On the Microfoundations of Aggregate Demand and Aggregate Supply.” Manuscript

Economies with nominal rigidities are usually modeled in an Aggregate Demand/Aggregate Supply framework. Early papers in the ‘New Keyne-sian Economics ’ literature typically assumed aggregate demand followed the quantity theory of money, but provided much more detailed formulations of aggregate supply. More recent papers have tried to give more detailed micro-foundations for aggregate demand. However, since consumers and rms are linked both through the goods market and the labor market, in general the form of aggregate demand is unlikely to be independent of the specication of production technology and wage- and price-setting behavior which underlie aggregate supply, and aggregate supply may also not be independent of the preferences and constraints which underlie aggregate demand. This paper establishes necessary and sucient conditions for a broad class of models under which aggregate demand may be derived separately from aggregate supply. The conditions are that both the marginal rate of substitution of consumption across periods and the marginal rate of substitution between consumption and real balances must be independent of hours worked. These conditions are restrictive; they are violated by two common money demand models, the Baumol-Tobin model and the shopping time model