THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 665

CHAPTER 24 Aggregate Demand and Supply Analysis 633 rises because of a reduction of aggregate demand that shifts the AD curve inward, the natural rate of unemployment is viewed as rising above the full employment level This could occur because the unemployed become discouraged and fail to look hard for work or because employers may be reluctant to hire workers who have been unemployed for a long time, seeing it as a signal that the worker is undesirable The outcome is that the natural rate of unemployment shifts upward after unemployment has become high, and Yn falls below the full employment level In this situation, the self-correcting mechanism will be able to return the economy only to the natural rate levels of output and unemployment, not to the full employment level Only with expansionary policy to shift the aggregate demand curve to the right and raise aggregate output can the natural rate of unemployment be lowered (Yn raised) to the full employment level Proponents of hysteresis are thus more likely to promote governmemnt intervention and expansionary policies to restore the economy to full employment Conclusions Aggregate demand and supply analysis yields the following conclusions (under the usual assumption that the natural rate level of output is unaffected by aggregate demand and supply shocks): A shift in the aggregate demand curve which can be caused by changes in monetary policy (the money supply), fiscal policy (government spending or taxes), international trade (net exports), or animal spirits (business and consumer optimism) affects output only in the short run and has no effect in the long run Furthermore, the initial change in the price level is less than is achieved in the long run, when the aggregate supply curve has fully adjusted A shift in the aggregate supply curve which can be caused by changes in expected inflation, workers attempts to push up real wages, or a supply shock affects output and prices only in the short run and has no effect in the long run (holding the aggregate demand curve constant) The economy has a self-correcting mechanism, which will return it to the natural rate levels of unemployment and aggregate output over time A PP LI CATI O N Explaining Past Business Cycle Episodes Aggregate supply and demand analysis is an extremely useful tool for analyzing aggregate economic activity; we will apply it to several business cycle episodes To simplify our analysis, we always assume that aggregate output is initially at the natural rate level The United States During the Vietnam War Buildup, 1964 1970 America s involvement in Vietnam began to escalate in the early 1960s, and after 1964, the United States was fighting a full-scale war Beginning in 1965, the resulting increases in military expenditure raised government spending, while at the same time the Federal Reserve increased the rate of money growth in an attempt to keep interest rates from rising What does aggregate supply and demand analysis suggest should have happened to aggregate output and the price level in the United States as a result of the Vietnam War buildup? The rise in government spending and the higher rate of money growth would shift the aggregate demand curve to the right (shown in Figure 24-6 on page 631)