Chapter 17
Monetary Theory I: The Aggregate Demand
and Aggregate Supply Model
Brief Chapter Summary and Chapter Objectives  
17.1 The Aggregate Demand Curve (pages 521–525)
Explain how the aggregate demand curve is derived.
Economists analyze the demand for goods and services by households, firms, and the government
in terms of aggregate expenditure.
An increase in the price level reduces real money balances, which drives up interest rates. The
result is lower aggregate expenditure and a downward-sloping aggregate
demand curve.
Factors that affect consumer spending, investment, or government purchases cause the aggregate
demand curve to shift.
17.2 The Aggregate Supply Curve (pages 525–532)
Explain how the aggregate supply curve is derived.
Firms differ in their reaction to changes in the price level in the short run and the long run.
There are two views as to why the short-run aggregate supply curve slopes up to the right: One
view is based on the misperceptions theory, and the other view is based on
the short-run stickiness
of prices.
Both views agree that the long-run aggregate supply curve is vertical at potential GDP.
Changes in labor costs, other input costs, and the expected price level cause the short-run
aggregate supply to shift.
The LRAS curve shifts over time to reflect growth in potential GDP, which results from increased
inputs and higher productivity.
17.3Equilibrium in the Aggregate Demand and Aggregate Supply Model
(pages 533–537) Demonstrate macroeconomic equilibrium using the
aggregate demand and aggregate supply model.
Short-run equilibrium occurs where the aggregate demand curve intersects
the short-run aggregate
supply curve, and long-run equilibrium occurs where the aggregate demand
curve, the short-run aggregate supply curve, and the long-run aggregate
supply curve all intersect.
The economy will self-correct to return to potential GDP in the long run.
17.4 The E(ects of Monetary Policy (pages 537–544)
Use the aggregate demand and aggregate supply model to show the e%ects of
monetary policy.
Though the economy will eventually self-correct from an adverse demand
shock, the Fed may employ expansionary monetary policy to speed up the
process.
Given the di’culties in implementing monetary policy, many economists
argue that the Fed should focus on long-run objectives and only implement
expansionary policy during severe recessions.
Expansionary monetary policy could not address some of the problems
associated with the recession of 2007–2009.
Key Terms and Concepts 
Aggregate demand (AD) curve A curve that shows
the relationship between the price level and
aggregate expenditure on goods and services.
Aggregate supply The total quantity of output,
or GDP, that firms are willing to supply at a
given price level.
Business cycle Alternating periods of economic
expansion and economic recession.
Long-run aggregate supply (LRAS) curve A
curve that shows the relationship in the long run
between the price level and the quantity of
aggregate output, or real GDP, supplied by firms.
Monetary neutrality The proposition that
changes in the money supply have no effect on
output in the long run because an increase
(decrease) in the money supply raises (lowers)
the price level in the long run but does not
change the equilibrium level of output.
Real money balances The value of money held
by households and firms, adjusted for changes in
the price level; M/P.
Short-run aggregate supply (SRAS) curve A
curve that shows the relationship in the short run
between the price level and the quantity of
aggregate output, or real GDP, supplied by firms.
Stabilization policy A monetary policy or fiscal
policy intended to reduce the severity of the
business cycle and stabilize the economy.
Supply shock An unexpected change in
production costs or in technology that causes the
short-run aggregate supply curve to shift.
Chapter Outline
Teaching Tips
This chapter focuses on the derivation of the aggregate demand and aggregate supply curves and on the
determination of equilibrium real GDP and the equilibrium price level in the short and long runs. The
discussion of short-run aggregate supply focuses on the new classical and new Keynesian approaches.
Both the differences and the similarities of the two approaches are covered. Discussing the similarities
between the two models is important because students often receive the impression that the differences
among macroeconomists are greater than they actually are.
Why Was Unemployment So High for So Long?
A number of factors appear to account for the slow recovery from the recession of 2007-2009.
