2. 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.
3. Building Aggregate Demand
• 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
