The classical dichotomy divides variables into real variables (variables that measure quantities or relative prices) and nominal variables (variables that are measured in monetary terms).

According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables, that is, monetary neutrality.

Most economists believe that classical theory describes the world in the long run but not in the short run.

When looking at year-to-year economic changes, the assumption of monetary neutrality no longer applies. In the short run, real variables and nominal variables are highly correlated, and changes in the money supply can temporarily cause real GDP to deviate from its long-term trend.

Models of short-run economic fluctuations focus on the behavior of two variables: the first is the economy's output of goods and services, measured by real GDP; the second is measured by the CPI or GDP deflator. overall price level.

Aggregate Demand and Aggregate Supply Model: A model used by most economists to explain short-term fluctuations in economic activity around its long-term trend.

Aggregate demand curve: A curve showing the quantity of goods and services that households, businesses, governments, and foreign customers want to buy at each price level.

Aggregate supply curve: A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level.

The aggregate demand and aggregate supply models are completely different from the market demand and market supply models in microeconomics. Microeconomic substitution from one market to another is not possible for the economy as a whole.

1. Price level and consumption: wealth effect. Lower price levels increase the real value of money and make consumers wealthier, which in turn encourages them to spend more. Increased consumer spending means greater demand for goods and services. Conversely, rising price levels reduce the real value of money and make consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

2. Price level and investment: interest rate effect. The price level is a determinant of the quantity of money demanded. A lower price level lowers interest rates, encouraging more spending on investment goods, thereby increasing the demand for goods and services. Conversely, rising price levels raise interest rates, dampen investment spending, and reduce the quantity of goods and services demanded.

3. Price level and net exports: exchange rate effect. When the U.S. price level falls, causing U.S. interest rates to fall, the real value of the dollar in the foreign exchange market falls. This depreciation stimulates U.S. net exports, thereby increasing demand for goods and services. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar rises, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.

Importantly, the aggregate demand curve is drawn assuming "other things being equal", and in particular, all three explanations of the downward-sloping aggregate demand curve assume that the money supply is fixed. A change in the quantity of money shifts the aggregate demand curve.

1. Shifts caused by changes in consumption: When the price level is given, events that increase consumer spending (tax cuts, stock market surges) shift the aggregate demand curve to the right; when the price level is given, events that decrease consumer spending ( Tax increases, stock market downturns) shift the aggregate demand curve to the left.

2. Movement caused by changes in investment: When the price level is given, events that increase corporate investment (optimism about the future, a decrease in interest rates due to an increase in money supply) shift the aggregate demand curve to the right; Events that reduce business investment (pessimism about the future, rising interest rates due to a reduction in the money supply) shift the aggregate demand curve to the left.

3. Shifts caused by changes in government purchases: increases in government purchases of goods and services (increased spending on national defense or highway construction) shift the aggregate demand curve to the right; decreases in government purchases of goods and services (cuts in spending on national defense or highway construction) spending on highway construction) shifts the aggregate demand curve to the left.

4. Movement caused by changes in net exports: When the price level is given, events that increase net export spending (foreign economic prosperity, speculation that causes exchange rate declines) shift the aggregate demand curve to the right; when the price level is given, net export spending is reduced Events (foreign recession, speculation causing exchange rate increases) shift the aggregate demand curve to the left.

In the long run, an economy's production of goods and services (its real GDP) depends on its supply of labor, capital, and natural resources, and on the technology available to convert these factors of production into goods and services.

The price level does not affect these long-run determinants of real GDP, so the long-run aggregate supply curve is vertical.

The aggregate supply curve is vertical only in the long run.

Natural level of output: The level of production of goods and services that an economy achieves in the long run when unemployment is at its normal rate.

Any change in the economy that changes the natural level of output shifts the long-run aggregate supply curve.

1. Movement caused by labor changes. Any change in the number of workers and the natural unemployment rate will shift the long-term aggregate supply curve.

2. Movement caused by changes in capital. An increase in the capital stock in the economy increases productivity, thereby increasing the supply of goods and services, with the result that the long-run aggregate supply curve will shift to the right. Otherwise, move to the left.

3. Changes in natural resources cause movement.

4. Movement caused by changes in technical knowledge.

Although many factors determine the economy in the long run, and in theory these factors can cause such a move, the two most important factors in the real world are technology and monetary policy.

Long-term trends are the result of the superposition of short-term fluctuations. Short-term fluctuations in output and price levels should be viewed as departures from sustained long-term trends in output growth and inflation.

The long-run aggregate supply curve is vertical because in the long run the aggregate price level does not affect the economy's ability to produce goods and services. In contrast, in the short run the price level does affect the economy's output. The short-run aggregate supply curve slopes upward to the right.

When the actual price level in the economy deviates from people's expected price levels, supply deviates from its long-term or natural level.

1. Sticky wage theory. According to the sticky wage theory, the short-run aggregate supply curve slopes upward because nominal wages are determined based on expected prices, and when the actual price level turns out to be different from the expected level, nominal wages do not respond immediately.

2. Sticky price theory. Sticky price theory emphasizes that the prices of some goods and services are also slow to adjust to changes in economic conditions.

3. Illusion theory. According to the illusion theory, changes in the general price level temporarily mislead suppliers about what is happening in the individual markets in which they sell their products. Because of these short-run illusions, suppliers respond to changes in the price level, and this response causes the aggregate supply curve to slope upward to the right.

Supply of output = natural output level α (actual price level – expected price level) where α is the number that determines how much output responds to unexpected changes in the price level.

Whether the short-run aggregate supply curve slopes upward to the right is due to sticky wages, sticky prices, or an illusion, these conditions are not permanent.

When considering what causes the short-run aggregate supply curve to shift, we must consider all the variables that shift the long-run aggregate supply curve plus a new variable—the expected price level, which affects sticky wages, sticky prices, and the illusion of relative prices .

Shifts in the long-run aggregate supply curve are typically caused by changes in labor, capital, natural resources, and technological knowledge, and these same variables also shift the short-run aggregate supply curve.

When people change their expectations about the price level, the short-run aggregate supply curve will also shift.

General conclusion: An increase in the expected price level reduces the supply of goods and services and shifts the short-term aggregate supply curve to the left; a decrease in the expected price level increases the supply of goods and services and shifts the short-term aggregate supply curve to the right.

1. Determine whether an event shifts the aggregate demand curve or the aggregate supply curve (or both curves).

2. Determine the direction of the curve movement.

3. Use graphs of aggregate demand and aggregate supply to illustrate how this shift affects output and the price level in the short run.

4. Use aggregate demand and aggregate supply diagrams to analyze how the economy changes from its new short-term equilibrium to its long-term equilibrium.

1. In the short run, movements in aggregate demand cause fluctuations in the output of goods and services in the economy.

2. In the long run, movements in aggregate demand affect the overall price level, but do not affect output.

3. Policymakers who influence aggregate demand can potentially mitigate the severity of economic fluctuations.

1. Movements in aggregate supply will cause a combination of stagflation-recession (reduced output) and inflation (increased prices).

2. Policymakers who can influence aggregate demand can potentially mitigate the adverse effects on output, but only at the expense of exacerbating the inflation problem.