Aggregate Demand and Aggregate Supply in the Long Run

1
Aggregate Demand and Aggregate Supply in the Long
Run

• A brief introduction to business cycles

2
Model Background

• This model uses the quantity equation as
  aggregate demand and assumes long run supply to
  be perfectly vertical and short run supply to be
  perfectly horizontal.
• If the model is out of equilibrium it is the
  changing price level that returns the model to
  equilibrium.

3
Building Aggregate Demand

• The quantity theory of money says MVPY
• Rearranging we get (M/P)kY, where k 1/V, so
  as P increases Y decreases
• If we map this out we get an AD function

P

• An increase in M or a decrease in k implies that
  for any given P, Y is higher, hence an outward
  shift of AD. Changing M is monetary policy.
  Also because Y C I G NX, demand side
  variables can shift AD as well. Changing G or T
  is fiscal policy.

AD
AD
Y

• Similarly a decrease in M or increase in k would
  shift AD in.

4
Building Aggregate Supply long run

• In the long run output is determined by factor
  inputs (YF(K,L)) and is not dependent on price.
  Hence, long run aggregate supply is vertical.

P
LRAS

• In this context a shift in AD causes a change in
  the price level but has no effect on Y.

P
AD
P
AD
Y
5
Building Aggregate Supply short run

• In the short run price is fixed so the aggregate
  supply curve is horizontal.

P

• In this context a shift in AD causes a change in
  Y but has no effect on P.

SRAS
P
AD
AD
Y
Y
6
From the Short Run to the Long Run

• The economy begins in long run equilibrium at
  point 1.

• If aggregate demand shifts out, the economy moves
  from point 1 to point 2, above full employment
  output.

LRAS
P
3

• As we approach the long run there is upward
  pressure on P. As P increases Y decreases and we
  move along AD to point 3.

2
SRAS
P
AD
1

• The end result is that Y returns to the natural
  level but P is permanently higher.

AD
Y
Y
7
Stabilization Policy

• Fluctuations in the economy can shift either AD
  or AS.

• Fiscal and monetary policies are able to shift
  AD. Because of this a shock to AD can be
  corrected with P and Y returning to their
  pre-shock levels.

LRAS
P
SRAS

• However if there were a supply shock then a
  policy adjustment would imply a trade off between
  Y or P.

SRAS
P
AD

• With a negative supply shock accommodating the
  shock would mean returning the economy to Y
  causing a higher P in the long run.

AD
AD
Y

• The alternative would be to wait for the shock to
  pass.

8
Conclusion

• We constructed a basic AD/AS model. AD was
  derived from the quantity theory of money
  function. In the short run, P is sticky and SRAS
  is horizontal. In the long run factor inputs
  determine Y and P is variable so LRAS is
  vertical.