Aggregate Supply and Aggregate Demand [Money & Banking I Studied #11]

Alright!!~ Jumpin’ right iiin!!!

We learned AD and AS!~~!~! (aggregate demand - aggregate supply), so let’s lump the two together and draw them, and then we’ll look at Equilibrium!!~

AS-AD graph: the upward-sloping AS curve and the downward-sloping AD curve cross at the equilibrium, inflation π* and output Y*

Doooone~~~~~ Here the two curves cross at the short-run equilibrium! Their opposite slopes make that crossing unique in this diagram; opposite slopes alone wouldn’t guarantee a crossing in every possible case.

But wait! There was a fact that got super emphasized in the post right before this one:

If the long-run aggregate supply Y^p and the equilibrium output Y^* are not equal to each other, the curve moves!

What does???

In this model, as inflation expectations adjust, the short-run aggregate supply curve moves! Because Y^* - Y^p isn’t 0!!!!! An output gap opens up, so the inflation rate goes up (down, when output is below potential), the expected inflation rate follows it, and the short-run aggregate supply curve moves, until = 0!!

Then we can divide it into two situations: the case where Y^* > Y^p and the case where Y^* < Y^p !!!!!

(The case Y^* = Y^p just sits still, so it’s boring and it’s out! hehehehe)

Case Y* below Y^p: inflation falls, so the AS curve shifts down until Y^p = Y*, and the economy slides down along AD to potential output

Case Y* above Y^p: inflation rises, so the AS curve shifts up until Y^p = Y*, and the economy climbs up along AD to potential output

Jus’ attaching the pics should be aight? hehe

In this model, with the other curves held fixed and inflation expectations adjusting, output works its way back to potential. This is called the “self-correcting mechanism”! How quickly it works in practice is another question.

Okay, from now on the story is different!! Let’s think of it like this!

Suppose some country, having weathered every storm~~~, reaches long-run aggregate equilibrium!!

General Equilibrium: AD, AS and the vertical LRAS all cross at one point

Like sooo!!!!!

Now from here, we’ll look at the cases where AS, AD, or LRAS (long run aggregate supply) moves because of all sorts of variables!

Negative demand shock,
positive demand shock,
temporary (negative) supply shock,
permanent (negative) supply shock

Let’s look at these 4 situations. In those situations, on the graph it looks like this:

The four shocks on one AS-AD-LRAS graph: a negative demand shock moves AD left, a positive one moves AD right, a temporary (negative) supply shock moves AS up, and a permanent (negative) supply shock moves LRAS left

Soooo~~~ easyyy. It can all be explained with what we did~~~ before~

If the long-run aggregate supply Y^p and the equilibrium output Y^* are not equal to each other, the curve moves!! What does?~?~? In this model, the short-run aggregate supply curve moves as inflation expectations adjust!!!!!!

Because Y^* - Y^p isn’t 0!!!!! An output gap opens up, so the inflation rate goes up (down, when output is below potential), the expected inflation rate follows it, and the short-run aggregate supply curve moves, until = 0!!

That explains everything, lol.

When a negative demand shock sud!denly hits!!

Negative demand shock: AD shifts left to AD’, and the short-run equilibrium slides down along AS to lower inflation and lower output

When a sud!den negative demand shock hits like this!! There can be all sorts of things that set off a negative demand shock: $\overline{r}$ , $\overline{G}$ , $\overline{T}$ , $\overline{NX}$ , $\overline{f}$ , and so on and so on and so on! (We did this here.)

After the negative demand shock, output sits below Y^p, so the AS curve shifts down until Y* = Y^p, at lower inflation

Then: if the long-run aggregate supply Y^p and the short-run equilibrium output Y^* are not equal to each other, the curve moves. Because Y^* - Y^p isn’t 0! Until = 0!!

When a positive demand shock sud!!denly hits

Positive demand shock: AD shifts right to AD’, and the short-run equilibrium moves up along AS to higher inflation and higher output

When the demand curve suddenly moves like this!!!

(Causes: same as above.)

After the positive demand shock, output sits above Y^p, so the AS curve shifts up to AS’ until Y* = Y^p, at higher inflation

Then: if the long-run aggregate supply Y^p and the short-run equilibrium output Y^* are not equal to each other, the curve moves. Because Y^* - Y^p isn’t 0! Until = 0!!

When a temporary (negative) supply shock sud!!denly hits

Temporary (negative) supply shock: AS jumps up, so inflation rises and output falls, while LRAS stays put

There seem to be lots of things that could make it move like this!!! A temporary rise in crude oil prices, for example. Here we’re assuming the shock doesn’t change potential output; a disaster that destroys productive capacity would also affect LRAS.

This kind of temporary supply shock doesn’t change the economy’s production capacity, so LRAS stays just as it is!!!

After the temporary supply shock, output sits below Y^p, so the AS curve drifts back down until Y* = Y^p and inflation is back where it started

Then: if the long-run aggregate supply Y^p and the short-run equilibrium output Y^* are not equal to each other, the curve moves. Because Y^* - Y^p isn’t 0! Until = 0!!

When a permanent negative supply shock sud!!!denly hits!?

What kind of case is this??!

It’d be a case where the economy’s production capacity drops….well…. Like the country being reduced to ruins by a war? Or some regulation getting tightened for political reasons?? Something like that? hehehe

Well, in this case, on the graph:

Permanent (negative) supply shock: LRAS shifts left to LRAS’ at the lower potential output Y^p’

Well, here LRAS would move like this:

The AS curve shifts up until Y* = Y^p’, so the new equilibrium sits on LRAS’ at higher inflation

The original notes write this as follows: if the long-run aggregate supply Y^p and the short-run equilibrium output Y^* are not equal to each other, the curve moves. Because Y^* - Y^p isn’t 0! Until = 0!!

After this permanent shock, read those potential-output symbols as the new, lower $Y^{p\prime}$. The gap is $Y^*-Y^{p\prime}$ and closes at the new potential output, not at the old $Y^p$!

Okay, that’s it for this post. As for the next post, apparently it’ll cover “how to respond” in situations like those, hehe

Heads-up. The figures here are the original notes, slips and all. A few things to watch for:

After the permanent supply shock, the relevant potential output is the new $Y^{p\prime}$. The gap is $Y^*-Y^{p\prime}$, and it closes at that lower potential output, as the preceding diagram shows.
The label “General Equilibrium” here means long-run aggregate equilibrium in this AS–AD model.

When a negative demand shock sud!denly hits!!

When a positive demand shock sud!!denly hits

When a temporary (negative) supply shock sud!!denly hits

When a permanent negative supply shock sud!!!denly hits!?

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