# Aggregate Demand and Aggregate Supply in the Long Run - PowerPoint PPT Presentation

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## Aggregate Demand and Aggregate Supply in the Long Run

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### Aggregate Demand and Aggregate Supply in the Long Run. A brief introduction to business cycles ... This model uses the quantity equation as aggregate demand and ... – PowerPoint PPT presentation

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Title: 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.

Y
• Similarly a decrease in M or increase in k would

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
P
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
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
1
• The end result is that Y returns to the natural
level but P is permanently higher.

Y
Y
7
Stabilization Policy
• Fluctuations in the economy can shift either AD
or AS.
• Fiscal and monetary policies are able to shift
corrected with P and Y returning to their
pre-shock levels.

LRAS
P
SRAS
• However if there were a supply shock then a
Y or P.

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