The Economy in the Short Run: Aggregate Demand and Supply

Long run and short run

So far the course has used the long-run view, $Y = AK^aL^b$: output is set by inputs and technology. But actual GDP does not follow that smooth path. It swings around it, sometimes growing fast, sometimes shrinking. From this lecture on we explain those swings with the short-run view, $Y = C + I + G + NX$.

Business cycles

• Business cycles are fluctuations in aggregate economic activity, not in one particular variable.
• They have expansions and contractions; peaks and troughs are the turning points.
• Economic variables show comovement: they have regular, predictable patterns over the cycle.
• The cycle is recurrent but not periodic: it keeps happening, but not at fixed intervals.
• A particularly severe recession is a depression.

The lecture also sketches the debt cycle: in a bust, central banks lower interest rates to stimulate the economy; borrowing, spending and employment rise until a boom; then rates are raised to cool the economy, borrowers repay loans and cut spending, defaults and unemployment rise, and the cycle turns again.

Two time horizons

In the Keynesian view, demand depends on fiscal policy ($G$, $T$), monetary policy ($M$), other shifts in $C$ or $I$, and animal spirits: waves of optimism or pessimism.

Why are prices sticky?

The lecture links stickiness to market structure. Under perfect competition firms are price takers: many sellers, identical products, free entry, $P = MC$, zero economic profit in the long run. Firms with market power (the extreme is monopoly) are price setters: they choose a price where $MR = MC$ and hold it for a while. Price setters with contracts, menu costs and customers who dislike frequent changes create sticky prices.

Aggregate demand

The aggregate demand (AD) curve shows the quantity of output demanded at each price level. For a first model, derive it from the quantity equation:

With $M$ and $V$ fixed, a higher $P$ means each unit of money buys less: real money balances $M/P$ fall, and so does the quantity of goods demanded. That gives a downward-sloping AD. An increase in $M$ shifts AD to the right; a decrease shifts it to the left.

Aggregate supply

Long run: vertical

In the long run output is set by capital, labour and technology, $\bar Y = F(\bar K, \bar L)$, and does not depend on the price level. So the long-run aggregate supply (LRAS) curve is vertical at the full-employment or natural level of output, where unemployment is at its natural rate.

Short run: horizontal

In the extreme short run, assume all prices are stuck at a predetermined level $\bar P$, and firms sell as much as buyers want at that price. The short-run aggregate supply (SRAS) curve is then horizontal at $\bar P$.

Shocks and adjustment

Now combine them. Drag the money supply down to see a demand shock, then press Next period to watch prices adjust.

Walk through the lecture’s example: starting at the long-run equilibrium, $M$ falls.

1. AD shifts left. Prices are stuck, so the economy moves along the horizontal SRAS: output falls, the price level does not.
2. With output below $\bar Y$, prices gradually fall. The SRAS shifts down.
3. In the long run the economy is back at $\bar Y$, with a lower price level. Money had real effects only while prices were sticky.

Supply shocks

A supply shock changes production costs and so the prices firms charge; it is also called a price shock. Adverse examples: bad weather that ruins harvests and pushes up food prices, or an oil cartel raising the price of oil. Favourable supply shocks lower costs and prices.

Move the supply shock slider up. The SRAS jumps, prices rise and output falls at the same time: stagflation. The central bank now faces a dilemma: expanding demand would restore output but raise prices further; doing nothing leaves a recession until prices come back down.

Summary and review

• Business cycles: expansions, contractions, peaks, troughs; comovement; recurrent but not periodic.
• Long run: flexible prices, vertical LRAS at $\bar Y$. Short run: sticky prices, horizontal SRAS.
• Classical: supply determines output. Keynesian: demand matters in the short run.
• AD from $MV = PY$: downward sloping; higher $M$ shifts it right.
• Demand shocks move output first, prices later. Supply shocks cause stagflation.
• Prices rise when $Y > \bar Y$ and fall when $Y < \bar Y$, returning the economy to $\bar Y$.