AS-AD MODEL

Time Horizon in Macroeconomics

Long Run vs Short Run

Long run: Prices are flexible; market clearing

Short run: Prices are sticky Prices do not adjust to maintain equality in quantity

supplied and quantity demanded e.g. wages

Because of the difference in the behavior of prices,the effect policies may differ depending on the timehorizon.

AGGREGATE DEMAND AGGREGATE SUPPLY MODEL

Used to explain

Economic fluctuations

Effects of monetary and fiscal policies to the economy

The determination of price level and aggregate output

The economys behavior in the short run and long run

AGGREGATE DEMAND(AD)

Total real quantity of goods and services demanded in the economy at various prices,

ceteris paribus.

AGGREGATE DEMAND

Aggregate Output, Y

Price Level, P

AD

AGGREGATE DEMAND

Y = C + I + G + NX

Price level and consumption

Price level and investment

Price level and net exports

FISCAL POLICY AND AGGREGATE DEMAND

Expansionary Fiscal Policy (Increase in G; Decrease in T)

increases the aggregate demand.

Y

P

AD1AD2

AGGREGATE SUPPLY(AS)

Total real quantity of goods and services produced in the economy at various price

level, ceteris paribus.

AGGREGATE SUPPLY

LONG-RUN AGGREGATE SUPPLY (LRAS) CURVE

)L,K(FY

YY

Y

PLRAS

Y

AD

P1

AGGREGATE SUPPLY

SHIFT FACTORS OF LRAS:

1) Change in Labor

2) Change in Capital

3) Change in resource endowments

4) Change in technological knowledge

P2

Y

P

LRAS1

Y

P1

AD

LRAS2

Y

AGGREGATE SUPPLY

SHORT-RUN AGGREGATE SUPPLY (SRAS) CURVE

Y

P

SRAS

AD

P

In the short run, prices are sticky.

Y

PY

P

Y1

AD1

AD2

Expansionary fiscal policy increases the aggregate output in the short run.

SRAS

Y2

AS-AD MODEL

AS-AD MODEL

Y

P

LRAS

Y

AD

SRASP

INCREASE IN AGGREGATE DEMAND

Y

P

LRAS

Y

SRASP

AD1

AD2

P1

Y1