Lecture 10 on Aggregate Demand & Supply Model

Business Cycle Facts

  • Overview of the business cycle and its phases.
  • Importance of understanding how the economy expands and contracts.

Quantity Theory of Money

  • Relationship between the quantity of money and the price level in an economy.
  • Key equation: MV = PY, where M is money supply, V is velocity, P is price level, and Y is output.

Long Run vs. Short Run

Long Run:

  • All inputs and prices are flexible.
  • Includes capital accumulation and technological progress.
  • Determines potential output in the economy.

Short Run:

  • Only labor is flexible; capital and technology are fixed.
  • Some prices (like wages) are sticky.
  • Output determined by aggregate demand in the short run.

Aggregate Demand and Aggregate Supply Model

  • Simple framework for understanding price and output determination.
  • Demand Side (AD): Influences of spending and monetary policy.
  • Supply Side (AS): Production capabilities influenced by factors of production.

Aggregate Demand (AD)

  • Definition: Relationship between quantity of output demanded and aggregate price level.
  • Downward sloping curve, indicating an inverse relationship between price level and quantity of output demanded.
    • Equation: MV = PY

Shifts in Aggregate Demand:

  • Changes in money supply or velocity of money can shift AD.
  • Increase in M or V shifts AD to the right; decrease shifts AD to the left.

Aggregate Supply (AS)

  • Definition: Relationship between quantity of output supplied and price level.

Long Run Aggregate Supply (LRAS):

  • In the long run, prices are flexible and output is independent of the price level.
  • Represented by vertical curve in the AS-AD model.
  • Money neutrality: Changes in money supply affect only price levels in the long run, not real output.

Short Run Aggregate Supply (SRAS):

  • Prices may be sticky, causing a positive relationship between output and price level in the short run.
  • Changes in demand can lead to fluctuations in output and prices.

Short Run Frictions

  1. Price Rigidity: Prices do not adjust immediately.
  2. Wage Rigidity: Wages are fixed due to contracts, limiting labor adjustments.
  3. Money Illusion: Workers focus on nominal wages (W) rather than real wages (W/P).

Effects of Money Supply Changes

  • Short Run: Increasing the money supply raises output (output above trend).
  • Long Run: Output returns to potential (trend) level; results in inflation as price levels increase.

Stabilization Policy

  • Addresses shocks to aggregate demand and supply.
  • Demand shocks: Reduce goods demand given a price level (e.g., financial crises).
  • Supply shocks: Affect production costs, such as natural disasters or oil price increases.

IS-LM Model Introduction

  • Developed post-WWII, based on Keynesian principles.
  • Focuses on interactions between goods market (IS curve) and money market (LM curve).

IS Curve:

  • Represents combinations of interest rates and income levels for equilibrium in the goods market.
  • Equation: Y = C + I + G (Closed economy; no net exports).

Summary of Key Concepts for Upcoming Lecture:

  • AS-AD model as a basis for understanding economic dynamics.
  • How consumption (C) and investment (I) respond to interest rates (r) and income (Y).