Summary of the Macroeconomic Theory Background for the Chapter

"Aggregate Supply" and "Aggregate Demand" are not at all like demand and supply in microeconomics, and so a major task of the last five chapters has been to fill in the details that would make the concepts of "Aggregate Supply" and "Aggregate Demand" stand on their own as something more than analogies. By the end of Chapter 20 we knew that "equilibrium aggregate expenditure" would occur where planned expenditure is equal to production; that this might be less or more than "full employment." In this discussion, consumption expenditure in particular played a key role. Consumption expenditure was treated as the sum of two parts: 1) autonomous consumption and 2) the product of the Marginal Propensity to Consume, a constant, and income. Then "equilibrium aggregate expenditure" would be the product of the sum of the autonomous expenditures:

autonomous consumption plus
investment plus
government purchases plus
net exports

times "the multiplier,"

, where "MPC" means the Marginal Propensity to Consume.

"Aggregate Demand" is defined as the relationship between "equilibrium aggregate expenditure" and the price level. We noted that in the Simple Keynesian Model of Aggregate demand, this relationship is trivial -- a vertical line.

Skipping over to Ch. 23, we extended the reasoning of the Simple Keynesian Model, taking interest and the supply of money into account, to set out the Complete Keynesian Model of Aggregate Demand. In this more complete model, the Aggregate Demand relationship is downward sloping, because

Interest is a key cost of investment. Indeed
The profitability of investment can be expressed by the "internal rate of return," that is, the highest interest rate at which the investment would break even. Therefore
The higher the interest rate, the less investment can be profitably undertaken.
This defines an inverse relationship between interest and investment, the marginal efficiency of investment.
The interest rate in turn depends on the supply of money.
For these purposes, both the interest rate and the supply of money are adjusted for inflation -- real interest and real money balances.
Therefore, an increase in the price level will reduce the real value of a given nominal money supply, putting up interest rates, and therefore putting down investment and production.
This is the basis for an inverse aggregate demand relationship.

We had already, in chapters 21 and 22, considered some of the things that would shift the aggregate demand curve, noting that

a change in autonomous consumption
a change in investment
a change in net exports, or
a change in government purchases

would shift aggregate demand in the same direction by an amount equal to the change in the expenditure category times the multiplier. We also noted that a change in tax revenues would shift aggregate demand in the opposite direction by a smaller amount, the change in taxes times the tax multiplier,

. Since taxes have slightly less impact on aggregate demand than government spending, an equal change in spending and taxes would shift aggregate demand in the same direction by a multiplier of one.

We then went on to develop some ideas about Aggregate Supply. We may define Aggregate Supply as the relationship between the price level and the quantity of RGDP that businessmen find it profitable to sell. Essentially, we know three things about Aggregate Supply:

In the long run, it is vertical.
In the short run, it isn't.
If the price level is what people to expect it to be, both long and short run aggregate supply are at the NAIRGDP level.

The distinction between short and long run aggregate supply is that people react differently to the same events, depending on whether or not the events come as a surprise. Thus, in the short run, people are surprised by price changes and so they change their output decisions more than they would if they had anticipated the change. In the long run, people are not surprised, so they do not change output in response to changes in the price level at all.

In Chapter 20 we noted that the Keynesian equilibrium is not an equilibrium of "supply and demand" in the microeconomic sense, but a plan-fulfillment equilibrium -- a situation in which people can make their plans and have them come out as expected, on the average. A long run equilibrium of Aggregate Supply and Aggregate Demand is that same sort of plan-fulfillment equilibrium. People make their plans and things come out as they expect, without surprises. In the short run equilibrium, that's only true of demanders -- suppliers are surprised and are making the most of surprising opportunities or obstacles.

An Increase in Aggregate Demand