Unformatted text preview: ond to changes in supply and demand. In the short run, many prices are sticky at some predetermined level. A model of economic fluctuations must take into account this sort run price stickiness. The failure of prices to adjust quickly and completely means that in the short run, output and employment must do some of the adjusting instead. In other words, in the short run the classical dichotomy no longer holds: nominal variables can influence real variables, and the economy can deviate from the equilibrium predicted by the classical model. Classical theory posits that prices adjust to ensure that the quantity of output demanded equals the quantity supplied. The economy works differently when prices are sticky. Because monetary and fiscal policy can influence the economy’s output over the time horizon when prices are sticky, price stickiness shows why these policies may be useful for stabilizing the economy in the short run. Aggregate Demand is the relationship between the quantity of output demanded and the aggregate price level. Here we use the quantity theory Page 27 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 of money to provide a simple, although incomplete, derivation of the AD curve. MV = PY M/P = (M/P)d = k/Y where k = 1/V For any fixed money supply and velocity, the quantity equation yields a negative relationship between the price level P and output Y. This downward sloping curve is the AD curve. The AD curve is drawn for a fixed value of the money supply. If the money supply changes, then the possible combinations of P and Y change, which means that the AD curve shifts. If the Bank of Canada reduces the money supply, the AD curve shifts inward. If the Bank of Canada increases the money supply, the AD curve shifts outward. The quantity equation tells us that an increase in M leads to an increase in PY. For any given price level, the amount of output is higher, and for any given amount of output, the price level is higher. Therefore the relationship works! Aggregate Supply is the relationship between the quantity of goods and services supplied and the price level. Since there is flexible prices in the long run and sticky prices in the sho...
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 Fall '10
 Henriques
 Economics, Macroeconomics

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