Aggregate Demand and Aggregate Supply in the Long Run

Aggregate Supply in the Long Run P Y 0 AS lr In the long run, all of the economy’s resources are fully employed. As a result, the aggregate supply curve is vertical, demonstrating that output (Y) is constant at every price level. Note that Y equals Y femp at P 2 and P 1. Y femp P2P1P2P1

Aggregate Demand and Aggregate Supply in the Long Run P Y 0 AS lr In the long run, all of the economy’s resources are fully employed. Consequently, if aggregate demand increases or decreases in the long run, it results only in a change in the price level. Note that an increase in aggregate demand from AD 1 to AD 2 causes the price level to rise to from P 1 to P 2, while a decrease in aggregate demand from AD 2 to AD 2 causes the price level to fall from P 2 to P 1 Y femp P2P1P2P1 AD 2 AD 1

Aggregate Demand and Supply: Short Run Y P 0 AS In the short run, the aggregate supply curve is flat or upward sloping. The flat section occurs when the unemployment of resources is high. The upward sloping section occurs when there are lower levels of resource unemployment.

Aggregate Demand and Supply: Short Run Y P 0 AS AD 2 Given an upward sloping short-run aggregate supply curve, changes in aggregate demand change both the price level, P, and output, Y. Increases in AD cause Y and P to rise. Decreases in AD cause Y and P to fall. Y 1 Y 2 Y 3 AD 1 AD 3

Aggregate Demand and Supply: Short Run Y P 0 AS 3 In the short run, changes in AS change P and Y. Increases in AS cause Y to rise and P to fall. Decreases in AS cause Y to fall and P to rise. Y 1 Y 2 Y 3 AD 1 AS 2 AS 1

Aggregate Demand and Supply Y P 0 AS sr Y AD AS lr Long run equilibrium occurs at the intersection of aggregate demand and the long run aggregate supply curve where P = P and Y = Y. Since in the long run all prices have adjusted, short run equilibrium occurs at the same P-Y combination. P

Reduction in Aggregate Demand Y P 0 AS 1 Y* AD 1 AS lr P1P1 AD A decrease in aggregate demand from AD 1 to AD 2 moves the economy from point 1 to point 2. At point 2 the economy is in a recessionary gap equal to Y* - Y 1 because the economy is below Y*, the full employment level of Y. AS lr > AD, causing the price level to fall. Decreases in P increase aggregate demand, causing Y to rise from Y 1 to Y*. Decreases in wages cause the aggregate supply curve to shift right. Y1Y1 AS 2 P2P2

Increase in Aggregate Demand Y P 0 AS 1 Y* Y 1 AD 1 AS lr P1P1 AD 2 P2P An increase in aggregate demand from AD 1 to AD 2 moves the economy from point 1 to point 2. At point 2, the economy is in an inflationary gap equal to Y 1 – Y* because Y 1 is above Y*, the full employment level of Y. AD > AS lr, causing the price level to rise. Increases in P decrease aggregate demand, causing Y to fall from Y 1 to Y*. Increases in wages cause the aggregate supply curve to shift left. AS 2

Y P 0 AS 1 Y 1 Y* AD AS lr P1P1 Adverse Aggregate Supply Shock AS 2 P2P2 1 2 Adverse supply shocks push up costs and prices. If aggregate demand is fixed, the economy moves from point 1 to point 2 as Y falls and P rises. At point 2, AD < AS and Y 1 < Y*. Output is lower and the price level is higher. This is known as “stagflation.” To reach Y*, prices and wages must fall..

Y P 0 AS 1 Y 1 Y* AD AS lr P1P1 Increase in Aggregate Supply AS 2 P2P2 1 2 Increases in aggregate supply push down costs and prices. If aggregate demand is fixed, the economy moves from point 1 to point 2 as Y rises and P falls. In the USA during the 1990s, increases in productivity, decreases in resource costs, and a strong dollar that decreased the cost of imports resulted in a rightward shift of the aggregate supply curve

Conclusions: Long Run The crucial difference between the long and short run is that output is inflexible in the long run but not the short run. The long run aggregate supply curve is vertical. Therefore, shifts in aggregate demand cannot change output in the long run.

Conclusions: Short Run The short run aggregate supply curve is upward sloping. Therefore, shifts in aggregate demand can change levels of output and price levels. Shocks to aggregate demand and short run aggregate supply can cause fluctuations in economic activity.

Conclusions: Short Run Since the government can shift aggregate demand with fiscal and monetary policy, as well as aggregate supply with fiscal policy stabilization policies can be used to offset the impact of shifts in aggregate demand and aggregate supply.