ch 26: the aggregate demand/aggregate supply model...

CH 26: The Aggregate Demand/Aggregate

Supply Model

Lecture

Classical vs. Keynesian

Classical Economists

• Believed markets were self-regulating through the “invisible hand”

• Favored a laissez-faire approach

• Believed the economy would always return to its potential output and target rate of unemployment in the long run

• Think of economists like Adam Smith

Keynesian Economics

• First outlined in 1936 by John Maynard Keynes in his book The General Theory of Employment, Interest and Money

• Looked at the short run and relationship to AD

• The Great Depression led to the development of this approach

Keynesian Economics

• Dealt with the adjustment of wages and the price levelto changes in expenditures

• If people stopped buying goods, this decreased aggregate demand and would decrease production

• Keynesians argued that, in times of recession, spending is a public good that benefits everyone (increases AD)

Keynesian Economics• Paradox of thrift

• Popularized by Keynes

• Personal savings hurts the economy during a recession

• Leads to a decrease in AD as people consume fewer goods

• Think about it: the government offered a stimulus (tax cuts) to people during the Great Recession and people saved, and did not spend, that money—did this help the economy?

Demand-side versus Supply-side Economics• Keynesian economics is demand-side economics

• Supply-side economics is commonly referred to as Reaganomics, or trickle-down economics

Supply-side Economics

• Generally favors a decrease in marginal tax rates

• This leads to more people working

• Also favors tax reductions for businesses

• As a result, business can hire more workers

• With more workers businesses can increase production, creating more supply

• With more supply comes lower prices

• Commonly used in the 1980s (and the Trump tax cut)

The AS/AD Model

The AS/AD Model

• Consists of 3 curves:

• AD (Aggregate Demand)

• SRAS (Short-run Aggregate Supply)

• LRAS (Long-run Aggregate Supply)

The AS/AD Model

• In macro, we are talking about the price level of ALL goods—not just one good (micro)

• On the horizontal axis we look at aggregate output (real GDP), not just the output of a single good

Draw the Graph: AS/AD Short-run Equilibrium

Price Level

Real GDP

SRAS

AD

P1

YP

Draw the Graph: AS/AD Long-run Equilibrium

Price Level

Real GDP

SRAS

AD

LRAS

P1

YP

Aggregate Demand

Aggregate Demand

• Aggregate demand (AD) represents all of the goods and services (real GDP) that buyers are willing and able to purchase at different prices

Aggregate Demand

• Aggregate Demand Curve (AD)

• Shows how a change in the price level will change aggregate expenditures on all goods and services in an economy

•Remember, AD is a sum of aggregate expenditures: C + I + G+ (Xn)

The Slope of the AD Curve• The AD curve is downward sloping because of:

• Real Wealth Effect (or Real Balance Effect):

• A decrease in the price level increases the purchasing power of money

• People have more money and save more money

• Banks can then loan out more money and interest rates decrease

• Higher price levels reduce purchasing power

The Slope of the AD Curve

• Interest rate effect: when the price level increases, lenders need to charge higher interest rates to get a real return on their loans

• Higher interest rates discourage consumer spending and business investment

The Slope of the AD Curve

• Exchange rate effect: as the price level falls (assuming the exchange rate does not change), net exports will rise

• When the U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods

• Exports fall and imports rise causing real GDP demanded to fall

Shifts in AD

Price Level

Real GDP

SRAS

AD

LRAS

P1

YP

Any component of GDP shifts AD:• C=Consumption• I=Investment• G=Government spending• Xn=Net exports

*Expansionary and contractionary monetary and fiscal policy also affect AD*

1. Change in Consumer Spending

2. Change in Investment Spending

3. Change in Government Spending

4. Change in Net Exports (X-M)

AD Shift Factors

AD Shift Factors

• Change in Consumer Spending

• Disposable income (and distribution of income)

• Consumer expectations (prices, status of economy, etc.)

• Taxes (increases or decreases in income taxes)

• Household indebtedness (more or less consumer debt)

AD Shift Factors

• Change in Investment Spending

• Real interest rates (price of borrowing money)

• Productivity and technology (new machinery)

• Business taxes (higher or lower corporate taxes)

AD Shift Factors

• Change in Government Spending

• Government expenditures (such as defense spending, public works programs, etc.)

