CH 3.2 Macro8_Aggregate Demand _Aggregate Supply long and run.ppt

1. Aggregate Demand
and Aggregate
Supply in the Short
and Long Run
A brief introduction to business
cycles
Assoc Prof Ergin Akalpler

2. Aggregate supply
Aggregate supply (AS) is defined as the total amount of
goods and services (real output) produced and supplied
by an economy’s firms over a period of time.
It includes the supply of a number of types of goods and
services including private consumer goods, capital goods,
public and merit goods and goods for overseas markets.

3. Components of AS
• Consumer goods
• Private consumer goods and services, such as motor vehicles,
computers, clothes and entertainment, are supplied by the private
sector, and consumed by households. For a developed economy,
this is the single largest component of aggregate supply.
• Capital goods
• Capital goods, such as machinery, equipment, and plant, are
supplied to other firms. These investment goods are significant in
that their use adds to capacity, and increases the economy’s
ability to supply private consumer goods in the future.

4. Components of AS
• Public and merit goods
• Goods and services produced by private firms for
use by central or local government, such as
education and healthcare, are also a significant
component of aggregate supply. Many private firms
such as those in construction, IT and
pharmaceuticals, rely on contracts to supply to the
public sector.
• Traded goods
• Goods and services for export, such as chemicals,
entertainment, and financial services are also a key
component of aggregate supply.

5. The Classical view
The Classical view of real output was that it was fixed at a
particular level.
At this level, all the factors of production in the economy
would be fully employed. (let say at output 500).

6. Changes in AD will only bring about changes in the price level, not the level of real output

7. The Keynesian view
• The Keynesian AS curve assumes that prices and
wages are fixed until full employment is reached.
• Over the ‘Keynesian range’ there is spare capacity
in the economy, the price level is stable, and real
output can expand as a result of increases in AD
without any inflationary pressure.
• In keynesien economics in short run price is fixed
and AS is horizontal and
• in the long run AS becomes vertical and not
affected from price changes as in classical
approach

9. • Beyond full employment, any changes in AD will bring about higher price
levels. The Keynesian view of AS was adapted to show an ‘intermediate range’
where both unemployment and inflation could occur together.
In the short run as it is seen price
changes are observed. In
intermediate range it becomes
effective on AS and shift outward.
This causes higher price (inflation)
and shift Y to the right.

10. The ‘modern’ short run-long run view
• To solve the problem of the Keynesian and Classical AS curve,
modern economists tend to separate the short run AS curve
(SRAS) from the long run AS (LRAS) curve.
• The short run is assumed to begin immediately after an
increase in the price level
• (for example, as a result of an increase in AD), and ends when
input prices (costs of production) have increased.
• Hence, during the short run producers are experiencing an
increase in their ‘real’ prices and produce more output – and the
supply curve slopes upwards.

11. • Any increase in input prices (costs) which may follow is assumed to
lag behind increases in the general price level.
• In this analysis, SRAS and LRAS are separated. This allows
economists to be more flexible in their analysis of a modern
economy. This can be seen in the following example:
• PRICE LEVEL SRAS £bn LRAS £bn
• P8 650 500
• P7 600 500
• P6 550 500
• P5 500 500
• P4 450 500
• P3 400 500
• P2 350 500
• P1 300 500
• P0 250 500

13. The most likely cause of a shift in the SRAS curve is to accommodate
changes in the short run AD curve.

14. AD-AS Short Run
Building the short run AD-AS
model from the IS-LM
framework

15. Theory of Short Run Fluctuations
Keynesian
Cross
Money
Market
IS
Curve
LM
Curve
IS-LM
Model
AS
Curve
AD
Curve
AD-AS
Model
Short-run
Fluctuations
Explanation
The IS curve is generated from
the Keynesian Cross and the
LM curve is generated from the
market for real money
balances.
Now we will generate the AD
curve from IS-LM and use
short run and long run models
of AS to explain short run
economic fluctuations.

16. Fiscal Policy and the IS curve (government expenditure)
Y
LM
Y1
r1
r
IS1
An increase in government purchases
shifts the IS curve to the right.
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
IS2
r2
Y2
…which raises income...
The IS curve shifts to the
right by ΔG/(1-MPC),...
...and the interest rate.

17. Fiscal Policy and the IS curve (government expenditure)
Y
LM
Y1
r1
r
IS1
A decrease in taxes shifts the IS curve to
the right.
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
IS2
r2
Y2
…which raises income...
The IS curve shifts to the right
by ΔTxMPC/(1–MPC),...
...and the interest rate.

18. Fiscal Policy and the IS curve
(tax changes)
• Note that government expenditure has a
larger effect than does the same change in
taxes.
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM

19. Monetary Policy and the LM curve
Y
LM1
Y1
r1
r
IS1
An increase in the money supply shifts
the LM curve to the right,...
Y=C(Y-T)+I(r)+G ...IS
M/P=L(r,Y) ...LM
LM2
r2
Y2
…which raises income...
...and lowers the interest rate.

