1) The document presents slides on aggregate demand, aggregate supply, and the effects of monetary and fiscal policy. 2) It explains how the aggregate demand curve slopes downward, due to the wealth effect, interest rate effect, and exchange rate effect as prices rise. 3) It also discusses the short-run and long-run aggregate supply curves and how they are determined by factors like sticky wages and prices in the short-run. 4) The slides show how monetary policy works through interest rates and money supply to shift the aggregate demand curve, and how fiscal policy using government spending and taxes can also shift aggregate demand.

1. Aggregate Demand and Aggregate
Supply Premium PowerPoint
Slides by
Ron Cronovich
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
N. Gregory Mankiw
Economics
Principles of
Sixth Edition
33

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Why the AD Curve Slopes Downward
Y = C + I + G + NX
Assume G fixed
by govt policy.
To understand
the slope of AD,
must determine
how a change in P
affects C, I, and NX.
P
Y
AD
P1
Y1
P2
Y2 Y1

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The Wealth Effect (P and C )
Suppose P rises.
 The dollars people hold buy fewer g&s,
so real wealth is lower.
 People feel poorer.
Result: C falls.

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The Interest-Rate Effect (P and I )
Suppose P rises.
 Buying g&s requires more dollars.
 To get these dollars, people sell bonds or other assets.
 This drives up interest rates.
Result: I falls.
(Recall, I depends negatively on interest rates.)

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The Exchange-Rate Effect (P and NX )
Suppose P rises.
 U.S. interest rates rise (the interest-rate effect).
 Foreign investors desire more U.S. bonds.
 Higher demand for $ in foreign exchange market.
 U.S. exchange rate appreciates.
 U.S. exports more expensive to people abroad, imports cheaper
to U.S. residents.
Result: NX falls.

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The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of
output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or
full-employment
output.
P
Y
LRAS
YN

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Classical Dichotomy: Real variables vs Nominal variables
Monetary Neutrality: Real variables don’t depend on Nominal variables

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Why LRAS Is Vertical
YN determined by the
economy’s stocks of
labor, capital, and
natural resources,
and on the level of
technology.
An increase in P
P
Y
LRAS
P1
does not affect
any of these,
so it does not
affect YN.
(Classical dichotomy)
P2
YN

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Short Run Aggregate Supply (SRAS)
The SRAS curve
is upward sloping:
Over the period
of 1–2 years,
an increase in P
P
Y
SRAS
causes an
increase in the
quantity of g & s
supplied.
Y2
P1
Y1
P2

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1. The Sticky-Wage Theory
 Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
 Due to labor contracts, social norms
 Firms and workers set the nominal wage in advance based on PE,
the price level they expect to prevail.

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Eg:
Wr = Wn / Pe = Nominal wage / Expected price level
Wr = 100/10 = 10
*Actual P > Pe => 11 > 10 => Wr = 10 = 110/11 => Q(AS) increases
* Actual P < Pe => 9 < 10 => Wr = 10 = 90/9 => Q(AS) decreases

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2. The Sticky-Price Theory
 Imperfection:
Many prices are sticky in the short run.
 Due to menu costs, the costs of adjusting prices.
 Examples: cost of printing new menus,
the time required to change price tags
 Firms set sticky prices in advance based
on PE.

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2. The Sticky-Price Theory
 Suppose the Fed increases the money supply unexpectedly. In the
long run, P will rise.
 In the short run, firms without menu costs can raise their prices
immediately.
 Firms with menu costs wait to raise prices. Meanwhile, their prices
are relatively low,
which increases demand for their products,
so they increase output and employment.
 Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.

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3. The Misperceptions Theory
 Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
 If P rises above PE, a firm sees its price rise before realizing all
prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.
 So, an increase in P can cause an increase in Y,
making the SRAS curve upward-sloping.

