Aggregate Supply and Demand

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Aggregate Supply and Demand

The quantity theory can be shown graphically in terms of the

aggregate-supply aggregate-demand framework that has become popular in

macroeconomic textbooks. Aggregate demand is the amount people will

spend, or money multiplied by velocity. If money is 30 and velocity is

7, total spending will be 210. Total spending of 210 can be divided

between prices and quantities in a number of ways. If the price level

(P) is 1, quantity (Q) will be 210. If P is 2, Q will be 105, if P is

3, Q will be 70, if P is 5, Q will be 42, etc. When graphed with axes

of price level and transactions, aggregate demand has the form of a

rectangular hyperbola.1 This aggregate-demand curve is shown below as

the MV curve.

The quantity theory assumes that transactions are determined outside

the model by the availability of resources and by technology. Because

it assumes there are no adjustment problems, the aggregate supply

curve is the vertical line shown in the graph above as the T curve. At

each price level the same quantity is available, or price level does

not influence quantity supplied. The price level is determined by the

intersection of these two curves. If the amount of money increases,

the aggregate demand curve shifts to the right. Since transactions are

fixed, the end results must be an increase in price level.

Notice that aggregate-supply and aggregate-demand curves are

describing what happens in the market for goods and services, not in

the market for money balances. If there is a disturbance in the money

market, that disturbance is transmitted to the goods-and-services

market via the aggregate-demand curve. The quantity theory encourages

us to see a purchase of goods as a sale of money, and a sale of goods

as a purchase of money. Changes in the resource market are transferred

to the goods-and-services market via the aggregate supply curve. The

quantity theory does not see the market for goods and services as the

place disturbances begin. What we see happening in this part of the

economy is the result of events in other sectors.

Though very simple, this model helps make sense of a number of

historical events. For example, U. S. economic growth in the late 19th

century, spurred by increases in resources and improving technology,

was faster than the growth in money stock. The graph above predicts

deflation...

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...lry, tableware, and artistic purposes. Their actions will reflect

the law of demand: whenever a commodity becomes cheaper, people use

more of it. Thus if there is a sudden influx of gold into a country

that uses it as money, part of the influx will be diverted to its

commodity use, and the effects on the amount of money, and hence on

the price level, will be lessened. On the other hand, a sudden decline

will also be cushioned, because as the commodity grows more valuable,

people will transfer it from its commodity use into a monetary use. If

the amount of gold declines and it rises in value, there is an

incentive to melt down jewelry, tableware, and artistic objects and

use the gold as money. Hence a doubling of gold may not double the

amount of money, and cutting the amount of gold by one half may not

cut money by one half.

Second, if money falls in value, the incentive to produce more of it

is cut and if it rises in value, the incentive to produce more of it

is raised. If the value of gold increases, more people will try to

find it, and if its value declines, fewer people will search for it.

The third reason takes us into the realm of international economics.

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