20. Together Monetary and Fiscal Policy Interactions
Y
LM1
r
IS2
IS1
…if the money
supply is held
constant, the
LM curve stays
the same.
• How the economy
responds to a tax
increase depends on
the response of the
money supply.
• MS stay constant but
• But the
interest rate
and output
fall.

21. Monetary and Fiscal Policy Interactions
Y
LM1
r
IS2
IS1
LM2
…if to hold the
interest rate constant,
the money supply
contracts.
• Only output
falls.
• How the economy
responds to a tax
increase depends on
the response of the
money supply.
• MS decrease /
contracts

22. Monetary and Fiscal Policy Interactions
Y
LM1
r
IS2
LM2
IS1
…if to hold
income
constant, the
money supply
expands.
• Only the
interest rate
falls.
• How the economy
responds to a tax
increase depends on
the response of the
money supply.
• MS expands

23. IS-LM as a theory of Aggregate Demand
• We now allow price
level to vary in the IS-
LM model. This
provides a theory for
the position and
slope of the AD
curve.
Y
LM(P1)
Y1
r
IS1
LM(P2)
Y2
Y
Y1
AD
Y2
P
A higher price level P shifts the
LM curve upward…
…lowering income Y.
P2
P1
The AD curve
summarizes the
relationship between
P and Y.

24. IS-LM as a theory of Aggregate Demand
• If we hold price
constant we can see
the effects of monetary
and fiscal policy on AD
via IS-LM.
Y
LM(P1)
Y1
r
IS1
LM(P1)
Y2
Y
Y2
AD1
Y1
P
A monetary expansion shifts the
LM curve outward…
…increasing income Y.
P1
Increasing AD at any
given price level.
AD2

25. IS-LM as a theory of Aggregate Demand
Y
LM(P1)
Y1
r
IS1
IS2
Y2
Y
Y2
AD1
Y1
P
A fiscal expansion shifts the IS
curve outward…
…increasing income Y.
P1
Increasing
AD at any
given price
level.
AD2

26. IS-LM and AD-AS the Short Run and the Long Run
• Now let’s add short-run and long-run
AS to our IS-LM and AD models.
Assume the economy is operating
below full employment output.
Y
Y
LM(P2)
r
IS
LM(P1)
Y
AD1
P
In the short run price is fixed at P1
and equilibrium is at point 1.
As price falls money demand
decreases and the LM curve shifts
out.
P1 SRAS1
LRAS
Y
1
2
1
2 SRAS2
P2
• Long run equilibrium is achieved
at point 2.
In the long run price falls to P2,
quantity demanded increases, and
equilibrium moves to point 2. This
is characterized by a shifting SRAS
curve.

27. The Algebra of the IS-LM theory of AD
• The algebra behind the system is a bit tedious.
But, by solving the LM curve for “r” and
plugging into the IS curve which contains “r” on
the right hand side you obtain the IS-LM
equilibrium condition or AD curve.

28. The Algebra of the IS-LM theory of AD
1
1 1 1 1
a c b d
Y G T r
b b b b

   
   
( / ) (1/ ) /
r e f Y f M P
 
The IS curve boils down to…
The LM curve boils
down to…
Plugging “r” into the IS
curve and solving for Y
yields…
( )
1 1 1 (1 )[ /(1 )]
z a c z zb d M
Y G T
b b b b f de b P

   
     

29. Conclusions short run
• In this section we derived the AD curve via the IS-
LM equilibrium condition. We looked at fiscal and
monetary policy effects on the IS-LM model. We
looked at the shifting effects that monetary and
fiscal policies have on the AD curve and used the
IS-LM model with the AD-AS model to explain short
run and long run changes to the economy.

30. Model Background in the long run
• 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.

31. Building Aggregate Demand long run
• The quantity theory of money says
MV=PY
• Rearranging we get (M/P)=kY, where k
= 1/V, so as P increases Y decreases
• If we map this out we get an AD
function
Y
P
AD
AD
AD
• 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.

32. 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.
Y
P LRAS
AD
AD
Y
P*
P*
• In this context a shift in AD causes
a change in the price level but has
no effect on Y.

33. Building Aggregate Supply: short run
• In the short run price is fixed so
the aggregate supply curve is
horizontal.
Y
P
SRAS
AD
AD
Y
P*
Y
• In this context a shift in AD causes
a change in Y but has no effect on
P.

34. From the Short Run to the Long Run
• The economy begins in long run
equilibrium at point 1.
Y
P
SRAS
AD
AD
Y
P*
Y
LRAS
1
2
3
• 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
the natural level but P is
permanently higher.

35. Stabilization Policy
• Fluctuations in the economy can
shift either AD or AS.
Y
P
SRAS
AD
AD
Y
P*
LRAS
AD
SRAS
• 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 pre-
shock 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.

36. 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.