Explaining Fluctuations in Output

The Aggregate Demand Curve Shows
Aggregate Demand Curve Shifts
Aggregate Demand Curve Definition
Aggregate Real Money Demand Curve Formula
Aggregate Demand Supply Curve
Aggregate Real Money Demand Curve

In the short run, output fluctuates with shifts in either aggregate supply or aggregate demand; in the long run, only aggregate supply affects output.

The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. An example of an aggregate demand curve is given in Figure. The vertical axis represents the price level of all final goods and services. If money supply is further increased and as a result aggregate demand curve shifts upward to AD 3, and cuts aggregate supply curve AS at point E 3, even then only aggregate output rises to its full employment level Y F, price level remaining unchanged. Thus with aggregate demand curve AD 3 economy is operating at full employment level of output. Money supply, an increase in the price level from PI to P2 shifts the LM curve upward because real balances decline; this reduces income from Yl to Y2. The aggregate demand curve in Figure Il—I(B) summarizes this relationship between the price level and income that results from the IS—LM model. Figure 11—1 0 92 A. The IS-LM Model Income. Aggregate demand occurs at the point where the IS and LM curves intersect at a particular price. If some individual considers a higher price level, then the real supply of money will definitely be lower. As a result, the LM curve will shift higher. Furthermore, the aggregate demand will be lower.

Learning Objectives

Differentiate between short-run and long-run effects of nominal fluctuations

Key Takeaways

Key Points

The Aggregate Demand Curve Shows

In the short run, output is determined by both the aggregate supply and aggregate demand within an economy. Anything that causes labor, capital, or efficiency to go up or down results in fluctuations in economic output.
Aggregate supply and aggregate demand are graphed together to determine equilibrium. The equilibrium is the point where supply and demand meet.
According to Hume, in the short-run, and increase in the money supply will lead to an increase in production.
According to Hume, in the long-run, an increase in the money supply will do nothing.

Key Terms

nominal: Without adjustment to remove the effects of inflation (in contrast to real).
economic output: The productivity of a country or region measured by the value of goods and services produced.

Economic Output

In economics, output is the quantity of goods and services produced in a given time period. The level of output is determined by both the aggregate supply and aggregate demand within an economy. National output is what makes a country rich, not large amounts of money. For this reason, understanding the fluctuations in economic output is critical for long term growth. There are a series of factors that influence fluctuations in economic output including increases in growth and inputs in factors of production. Anything that causes labor, capital, or efficiency to go up or down results in fluctuations in economic output.

Aggregate Supply and Aggregate Demand

Aggregate supply is the total amount of goods and services that firms are willing to sell at a given price in an economy. The aggregate demand is the total amounts of goods and services that will be purchased at all possible price levels.

In a standard AS-AD model, the output (Y) is the x-axis and price (P) is the y-axis. Aggregate supply and aggregate demand are graphed together to determine equilibrium. The equilibrium is the point where supply and demand meet to determine the output of a good or service.

Short-run vs. Long-run Fluctuations

Supply and demand may fluctuate for a number of reasons, and this in turn may affect the level of output. There are noticeable differences between short-run and long-run fluctuations in output.

Over the short-run, an outward shift in the aggregate supply curve would result in increased output and lower prices. An outward shift in the aggregate demand curve would also increase output and raise prices. Short-run nominal fluctuations result in a change in the output level. In the short-run an increase in money will increase production due to a shift in the aggregate supply. More goods are produced because the output is increased and more goods are bought because of the lower prices.

AS-AD Model: This AS-AD model shows how the aggregate supply and aggregate demand are graphed to show economic output. The AD curve shifts to the right which increases output and price.

In the long-run, the aggregate supply curve and aggregate demand curve are only affected by capital, labor, and technology. Everything in the economy is assumed to be optimal. The aggregate supply curve is vertical which reflects economists’ belief that changes in aggregate demand only temporarily change the economy’s total output. In the long-run an increase in money will do nothing for output, but it will increase prices.

Classical Theory

Classical theory, the first modern school of economic thought, reoriented economics from individual interests to national interests.

Learning Objectives

Identify the assumptions fundamental to classical economics

Key Takeaways

Key Points

When classical theory emerged, society was undergoing many changes. The primary economic question involved how a society could be organized around a system in which every individual sought his own monetary gain.
Classical economics focuses on the growth in the wealth of nations and promotes policies that create national economic expansion.
Classical theory assumptions include the beliefs that markets self-regulate, prices are flexible for goods and wages, supply creates its own demand, and there is equality between savings and investments.

Key Terms

self-regulating: Describing something capable of controlling itself.

Classical Theory

Classical theory was the first modern school of economic thought. It began in 1776 and ended around 1870 with the beginning of neoclassical economics. Notable classical economists include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus, and John Stuart Mill. During the period in which classical theory emerged, society was undergoing many changes. The primary economic question involved how a society could be organized around a system in which every individual sought his own monetary gain. It was not possible for a society to grow as a unit unless its members were committed to working together. Classical theory reoriented economics away from individual interests to national interests. Classical economics focuses on the growth in the wealth of nations and promotes policies that create national expansion. During this time period, theorists developed the theory of value or price which allowed for further analysis of markets and wealth. It analyzed and explained the price of goods and services in addition to the exchange value.

Adam Smith: Adam Smith was one of the individuals who helped establish classical economic theory.

Classical Theory Assumptions

Classical theory was developed according to specific economic assumptions:

Self-regulating markets: classical theorists believed that free markets regulate themselves when they are free of any intervention. Adam Smith referred to the market’s ability to self-regulate as the “invisible hand” because markets move towards their natural equilibrium without outside intervention.
Flexible prices: classical economics assumes that prices are flexible for goods and wages. They also assumed that money only affects price and wage levels.
Supply creates its own demand: based on Say’s Law, classical theorists believed that supply creates its own demand. Production will generate an income enough to purchase all of the output produced. Classical economics assumes that there will be a net saving or spending of cash or

Aggregate Real Money Demand Curve