Average Price Level

Real Output = National Income = Y

0

Aggregate Demand Curve

The AD curve shows total demand in an economy,And thus output from households, firms,the government and the international sector at difference price levels. A fall in prices from PL1 toPL2 leads to an increase in real output from Y1 to Y2.

AD = C+I+G+[X-M]

Y1 Y2

P1

P2

C = Consumption I = Investments G = Government Spending X = Exports M = Imports

Average Price Level ($)

Real Output (Y)0

SRAS

Y1 Y2

P1

P2

Short-Run Aggregate Supply (SRAS) Curve

In the short run, increases in output will normally onlybe achieved in increases in average costs. These are passed onto the consumers through higher prices. So an increase in output from Y1 to Y2 will only be achieved with an increase in prices from P1 to P2.

Average Price Level ($)

Real Output (Y)

0

(1)(2)

(3)

LRAS

Y1

Keynesian Long-Run Aggregate Supply Curve

1. Output maybe increased with no increase in prices, because there is lots of spare capacity in the economy.

2. Spare capacity is being used up and output goes up, but with increases in costs as factors of production cost more

3. Output cannot be increased because all factors are being used.

AveragePrice Level ($)

0Real Output (Y)

P1

P2

Neo-Classical Long Run Average Supply (LRAS) Curve

Neo-Classical economists believe that the LRAS curve us set by quantity and quality of factors of production in the economy and so it is perfectly inelastic at the full employment level of output (Y1)

Y1

AveragePrice Level ($)

0Real Output (Y)

SRAS

AD

Short-run Equilibrium Output

The economy is in short-run equilibrium where AD equals SRAS and so there will be an output level of Y at a price level of P.

P

Y

AveragePrice Level ($)

0Real Output (Y)

Expansionary Demand-Side Policy

AD1

AD2

P1

P2

Y1 Y2

A government may use fiscal and/or monetary policy to shift AD from AD1 to AD2. This would have an effect of expanding the economy from Y1 to Y2, thus increasing employment. However, there will be a “trade-off” as the price level rises from P1 to P2.

AveragePrice Level ($)

0Real Output (Y)

LRAS1 LRAS2

Y1 Y2

P1

P2

The Effect of Supply-Side Policies for Keynesian and Neo-Classical LRAS Curves

Both Keynesian and Neo-Classical economists believe that an improvement in the quantity and/or quality of factors of production will shift the LRAS curve to the right.

AveragePrice Level ($)

0Real Output (Y)

SRAS2

SRAS1

AD

P2

P1

Y1 Y2

Cost Push Inflation

When there is an increase in the costs of facts of production such as wage increases in oil prices, then firms’ costs are pushed upwards, the STAS curve shifts from SRAS1 to SRAS2, and the average price level rises from P1 to P2. This is cost-push inflation. Real output also falls from Y1 to Y2.

AveragePrice Level ($)

0Real Output (Y)

LRAS

AD

Y Y1

P

The Equilibrium Level and the Full Employment Level, of National Income

The long-run equilibrium level of national income is where AD is equal to LRAS. The full employment level of national income is where all factors are being employed. Keynesians believe that the two do no necessarily coincide. The equilibrium level is at Y, but the employment level is at Y1.

AveragePrice Level ($)

0Real Output (Y)

SRAS

AD2AD1

P2

P1

Y1 Y2

Demand Pull Inflation

An increase in AD, caused by a sustained increase in any of the components of AD will shift the AD curve from AD1 to AD2, and the average price level will rise from P1 to P2. This is demand-pull inflation, in this case real output increases from Y1 to Y2.