Aggregate Demand
and Aggregate
Supply in the Long
Run
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 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.
Building Aggregate Demand
• The quantity theory of money says
MV=PY
• Rearranging we get (M/P)=kY, where k
P
= 1/V, so as P increases Y decreases
• If we map this out we get an AD
function
• 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.
• Similarly a decrease in M or increase in
k would shift AD in.
AD
AD
AD
Y
Building Aggregate Supply: long run
• In the long run output is
determined by factor inputs
(Y=F(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
Y
Building Aggregate Supply: short run
• In the short run price is fixed so
the aggregate supply curve is
horizontal.
• In this context a shift in AD causes
P
a change in Y but has no effect on
P.
SRAS
P*
AD
AD
Y
Y
Y
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.
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.
• The end result is that Y returns to
P
LRAS
3
2
SRAS
P*
AD
1
the natural level but P is
permanently higher.
AD
Y
Y
Y
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 preshock levels.
However if there were a supply
shock then a policy adjustment
would imply a trade off between Y
or P.
With a negative supply shock
accommodating the shock would
mean returning the economy to Y
causing a higher P in the long run.
The alternative would be to wait
for the shock to pass.
P
LRAS
SRAS
SRAS
P*
AD
AD
AD
Y
Y
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.