AD Shift Factors

• Change in Net Exports (X-M)

• Exchange rates (for example, if the U.S. dollar appreciates or depreciates relative to the euro)

AD Shift Factors: Monetary and Fiscal Policy

• Monetary and fiscal policy can also be represented by shifting the AD curve

• Monetary policy involves the Federal Reserve Bank changing the money supply and interest rates

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AD Shift Factors: Monetary Policy• Expansionary monetary policy: If the Fed expands the

money supply it can offer lower interest rates— this shifts the AD curve to the right (increase)

• Contractionary monetary policy: If the Fed contracts the money supply this shifts the AD curve to the left(decrease)

AD Shift Factors: Fiscal Policy

• Fiscal policy is the deliberate change in either government spending or taxes to stimulate, or slow down, the economy

• Fiscal policies are used to achieve full employment

• Expansionary fiscal policies are used to restore full employment when there is a recessionary (negative output) gap

• If the government spends money and does not increase taxes, this shifts the AD curve to the right (increase)

AD Shift Factors: Fiscal Policy

• Contractionary fiscal policies are used to restore full employment when there is an inflationary (positive output) gap

• If the government holds spending constant and raises taxes,this shifts the AD curve to the left (decrease)

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Aggregate Supply

Aggregate Supply

• Aggregate supply represents the amount of goods and services (real GDP) that firms will produce in an economy at different price levels

• The supply for everything by all firms

• Aggregate supply differentiates between short-run and long-run and has two different curves

Short-run Aggregate Supply (SRAS)

Short-run Aggregate Supply Curve (SRAS)

• Shows how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant

The Slope of the SRAS Curve

• In the short-run, an increase in output is accompanied by a rise in the price level

• In the short-run, wages and the price of resources will not increase as the price level increases

• The curve is upward sloping due to sticky wages and prices

Short-run Aggregate Supply (SRAS)

• Sticky prices means that prices do not change when there is a change in AD (short-run)

• Sticky wages means that wages do not change when there is a change in AD (short-run)

Short-run Aggregate Supply (SRAS)• Generally, prices and wages are not downwardly

flexible• Example: If a business increases the prices of its goods and becomes more profitable, it will notlower its prices

• The Ratchet Effect: prices can easily move up but notdown

• If prices were to fall, the cost of resources must fall or firms would go out of business

Shifts in SRAS

SRAS Shifters: R.G.P.• Resource prices (input prices)• Government actions (taxes and

subsidies)• Productivity/technology

Shifts in SRAS

Change in Resource Prices

• Prices of domestic and imported resources

• Supply shocks (negative and positive supply shocks)

• Inflationary expectations (if people expect higher prices in the future)

• If consumers and producers expect higher prices in the future, workers will demand higher wages and costs will increase

Shifts in SRAS

Changes in Government Actions

• Taxes on producers (such as corporate taxes)

• Subsidies for domestic producers

• Government regulations (that affect producers)

Shifts in SRAS

Changes in Productivity

• Technology (that increases production)

Long-run Aggregate Supply

The LRAS Curve

• The long-run aggregate supply curve (LRAS) shows the long-run relationship between output and the price level

• In the long-run, wages and resources prices are flexibleand will change as the price level changes

• A consequence of flexible long-run prices and wages is the lack of a long-run tradeoff between inflation and unemployment

The LRAS Curve

• The position of the LRAS curve is determined by the potential output, which is the amount of goods and services an economy can produce at full employment

• The LRAS curve is vertical because potential output is unaffected by the price level

• The LRAS corresponds to the PPC because both represent maximum sustainable capacity (the total output an economic system will produce over a set period of time it all resources are fully employed)

The LRAS CurvePrice level

Real GDP

LRAS1Shifts in the LRAS are caused by changes in:

• Capital stock

• Resources

• Technology

If it shifts the PPC, it also shifts LRAS

YP

Long-run Equilibrium in the AS/AD Model

Price Level

Real GDP

P1

YP

LRAS

SRAS

AD

• At long run equilibrium the economy is at full employment (4-6% unemployment)

What happens when the economy is not in long-run equilibrium?

• The economy can operate above or below potential

• An inflationary gap (or positive output gap) is the amount by which equilibrium output is above full employment

• To eliminate an inflationary gap, fiscal policy should decrease government spending and/or increase taxes

What happens when the economy is not in long-run equilibrium?

• A recessionary gap (or negative output gap) is the amount by which equilibrium output is below full employment

• To eliminate a recessionary gap, fiscal policy should increase government spending and/or decrease taxes

Draw the Graph An Inflationary (Positive Output) Gap

Price Level

Real GDP

SRAS

LRAS

P1

YP

AD1

Y1

Draw the GraphAn Recessionary (Negative Output) Gap

Price Level

Real GDP

SRASLRAS

P1

YP

AD1

Y1

Sample #1: The economy is above full-employment. Show the impact of a contractionary fiscal policy.

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LRAS• Since the economy was

above potential, a contractionary fiscal policy will shift AD to the left.

Price level

Real GDP

P1

P2

Y2

AD1

SRAS1

AD2

Y1


• Do I have to shift AD2 to long run equilibrium?

