April 20, 2004
Aggregate Supply and Aggregate Demand
We concluded our discussion of the Keynesian IS/LM Model with the aggregate supply and aggregate demand curves. In the 1960's, this line of thinking seemed to resonate with the empirical Phillips Curve that was also quite popular.
We first constructed the aggregate demand curve by considering three price levels. Changing the price level changes the real money supply. This diagram also shows the effects of increasing government spending, which shifts the AD curve.
Here we have the two AD curves. The Early Keynesians would have agreed with a horizontal aggregate supply curve. During the Great Depression, we experienced deflation, there was considerable slack capacity, and additional output could have been produced without a price increase. The more recent AS curve is thought to be upward sloping to some extent.
The Classical Economists thought that the AS curve was vertical because output was determined by the supply and demand for a factor of production, labor. While their "equation of exchange" produces an AD curve much like the Keynesian AD curve, the effect of shifting that AD curve is limited to a change in P.
