short-run
aggregate supply curve by replacing the unemployment
gap (U – Un ) with the output gap, the difference between
output and potential output (Y – YP ) .

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Okun’s Law
• Okun’s law describes the negative relationship between
the unemployment gap and the output gap.
• Okun’s law states that for each percentage point that
output is above potential, the unemployment rate is one-
half of a percentage point below the natural rate of
unemployment. Alternatively, for every percentage point
that unemployment is above its natural rate, output is two
percentage points below potential output.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
 Figure 3 Okun’s Law, 1960–2019

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/UNRATE ;

https://fred.stlouisfed.org/series/GDPC1 ; https://fred.stlouisfed.org/series/GDPPOT ;

https://fred.stlouis.org/series/NROU .

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved
Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Copyright © 2022, 2019, 2016 Pearson Education, Inc. All Rights Reserved