Recoveries from recessions that are accompanied by financial crises tend to be slower than recoveries
following typical recessions. Some economists argue that the financial crisis not only led to increased
cyclical unemployment, but also to more structural unemployment, resulting in a higher natural rate of
unemployment. In 2012, uncertainty over the “fiscal cliff” may also have hindered recovery.
17.1 The Aggregate Demand Curve (pages 521–525)
Learning Objective: Explain how the aggregate demand curve is derived.
Economists analyze the demand for goods and services by households, firms, and the government
in terms of aggregate expenditure. We can use the concept of aggregate expenditure to develop the
aggregate demand (AD) curve, which shows the relationship between the price level and aggregate
expenditure on goods and services by households, firms, and the government.
A. The Money Market and the Aggregate Demand Curve
The AD curve is downward sloping because, if nothing else changes, an increase in the price
level reduces aggregate expenditure on goods and services. An increase in the price level
reduces real money balances, which drives up interest rates. Higher interest rates lead to lower
spending by households and firms, which results in an inverse relationship between the price
level and aggregate expenditure.
B. Shifts of the Aggregate Demand Curve
A shift of the aggregate demand curve to the right is expansionary because each price level is
associated with a higher level of aggregate expenditure. A shift of the aggregate demand curve
to the left is contractionary because each price level is associated with a lower level of
aggregate expenditure. Variables that affect consumer spending, investment, or government
purchases cause the aggregate demand curve to shift. These variables are:
The nominal money supply
Expected future income
The expected profitability of capital
Income taxes and business taxes
17.2 The Aggregate Supply Curve (pages 525–532)
Learning Objective: Explain how the aggregate supply curve is derived.
Firms differ in their reaction to changes in the price level in the short run and the long run.
Therefore, we divide our analysis of aggregate supply according to the time horizon that firms face.
A. The Short-Run Aggregate Supply (SRAS) Curve
There are the two main explanations of why the SRAS curve is upward sloping:
1. The new Classical view is based on the misperception theory, which emphasizes the
difficulty firms have in distinguishing between relative increases in the prices of their products
and general increases in the price level. When the actual price level is greater than the expected
price level, firms increase output. As a result, output can be higher or lower than the full
employment level in the short run—until firms can distinguish changes in relative prices from
changes in the general price level.
2. An alternative explanation is that prices take time to adjust to changes in aggregate demand
and are therefore sticky in the short run. The new Keynesian view uses characteristics of many
real-world markets—rigidity of long-term contracts and imperfect competition—to explain price
behavior. When firms have sticky prices, an increase in the price level will tend to increase these
firms’ profits in the short run and so will lead them to increase output.
B. The Long-Run Aggregate Supply (LRAS) Curve
In the new classical view, firms eventually can distinguish changes in the relative prices of their
products from changes in the price level. According to the new Keynesian view,
though input costs are sticky in the short run, over time, input costs increase in line
with the price level, so both firms with flexible prices and firms with sticky prices adjust their
prices in response to a change in demand in the long run. According to both views, the LRAS
curve is vertical at potential GDP.
C. Shifts in the Short-Run Aggregate Supply (SRAS) Curve
There are three main variables that cause the short-run aggregate supply curve to shift:
1. Changes in labor costs
2. Changes in the costs of other inputs
3. Changes in the expected price level.
An increase in any of these three factors leads to higher production costs, causing the SRAS
curve to shift to the left.
D. Shifts in the Long-Run Aggregate Supply (LRAS) Curve
The LRAS curve shifts over time to reflect growth in the potential level of output. Sources of
this economic growth include:
1. Increases in capital and labor inputs
2. Increases in productivity (output produced per unit of input). The principal sources of
changes in productivity are technological advances, worker training and education, government
regulation of production, and changes in energy prices.
17.3 Equilibrium in the Aggregate Demand and Aggregate Supply Model
(pages 533–537)
Learning Objective: Demonstrate macroeconomic equilibrium using the aggregate demand and
aggregate supply model.
