Long-run aggregate supply curve is vertical line and is at full employment. In the long-run, changes in the price level do not affect employment because unemployment output does not depend on price level. AD curve will only depend on taxes, government spending, and money supply. An increase in aggregate demand will increase price but output no change and will shift (AD) curve to the right. AD curve in the long-run do not change the level of output but change the price. It is only depends on price level. In others word, changes in demand will not affect the level of output but only changes the prices. For example, if the money supply increased by 10, (AD) curve also will shift by 10. Thus, it means prices will increase by 10.
Short-run aggregate supply curve are assumed to supply all the output with small change in price. The short-run (AS) curve is small upward sloping. More output supply, higher wages to pay. If AD curve shift to left, output will decrease, it could a recession in the economy. If demand is high, output may exceed full employment output. If demand is low, it is a shortage of employment. This is because price does not change fully and need not remain at full employment. In short-run, changes in demand will be shortage of employment. The economy is only at full employment when prices fully change in long-run. Any increase in AD curve will increase price level.
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Aggregate Demand Curve is downward sloping for 2 reasons: real wealth and foreign demand effect, it shows the negative relationship between the aggregate output and price level. If price level rises, aggregate output falls, vice-versa. Change in the price level causes a movement along the AD curve.
Aggregate Supply curve is a graph shows the relationship between the aggregate quantity of output supplied by all firm in an economy and the overall price level.
There are 3 segments in the shape of AS curve.
Keynesian range, national income or output is less than full employment or output level. It is a horizontal range and economy is in recession with large amount of unemployment. There prices are no increase because firms can acquire workers and inputs at stable the prices. Multiplier is full.
Intermediate range, an expansion of real output is accompany by a rising price level and it is upward sloping. Firms may still face shortage of employment. Thus, cost of production may increase, and firms may increase prices. Multiplier is close to zero.
Classical range, it is vertical and economy has reached full employment. When price increase, real output remains constant. Multiplier is zero.
Price level, P
Aggregate Demand and Short- Run Aggregate Supply Curve
Price level, P
Aggregate Demand and Long- Run Aggregate Supply Curve
In the diagram above shows changes in equilibrium income. When the original aggregate demand curve (AD1) moves to the right from AD1 to AD2 in the classical range (AS), then there is an increase from P1 up to P2, means the price will be rise, vice versa. However, there might no increase in output (Yf) since there are maximum controlled in the resources. At the same time, the original long-run equilibrium point will be increase along with the growth of price. If assume that the aggregate supply (AS) have a long-run aggregate supply (LRAS) when the AD1 shifts to AD2, the long-run equilibrium point will be downward and shifts to the lower right side, means the long-run equilibrium point will be fallen to a new long-run equilibrium point. Besides, the original output (Yf) will rise to a new output level (Yf1).
Commercial banks and other banks are different, because Central Bank can created money, the process is called Credit Creation. Commercial Banks have not purposely to create of money, which is during daily operations activities of banks, so the process of the credit creation was naturally occurring.
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Before the process of credit creation, we must set out these assumptions.
The Commercial Banks must set out fixed reserve ratio.
The Commercial Banks do not hold excess reserves, hold only the required reserves.
No cash drain from the financial system.
The Commercial Banks have only one kind of asset and one kind of liability. (demand deposit and loans)
Let assume that an individual opens an account with Bank A and deposit RM100000 in an account. This new deposits is called Primary Deposit, and we call Bank A as First Generation Bank. Assumed the required reserve ratio is 20%, so we can see the balance sheet of Bank A will record on credit side of bankââ‚¬â„¢s T account, deposit show a rise RM100000 and on debit side will show a rise RM20000 to held as required reserved, RM80000 will loans to investors and business purposes.
The bank has RM80000 worth of excess reserve to loan out. Assume that Bank A does not keep excess reserves. As the result, Bank A has RM80,000 is loaned out. So, individuals or firm who receive loan of RM80000 from Bank A and put it in other banksââ‚¬"Bank B. Bank B is Second Generation Bank. Bank B must have 20% of fixed reserve ratio. The T account of Bank B will show RM80000 on credit side and a rise RM16000 as required reserves and RM64000 as the loans on the debit side.
Again, individuals or firms who receive loan of RM64000 from Bank B and put in others bank ââ‚¬" Bank C. Bank C is Third Generation Bank. Banks C also must have 20% of fixed reserve ratio. T Account of Bank C will show RM64000 on credit side and RM12800 as required reserves and RM51200 as the loans on the debit side.
The process goes on and on until the deposit becomes 0. In theory, continue to the lending and deposit the money getting smaller and smaller, eventually spent so fast. Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction. A summary of the whole succession of new deposits and new loans generated throughout the banking system arising from the initial deposit of RM100000 can be shown in the table below.
New Deposit (RM)
New Loans (RM)
Addition to Reserves (RM)
Bank A(1st Generation Bank)
Bank B (2nd Generation Bank)
Bank C(3th Generation Bank)
Bank D (4th Generation Bank)
Bank E(5th Generation Bank)
* Required Reserve ratio = 20% or 0.2
The table shows the ability if the banking system to create deposit money whenever it receives new reserves, in this case RM100000 and detail of the workings of credit creation.
Without using the table above to do calculation, we also can use money multiplier to calculate. For example, required reserve ratio is 0.2.
limitations of credit creation.
Commercial bank can expands the money supply and unlimited create the deposits through loans to create the credit naturally. Credit creation means to expand the bank deposits in multiply. In fact, there are a number of limitations of credit creation below:
The Sum of Money: The terms of credit creation needs a great amount of money with the banking system vice-versa.
The Influence of Required Reserve Ratio: If central bank reduce the required reserve ratio, then the credit creation power will be increase, vice-versa.
Availability of Borrowers: Credit created by banks because of loans, so the borrowers are independent by the range of credit creation, means thereââ‚¬â„¢s no credit creation without borrowers.
Availability of Securities: Banks can only award loans with the securities that they recognise. Therefore, credit creation will be higher when there is higher availability of securities.
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Banking Habits: Credit creation power will also be effect by the development of banking system and the habits of the bank users.
Business Conditions: Business man would not loan from the bank when the business is downturn, vice-versa.
Monetary Policy of Central Bank: The control of the credit creation and commercial banks in the country is one of the important functions of central bank. Central bank will adopt different policies to control the credit creation power of the banks. Hence the central bank policy will influence the credit creation of the banks.
Leakages: The potential credit creation might bigger than the real credit creation because of the leakages. Excess reserve and currency drains are included by the leakages of credit creation that there can effects the power of the banks to create credit.