16. Short-Run Aggregate Supply/Aggregate Demand and Policy

This chapter deals with relationships between the price level and real output. A higher price level is linked with a reduced level of aggregate demand (AD), but with an increased level of aggregate supply (AS). The curves for AD and AS are first explained in conventional Keynesian terms, where a change in the price level causes a change in the quantity demanded and the quantity supplied; AD is shaped by the central bank’s response to inflation, while AS is driven by stories of sticky wages or worker misperceptions. These are followed by alternative explanations: AD is shaped by the uncertain transition from planned expenditure to achieved real demand. AS results from the varying degree of firms’ willingness and ability to respond to increased demand by increasing output. The chapter ends with a discussion of the Lucas critique and an extension of that insight to broader issues of how policy is perceived.