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, AD
hence an outward shift of AD. AD
Changing M is monetary policy. Also
because Y = C + I + G + NX, demand AD
side variables can shift AD as well. Y
Changing G or T is fiscal policy.
• Similarly a decrease in M or increase in
k would shift AD in.
 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
P LRAS
aggregate supply is vertical.

• 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.
P
• In this context a shift in AD
causes a change in Y but has no
effect on P.

P* SRAS
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 P
LRAS
to point 2, above full employment
output. 3
• As we approach the long run there
is upward pressure on P. As P 2
increases Y decreases and we P* SRAS
move along AD to point 3.
AD
• The end result is that Y returns to 1
the natural level but P is AD
permanently higher. 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 P LRAS
shock to AD can be corrected with
P and Y returning to their pre-
shock levels. SRAS
• However if there were a supply
shock then a policy adjustment P* SRAS
would imply a trade off between Y
or P. AD
• With a negative supply shock AD
accommodating the shock would AD
Y
mean returning the economy to Y
causing a higher P in the long run. Y
• The alternative would be to wait
for the shock to pass.
 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.