Monetary Theory I: The Aggregate Demand and Aggregate Supply Model

Aggregate demand curve

Shows relationship between price level and quantity of real GDP demanded

Aggregate supply curve

Shows relationship between price level and quantity of aggregate output supplied

Macroeconomic equilibrium

State where aggregate demand equals aggregate supply

Monetary policy

Actions taken by central bank to control money supply and interest rates

AD-AS Model

Explains short-run fluctuations in real GDP and price level

John Maynard Keynes

Economist who provided new understanding of recessions in The General Theory of Employment, Interest, and Money

LRAS

Long-run aggregate supply curve, shows relationship between price level and quantity of real GDP supplied in long run

SRAS

Short-run aggregate supply curve, shows relationship between price level and quantity of real GDP supplied in short run

Determinants of AD

Monetary policy, fiscal policy, consumption, investment, net exports

Determinants of LRAS

Resources, technology

Determinants of SRAS

Resources, technology, costs of production, expected price level

New Classical View

Believes price increase is due to overall inflation or greater demand for product

New Keynesian View

Believes price increase is due to slow adjustment of prices in short run

Macroeconomic Equilibrium

State where aggregate demand and short-run aggregate supply intersect

Demand shocks

Shocks that affect aggregate demand and knock economy out of long-run equilibrium

Supply shocks

Shocks that affect aggregate supply and knock economy out of long-run equilibrium

Monetary policy

Policy that uses changes in money supply to stabilize the economy

Fiscal policy

Policy that uses changes in government spending and taxation to stabilize the economy

Automatic mechanism

Process by which the economy self-corrects to return to long-run equilibrium

Negative demand shock

Decrease in aggregate demand that leads to recession

Positive demand shock

Increase in aggregate demand that leads to expansion

Negative supply shock

Decrease in aggregate supply that leads to higher prices

Positive supply shock

Increase in aggregate supply that leads to lower prices

Recessions

Caused by negative shocks to aggregate demand or supply

Stabilization policy

Monetary or fiscal policy intended to reduce severity of business cycle and stabilize the economy

Lags

Time delays in recognizing and implementing policy and its impact on the economy