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Aggregate Demand and Aggregate Supply in the Long Run

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A brief introduction to business cycles Model Background This model uses the quantity equation as aggregate demand and assumes long run supply to be perfectly ... – 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.

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.
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