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Lecture 24

Uploaded by

bc220425047jra
Copyright
© © All Rights Reserved
Available Formats
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Macroeconomics

Lecture 24

1
Review of the Previous
Lecture
• Policies to Promote Growth (Cont)
– Policies to Increase Savings Rate
– Allocating the Economy’s Investment
– Encouraging Technological Progress
• Convergence

2
Topics under Discussion
• Economic Fluctuation
– Long Run vs Short Run
– Model of Aggregate Demand and
Supply

3
Issues under Discussion
• difference between short run & long
run
• introduction to aggregate demand
• aggregate supply in the short run &
long run
• see how model of aggregate supply
and demand can be used to analyze
short-run and long-run effects of
“shocks”
4
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. 5
In Classical Macroeconomic
Recall
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.
6
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?
7
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
• shows how the price level and aggregate
output are determined
• shows how the economy’s behavior is
different in the short run and long run
8
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.
• In the coming lectures, we shall discuss the
theory of aggregate demand in more detail.

9
The Quantity Equation as Agg.
Demand
• Recall the quantity equation
MV = PY
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:
10
The downward-sloping AD
curve
An increase in the P
price level causes
a fall in real
money balances
(M/P ), causing a
decrease in the
demand for goods
AD
& services.
Y

11
Shifting the AD curve
P

An increase in
the money
supply shifts
the AD curve
to the right.
AD
AD 2

1
Y

12
Aggregate Supply in the Long
• Recall Run
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.
13
Aggregate Supply in the
Long Run

 Full-employment output does not


depend on the price level,
so the long run aggregate supply
(LRAS) curve is vertical:

14
The long-run aggregate supply
curve
P LRAS

The LRAS curve


is vertical at the
full-employment
level of output.

Y
Y

15
Long-run effects of an
increase in M
P LRAS
An increase
in M shifts
the AD curve
to the right.
In the long run, P2
this increases
the price level… P1 AD
AD 2

1
…but leaves Y
Y
output the same.
16
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: 17
The short run aggregate
supply curve
P
The SRAS curve is
horizontal:
The price level is
fixed at a
SRAS
predetermined level,P
and firms sell as
much as buyers
demand. Y

18
Short-run effects of an
increase in M
P
In the short run
when prices
are sticky,… …an increase
in aggregate
demand…
SRAS
P
AD
AD2
1
Y
…causes Y1 Y2
output to rise.
19
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,
equilibrium, if the price level
will
Y  Y rise
Y  Y fall

Y  Y remain constant

This adjustment of prices is what moves the


20
economy to its long-run equilibrium.
The SR & LR effects of M > 0
P LRAS
A = initial equilibrium

B = new short-run
eq’m after SBP P2 C
increases M B SRAS
P
C = long-run A AD
equilibrium AD2
1
Y
Y Y2

21
Summary
• Economic Fluctuation
– Long Run vs Short Run
– Model of Aggregate Demand and Supply

22
Upcoming Topics
• Shocks
– Effects of Demand Shocks
– Effects of Supply Shocks
– Stabilization policy

23

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