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Aggregate Demand and Aggregate Supply in the Long Run A brief introduction to business cycles

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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.

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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 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.

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

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

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From the Short Run to the Long Run The economy begins in long run equilibrium at point 1. Y P SRAS AD P* Y LRAS 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.

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Stabilization Policy Fluctuations in the economy can shift either AD or AS. Y P SRAS AD 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.

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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.

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