A. Short-Run Equilibrium
The economy’s short-run equilibrium occurs at the intersection of the AD and SRAS curves.
B. Long-Run Equilibrium
The economy’s long-run equilibrium occurs at the intersection of the AD, SRAS, and LRAS
curves. If aggregate demand expands unexpectedly, shifting the aggregate demand curve to the
right, output and the price level both increase in the short run. But over time, as firms learn that
the general price level has risen and as input costs rise, the SRAS curve shifts to the left. In the
long run, the SRAS curve will have to shift far enough to intersect with AD at YP. Because
changes in the money supply only affect AD and not YP, economists generally agree that money
is neutral in the long run.
Teaching Tips
The Federal Reserve initiated a second round of quantitative easing in November 2010, and a third round
in September 2012. These rounds of quantitative easing caused economists to debate the role of money in
promoting economic growth.
Opponents of quantitative easing emphasized that a nation cannot generate economic growth by
printing money. Instead, it must focus on policy that improves productivity.
Proponents of additional quantitative easing emphasized that this policy would reduce real interest
rates and therefore promote consumer spending and investment.
Have students evaluate both arguments in the context of the aggregate demand—aggregate supply model.
One conclusion is that proponents of quantitative easing were considering the short run while opponents
focused on the long run.
C. Economic Fluctuations in the United States
The AD-AS model can be used to explain economic fluctuations. Policies that increase AD
without increasing AS may result in higher inflation. Economic policy designed to promote
investment can affect both AD and AS and so investment incentive are unlikely to be
inflationary.
17.4 The Effects of Monetary Policy (pages 537–544)
Learning Objective: Use the aggregate demand and aggregate supply model to show the effects of
monetary policy.
The business cycle refers to alternating periods of economic expansion and economic recession.
Most economists believe that increases in the money supply and decreases in interest rates can increase
short-run output. It may be possible, then, for the Fed to use monetary policies to stabilize the economy
by reducing the severity of recessions and smoothing short-run fluctuations in output.
A. An Expansionary Monetary Policy
If the economy experiences an adverse AD shock, output will decline in the short run. The
economy will eventually self-correct and return to potential GDP, but it may take years. The
Fed can try to speed up the recovery by using open market operations to lower the target for the
federal funds rate. An expansionary monetary policy will shift the AD curve back to the right,
enabling GDP to return to its potential level more quickly, although at a higher price level than
what would occur if no action was taken. However, precise implementation of such
a policy is di’cult given lags in policy, therefore economists generally advocate
that policymakers focus on long-run objectives such as low inflation or steady economic
growth. Many economists argue that policymakers should restrict the use of activist policy to
fighting major downturns in the economy.
B. Was Monetary Policy Ineffective During the 2007–2009 Recession?
In late 2012, the U.S. unemployment rate remained stubbornly high, and increases in real GDP
were disappointingly modest. Do these facts indicate that monetary policy had failed? Not
necessarily. Research has shown that both in the United States and in other countries,
recessions started by financial crises are almost always very severe. In addition, some of the
decline in output appear to have been structural and therefore was not responsive to
expansionary monetary policy. Some economists believe that hysteresis may occur if high rates
of unemployment persist. Hysteresis is a process of workers losing their skills–or being viewed
by employers as lacking current skills for jobs. Some economists argue that unusual levels of
uncertainty due to the severity of the financial crisis and indecision over recent economic
policy have led to problems with aggregate supply.
Teaching Tips
The last section of the chapter, “Was Monetary Policy Ineffective During the 2007-2009 Recession?” on
pages 541-544 examines reasons for the limited effectiveness of monetary policy during and following
the financial crisis. Ask students to discuss the supply-side reasons for continued high unemployment
(for example, hysteresis and uncertainty) as well as the demand-side reasons (such as weak economic
growth). Given this context, have them evaluate the effect of monetary policy during and after the
recession of 2007-2009.