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LRAS
YN
The Effects of a Shift in AD
Event: Stock market crash
1. Affects C, AD curve
2. C falls, so AD shifts left
3. SR eq’m at B.
P and Y lower,
unemp higher
4. Over time, PE falls,
SRAS shifts right,
until LR eq’m at C.
Y and unemp back
at initial levels.
P
Y
AD1
SRAS1
AD2
SRAS2
P1 A
P2
Y2
B
P3 C
Eg:
Wr = Wn / Pe
Wr = 100/10 = 10
*Actual P > Pe => 11 > 10
=> Wr = 10 = 110/11 =>
Q(AS) increases
* Actual P < Pe => 9 < 10 =>
Wr = 10 = 90/9 => Q(AS)
decreases

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LRAS
YN
The Effects of a Shift in SRAS
Event: Oil prices rise
1. Increases costs,
shifts SRAS
(assume LRAS constant)
2. SRAS shifts left
3. SR eq’m at point B.
P higher, Y lower,
unemp higher
From A to B,
stagflation,
a period of
falling output
and rising prices.
P
Y
AD1
SRAS1
SRAS2
P1
A
P2
Y2
B

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Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment
causes wages to fall,
SRAS shifts right,
until LR eq’m at A.
Or, policymakers could
use fiscal or monetary
policy to increase AD
and accommodate the
AS shift:
Y back to YN, but
P permanently higher.
LRAS
YN
P
Y
AD1
SRAS1
SRAS2
P1
A
P2
Y2
B
AD2
P3 C

18. The Influence of
Monetary and Fiscal Policy on
Aggregate Demand
Premium PowerPoint
Slides by
Ron Cronovich
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
N. Gregory Mankiw
Economics
Principles of
Sixth Edition
34

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product or service or otherwise on a password-protected website for classroom use.
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To control AD:
- Monetary policy: use of MS to control the r => Increase/decrease I => AD shifts to the left /right
+ Theory of liquidity preference (short-run): the opportunity cost of holding money
- Fiscal policy: use of G (in the AD: Y=C+I+G+NX) => Increase/decrease G => AD shifts to the left
/right
+ Multiplier effect
+ Crowding-out effect

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How r Is Determined
MS curve is vertical:
Changes in r do not
affect MS, which is
fixed by the Fed.
MD curve is
downward sloping:
A fall in r increases
money demand.
M
Interest
rate MS
MD1
r1
Quantity fixed
by the Fed
Eq’m
interest
rate

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How the Interest-Rate Effect Works
Y
P
M
Interest
rate
AD
MS
MD1
MD2
P2
P1
Y1 Y2
r2
r1
A fall in P reduces money demand, which lowers r.
A fall in r increases I and the quantity of g&s demanded.

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product or service or otherwise on a password-protected website for classroom use.
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The Effects of Reducing the Money Supply
Y
P
M
Interest
rate
AD1
MS1
MD
P1
Y1
r1
MS2
r2
AD2
Y2
The Fed can raise r by reducing the money supply.
An increase in r reduces the quantity of g&s demanded.

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Fiscal Policy and Aggregate Demand
 Fiscal policy: the setting of the level of govt spending and
taxation by govt policymakers
 Expansionary fiscal policy
 an increase in G and/or decrease in T
 shifts AD right
 Contractionary fiscal policy
 a decrease in G and/or increase in T
 shifts AD left
 Fiscal policy has two effects on AD...

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1. The Multiplier Effect
 If the govt buys $20b of planes from Boeing,
Boeing’s revenue increases by $20b.
 This is distributed to Boeing’s workers (as wages)
and owners (as profits or stock dividends).
 These people are also consumers and will spend
a portion of the extra income.
 This extra consumption causes further increases
in aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending

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1. The Multiplier Effect
A $20b increase in G
initially shifts AD
to the right by $20b.
The increase in Y
causes C to rise,
which shifts AD
further to the right.
Y
P
AD1
P1
AD2
AD3
Y1 Y3
Y2
$20 billion

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Marginal Propensity to Consume
 How big is the multiplier effect?
It depends on how much consumers respond to increases in
income.
 Marginal propensity to consume (MPC):
the fraction of extra income that households consume rather than
save
E.g., if MPC = 0.8 and income rises $100,
C rises $80.

