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Macroeconomics ECO 403
VU
LESSON 24
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Issues under Consideration
·
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"
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.
In Classical Macroeconomic Theory,
Recall
·
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
·
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
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.
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Macroeconomics ECO 403
VU
·
In the coming lectures, we shall discuss the theory of aggregate demand in more detail.
The Quantity Equation as Aggregate 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:
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
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Shifting the AD curve
An increase in the money supply shifts the AD curve to the right.
P
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
Y
Y
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Macroeconomics ECO 403
VU
Long-run effects of an increase in M
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
Y
...but leaves output the
Y
same.
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
Y
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Macroeconomics ECO 403
VU
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 rise.
Y1
Y2
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 equilibrium,
then over time, the price
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 ΔM > 0
P
LRAS
C
P2
B
SRAS
P
A
AD2
AD1
Y
Y2
Y
A = initial equilibrium
B = new short-run equilibrium after SBP increases M
C = long-run equilibrium
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