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VU Lesson 24 Aggregate Demand and Aggregate Supply Time Horizons

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39 views4 pages

VU Lesson 24 Aggregate Demand and Aggregate Supply Time Horizons

helping others

Uploaded by

Ahmed Mukthar Ali
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Macroeconomics ECO 403 VU

Lesson 24
AGGREGATE DEMAND AND AGGREGATE SUPPLY

TIME HORIZONS
• Long run: Prices are flexible, respond to changes in supply or demand
• Short run: many prices are “sticky” at some predetermined level
The economy behaves much differently when prices are sticky.

CLASSICAL MACROECONOMIC THEORY


• Output is determined by the supply side:
• Supplies of capital, labor
• Technology
• Changes in demand for goods & services (C, I, G) only affect prices, not quantities.
• Complete price flexibility is a crucial assumption, so classical theory applies in the long
run.

WHEN PRICES ARE STICKY


Output and employment also depend on demand for goods & services, which is affected by:
Fiscal policy (G and T), monetary policy (M), other factors, like exogenous changes in C or I.
How? Why?

THE MODEL OF AGGREGATE DEMAND AND SUPPLY


The paradigm that most mainstream economists & policymakers use to think about economic
fluctuations and policies to stabilize the economy. This shows how the price level and
aggregate output are determined and how the economy’s behavior is different in the short run
and long run.

AGGREGATE DEMAND
The aggregate demand curve shows the relationship between the price level and the quantity
of output demanded. For an intro to the AD/AS model, we use a simple theory of aggregate
demand based on the Quantity Theory of Money.

THE QUANTITY EQUATION AS AGGREGATE DEMAND


Recall the quantity equation: M V = P Y and the money demand function it implies: (M/P) d = k
Y, where V = 1/k = velocity. For given values of M and V, these equations imply an inverse
relationship between P and Y.

THE DOWNWARD-SLOPING AD CURVE


An increase in the price level causes a fall in real money balances (M/P), causing a decrease
in the demand for goods & services.
P

AD
Y

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Macroeconomics ECO 403 VU

SHIFTING THE AD CURVE


An increase in the money supply shifts the AD curve to the right.

AD2
AD1
Y

AGGREGATE SUPPLY IN THE LONG RUN


Recall, In the long run, output is determined by factor supplies and technology:
Y = F (K , L )
Y is the full-employment or natural level of output, the level of output at which the economy’s
resources are fully employed. “Full employment” means that unemployment equals its natural
rate. Full-employment output does not depend on the price level, so the long run aggregate
supply (LRAS) curve is vertical.

P LRAS

LONG-RUN EFFECTS OF AN INCREASE IN MONEY


An increase in M shifts the AD curve to the right.

P LRAS

P2
In the long run, this
increases the price
level
P1 AD2

AD1

But leaves output the Y


Y
same.

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Macroeconomics ECO 403 VU

AGGREGATE SUPPLY IN THE SHORT RUN


In the real world, many prices are sticky in the short run. For now we assume that all prices
are stuck at a predetermined level in the short run and that firms are willing to sell as much as
their customers are willing to buy at that price level. Therefore, the short-run aggregate supply
(SRAS) curve is horizontal. The SRAS curve is horizontal: The price level is fixed at a
predetermined level, and firms sell as much as buyers demand.
P

SRAS
P

SHORT-RUN EFFECTS OF AN INCREASE IN M


P
In the short run when
prices are sticky.
An increase in
aggregate
demands

SRAS
P
AD2

AD1

Y
Causes output to Y1 Y2
rise.

FROM THE SHORT RUN TO THE LONG RUN


Over time, prices gradually become “unstuck.” When they do, will they rise or fall?

In the short-run then over time, the price


equilibrium, if level will

Y>Y Rise
Y<Y Fall
Y=Y Remain constant

This adjustment of prices is what moves the economy to its long-run equilibrium.

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Macroeconomics ECO 403 VU

THE SR & LR EFFECTS OF ∆M > 0

P LRAS

P2 C
B SRAS
P
A AD2
AD1
Y

Y Y2

A = initial equilibrium
B = new short-run equilibrium after SBP increases M
C = long-run equilibrium

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