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Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX identity
Y = C + G I and NX do not change
Y = MPC Y + G because C = MPC Y
solved for Y
1
1 – MPC
Y = G
A Formula for the Multiplier
The multiplier

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2. The Crowding-Out Effect
 Fiscal policy has another effect on AD
that works in the opposite direction.
 A fiscal expansion raises r,
which reduces investment,
which reduces the net increase in agg demand.
 So, the size of the AD shift may be smaller than the initial fiscal
expansion.
 This is called the crowding-out effect.

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How the Crowding-Out Effect Works
Y
P
M
Interest
rate
AD1
MS
MD2
MD1
P1
r1
r2
A $20b increase in G initially shifts AD right by $20b
But higher Y increases MD and r, which reduces AD.
AD3
AD2
Y1 Y2
$20 billion
Y3

30. The Short-Run Tradeoff Between
Inflation and Unemployment Premium PowerPoint
Slides by
Ron Cronovich
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
N. Gregory Mankiw
Economics
Principles of
Sixth Edition
35

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product or service or otherwise on a password-protected website for classroom use.
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31
The Vertical Long-Run Phillips Curve
u-rate
inflation
In the long run, faster money growth only causes
faster inflation.
Y
P
LRAS
AD1
AD2
Natural rate
of output
Natural rate of
unemployment
P1
P2
LRPC
low
infla-
tion
high
infla-
tion
31

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The Phillips Curve Equation
Short run
Fed can reduce u-rate below the natural u-rate
by making inflation greater than expected.
Long run
Expectations catch up to reality,
u-rate goes back to natural u-rate whether inflation
is high or low.
Unemp.
rate
Natural
rate of
unemp.
= – a Actual
inflation
Expected
inflation
–

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How Expected Inflation Shifts the PC
Initially, expected &
actual inflation = 3%,
unemployment =
natural rate (6%).
Fed makes inflation
2% higher than expected,
u-rate falls to 4%.
In the long run,
expected inflation
increases to 5%,
PC shifts upward,
unemployment returns to
its natural rate.
u-rate
inflation
PC1
LRPC
6%
3%
PC2
4%
5%
A
B C
Eg:
Wr = Wn / Pe
Wr = 100/10 = 10
*Actual P > Pe => 11 > 10
=> Wr = 10 = 110/11 =>
Q(AS) increases
* Actual P < Pe => 9 < 10 =>
Wr = 10 = 90/9 => Q(AS)
decreases

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How an Adverse Supply Shock Shifts the PC
u-rate
inflation
SRAS shifts left, prices rise, output & employment fall.
Inflation & u-rate both increase as the PC shifts upward.
Y
P
SRAS1
AD PC1
PC2
A
B
SRAS2
A
Y1
P1
Y2
B
P2

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Disinflationary Monetary Policy
Contractionary
monetary policy moves
economy from A to B.
Over time,
expected inflation falls,
PC shifts downward.
In the long run,
point C:
the natural rate
of unemployment,
lower inflation.
u-rate
inflation
LRPC
PC1
natural rate of
unemployment
A
PC2
C
B
Disinflation: a
reduction in the
inflation rate
To reduce inflation,
Fed must slow the
rate of money
growth,
which reduces agg
demand.
Eg:
Wr = Wn / Pe
Wr = 100/10 = 10
*Actual P > Pe => 11 > 10 =>
Wr = 10 = 110/11 => Q(AS)
increases
* Actual P < Pe => 9 < 10 =>
Wr = 10 = 90/9 => Q(AS)
decreases

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The Cost of Reducing Inflation
 Disinflation requires enduring a period of
high unemployment and low output.
 Sacrifice ratio:
percentage points of annual output lost
per 1 percentage point reduction in inflation
 Typical estimate of the sacrifice ratio: 5
 To reduce inflation rate 1%,
must sacrifice 5% of a year’s output.
 Can spread cost over time, e.g.
To reduce inflation by 6%, can either
 sacrifice 30% of GDP for one year
 sacrifice 10% of GDP for three years