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.