Chapter 25
Aggregate Demand
and Supply
Analysis
Monetarist View of AD
Quantity Theory of Money
MV = PY
Implication: M determines (P Y) if V is constant
Downward-Sloping AD
M = 1000, V = 2 → P Y = 2000
Point A:
P=2
Y = 1000
P Y = 2 x 1000
Point B:
P=1
Y = 2000
P Y = 1 x 2000
Point C:
P = 0.5
Y = 4000
P Y = 0.5 x 4000
Conclusion: P↓ (with M V constant) → Y↑ → downwardsloping AD
Shift in AD (given P)
M↑ → (P Y)↑ → Y↑ and AD shifts right
25-2
The AD Curve
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25-3
Keynesian View of AD
Y = C + I + G + NX
Downward-Sloping AD
P → M/P → i → C, I, NX → Y
Shift in AD (given P)
• Consumer Confidence  → C, I → AD (shifts right)
• Business Confidence  → I → AD (shifts right)
• Money Supply M → i → C, I, NX → AD (shifts right)
• Government Spending G → Y → AD (shifts right)
• Income Taxes T → Disposable Income  → C → AD (shifts
left)
• Economics Growth Abroad  → NX → AD (shifts right)
• Exchange Rate: Value of Domestic Currency  → NX  → AD
(shifts left)
25-4
Crowding–out Debate
• Monetarists: Complete Crowding out when
G → Government Borrowing  → i → C,
I, NX such that G = C+ I + NX → Y
unchanged
• Keynesians: Partial Crowding out when G →
Government Borrowing  → i → C, I,
NX but G > C+ I + NX → Y and AD
(shifts right)
25-5
Short-Run Aggregate Supply
Upward-Sloping SRAS
In the short-run, factor prices (nominal wages) are
fixed → Production costs are fixed → P → Profits
→ Y
Shift in SRAS (given P)
• Factor Prices  → Production Costs  → Profits  →
SRAS (shifts left)
• Expected Inflation  → Factor Prices  → Production
Costs  → SRAS  (shifts left)
• Corporate Taxes  → Profits  → SRAS  (shifts left)
• Government Regulations  → Production Costs  →
Profits  → SRAS  (shifts left)
© 2006 Pearson Addison-Wesley. All rights reserved
25-6
Long-Run Aggregate Supply
Vertical LRAS
• Nominal wages eventually change by the same amount as the
price level → LRAS is vertical (does not depend on the price
level).
Shift in LRAS (Economic Growth)
• Labour Force ↑ → Natural Level of Output Yn↑ and LRAS↑ (shift
right)
• Capital Stock ↑ → Natural Level of Output Yn↑ and LRAS↑ (shift
right)
• Technology (Productivity) ↑ → Natural Level of Output Yn↑ and
LRAS↑ (shift right)
Real Business Cycle Theory
1. Yn fluctuates because of supply (real) shocks.
2. Shifts in AD are small.
3. Conclusion: Business cycles result from real shocks.
4. Supports non-activism.
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25-7
Equilibrium
in the Long
Run
Panel (a): Y > Yn
Unemployment ↓ → Wages 
(given P) → Profits  → SRAS 
(shifts left until Y = Yn at LRAS)
Panel (b): Y < Yn
Unemployment ↑ → Wages 
(given P) → Profits  → SRAS ↑
(shifts right until Y = Yn at LRAS)
Activists (Keynesians) see
movement to LRAS (selfcorrecting mechanism) as slow;
non-activist (Classicals) see it as
fast.
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Effect of Shift in AD on Y
1.AD  (shifts right) → Y and P to point 1‘.
2.Y > Yn → Unemployment ↓ → Wages (given P) → SRAS ↓ (shifts
left until Y = Yn at point 2).
Conclusion: AD shifts right → Y and P in short run, but in the long
run Y is unchanged and P.
25-9
Effect of Shift in SRAS on Y
1. Negative Supply Shock: SRAS shifts left → Y and P to point 2.
2. Y < Yn → Unemployment ↑ → Wages  (given P) → SRAS shifts right
until return to point 1.
Conclusion: SRAS shifts left → Y and P in short run, but in the long run
Y and P are unchanged.
25-10