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How can Aggregate Demand and Aggregate Supply Explain GDP Movements?

When we describe GDP movements over the very long run we are concerned with economic growth over long periods of time–obviously. We use the production function with variable labour capital and technology, and consider issues such as what will change the rate of growth of output over very long periods. For this we would use the first diagram in the mid-term. The model that goes with this is AD-AS when the vertical AS curve is shifting outwards, as in Figure (b) below. Because the factors of production are increasing, the full employment level of output is increasing. Since economic growth over the very long-run averages a few percent per year, we know that the AS curve typically moves to the right by a few percent per year.

In the long run, we assume that capital and technology are fixed. Therefore, the AS curve is still vertical, but not moving, as in Figure (a). In Figure (a) we show the long run, where we assume that factors of production are fully employed but not changing, and the AS curve is vertical at the level of full employment output. Therefore, in the long run output is determined by aggregate supply alone. For a given AS curve, the price level is determined by the ‘level of aggregate demand. If AD were to increase, the price level would increase, while the level of output would remain constant. This model would describe the GDP movements in the second diagram in the mid-term, where the long run growth rate is flat.

The third time frame that macroeconomists study is the short run. In the short run prices are assumed to be sticky or even fixed. Therefore, in the short run the aggregate supply curve is flat. This is shown in the figure below.

It can be seen from Figure 1-3 that, in the short run, the price level is determined by the AS curve, and changes in aggregate demand will bring about changes in output. Therefore, in the short run, we assume that changes in output are determined by shifts in AD. This is consistent with the business cycles shown in the third diagram in the mid¬term.

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