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Long-run aggregate supply and monetary policy implications

In the classical model, aggregate production does not depend on the general price level.

If output is constant at any price level, we can graphically describe this relationship by drawing a vertical aggregate supply curve.

In the long run the intersection of the aggregate demand curve with this vertical aggregate supply curve determines the price level.

If the aggregate supply curve is vertical, changes in aggregate demand affect the price level, but not aggregate production.

For example, if the money supply decreases, the aggregate demand curve shifts to the left, as shown in the figure below.

The economy moves from the starting equilibrium, determined by the intersection of the aggregate supply curve and the aggregate demand curve, point A, to a new equilibrium, point B.

The shift in the aggregate demand curve only generates a change in the price level.

The vertical aggregate supply curve satisfies the classical dichotomy, since it implies that the level of aggregate production is independent of the money supply.

The long-run level of production, Y, is called the full employment level, or natural level, of aggregate production, and corresponds to the level of production at which all the economy's resources are fully employed or, more realistically, at which unemployment is at its natural rate.


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