THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 662

630 PA R T V I I Monetary Theory wages begin to fall, shifting the short-run aggregate supply curve rightward until it comes to rest at AS3 The economy (equilibrium) slides downward along the aggregate demand curve until it reaches the long-run equilibrium point 3, the intersection of the aggregate demand curve AD and the long-run aggregate supply curve (LRAS) at Yn Here, as in panel (a), the economy comes to rest when output has again returned to the natural rate level A striking feature of both panels of Figure 24-5 is that regardless of where output is initially, it returns eventually to the natural rate level This feature is described by saying that the economy has a self-correcting mechanism An important issue for policymakers is how rapidly this self-correcting mechanism works Many economists believe that the self-correcting mechanism takes a long time, so the approach to long-run equilibrium is slow This view is reflected in Keynes s often quoted remark, In the long run, we are all dead These economists view the self-correcting mechanism as slow because wages are inflexible, particularly in the downward direction when unemployment is high The resulting slow wage and price adjustments mean that the aggregate supply curve does not move quickly to restore the economy to the natural rate of unemployment Hence when unemployment is high, these economists, many of whom are followers of Keynes and are thus known as Keynesians, are more likely to see the need for active government policy to restore the economy to full employment Other economists believe that wages are sufficiently flexible that the wage and price adjustment process is reasonably rapid As a result of this flexibility, adjustment of the aggregate supply curve to its long-run position and the economy s return to the natural rate levels of output and unemployment will occur quickly Thus these economists see much less need for active government policy to restore the economy to the natural rate levels of output and unemployment when unemployment is high Indeed, Milton Friedman and his followers, known as monetarists, advocate the use of a rule whereby the money supply or the monetary base grows at a constant rate so as to minimize fluctuations in aggregate demand that might lead to output fluctuations We will return in Chapter 26 to the debate about whether government policy should react in a discretionary fashion to keep the economy near full employment Changes in the Equilibrium Caused by Aggregate Demand Shocks With an understanding of the distinction between short-run and long-run equilibria, you are now ready to analyze what happens when an economy s aggregate demand curve shifts Figure 24-6 depicts the effect of a rightward shift in the aggregate demand curve due to positive demand shocks: an increase in the money supply (M c), an increase in government spending (G c), an increase in net exports (NX c), a decrease in taxes (T *), or an increase in the willingness of consumers and businesses to spend because they become more optimistic (C c, I c) The figure has been drawn so that the economy initially is in long-run equilibrium at point 1, where the initial aggregate demand curve AD1 intersects the shortrun aggregate supply AS1 curve at Yn When the aggregate demand curve shifts rightward to AD2, the economy moves to point 1+ and both output and the price level rise However, the economy will not remain at point 1+ in the long run because output at Y1+ is above the natural rate level Wages will rise, increasing the costs of production at all price levels and the short-run aggregate supply curve will eventually shift leftward to AS2, where it finally comes to rest The economy (equilibrium) thus slides up the aggregate demand curve from point 1+ to point 2, which is the point of long-run equilibrium at the intersection of AD2 and the longrun aggregate supply curve (LRAS) at Yn Although the initial short-run effect