• As long as the question does not request that you close the gap, any shift to the left would work. Technically, you don’t know if this fiscal policy would have closed the gap.

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Sample #2: The economy is below full-employment. Show the impact of an expansionary fiscal policy.

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Price level

Real GDP

P1

P2

Y2

LRAS

SRAS1

AD1

• Since the economy is below potential, an expansionary fiscal policy will shift AD to the right.

Y1

AD2


• Do I have to shift AD2 to long run equilibrium?

• As long as the question does not request you to close the gap, any shift to the left would work. Technically, you don’t know if this fiscal policy would have closed the gap.

Changes in the AS/AD Model in the Short-run

Positive and Negative Shocks

• A positive shock in AD causes output, employment, and the price level to rise in the short run (increase in AD)

• A negative shock in AD causes output, employment, and the price level to fall in the short run (decrease in AD)

• A positive shock in SRAS causes output and employment to rise and the price level to fall in the short run (increase in SRAS)

• A negative shock in SRAS causes output and employment to fall and the price level to rise in the short run (decrease in SRAS)

Demand-pull Inflation

• Inflation can be caused by changes in AD (demand-pull) or aggregate supply (cost-push)

• Demand-pull inflation: inflation that occurs when the economy is at or above potential output

• Characterized by shortages of goods and workers

• Due to excess demand, firms raise the prices of goods (and workers raise the price of their labor)

• Think of it as too many dollars chasing too few goods

•According to the graph and starting at equilibrium point R, which of the following shifts identifies the short run and long run impact of a demand-pull inflation?

Short Run Long Run

A. R to N M to N

B. R to M R to N

C. R to Q Q to N

D. R to M R to Q

E. R to N N to Q

Cost-push Inflation

• Cost-push inflation: inflation that occurs when the economy is below potential output

• Higher production costs increase prices

• A negative supply shock increases the costs of production and forces producers to increase prices

Stagflation

• Stagflation is an increase in inflation and unemployment (think 1970s)

• More on this when we study the Phillips Curve

•On the graph, stagflation will be caused by a

A. Leftward shift in the short run aggregate supply curve only.

B. Rightward shift in the short run aggregate supply curve only.

C. Leftward shift in the aggregate demand curve only.

D. Rightward shift in the aggregate demand curve only.

E. Rightward shift in both the short run aggregate supply and aggregate demand curves.

Long-run Self-Adjustment

AS/AD Model in the Long-Run

• In the long run, in the absence of government policy actions, flexible wages and prices will adjust to restore full employment

• Unemployment will revert to its natural state after a shock to AD or SRAS

AS/AD Model in the Long-Run

• Shifts in LRAS indicate changes in the full-employment level of output and economic growth

Assume there is an increase in consumer spending. What happens to price level and output in the short-run?

Assume there is an increase in consumer spending. What happens to price level and output in the short-run?

Price Level

AD1

SRAS

Real GDP

LRAS

YP

AD2

P1

P2

Y1

P and Q will increase

If consumer spending increases, what happens to price level and output in the long-run?

If consumer spending increases, what happens to price level and output in the long-run?

Price Level

AD1

SRAS1

Real GDPYE

AD2

P1

P2

Y1

LRAS SRAS2

P3 Price level increases and output stays the

same

Economic Growth

• Economic growth can be measured as the growth rate in real GDP per capita over time

• An increase in consumption or government spending does not cause economic growth

• Only investment causes growth since firms increase their capital stock (machinery and tools purchased by businesses that increase their output)

Economic Growth: AS/AD and the PPCIf investment increases, what happens in the short-run and long-run?

AD1

SRAS1

Real GDPyE

AD2

PE

P1

y1

LRAS1

SRAS2

PriceLevel LRAS2

y2Consumer Goods

Cap

ital

Go

od

s

The PPC shifts outward since producers can make more

PPC2PPC1

Aggregate Production Function

• The aggregate production function shows that output per capita is positively related to both physical and human capital per capita

• This function also shows that aggregate employment and aggregate output are directly related since firms need to hire more workers in order to produce more output

Aggregate Production Function

PC1

Productivity

Real GDP per Worker

GDP2

GDP1

GDP3

PC2 PC3

Productivity levels off because of diminishing returns

Physical Capital per Worker

Public Policies and Long-Run Economic Growth

What government policies most likely result in long-run economic growth?

• Education/training spending increases human capital

• Infrastructure spending (public works projects like roads, bridges, etc.) increase physical capital

• Production/investment incentive programs (such as investment tax credits) increase physical capital


• Supply-side fiscal policies are government policies designed to increase production by reducing business taxes and/or regulations

• Ideally this would shift LRAS and the PPC to the right as businesses produce more goods


• Policies that impact productivity and labor force participation affect real GDP per capita and economic growth

• Government spending does not necessarily result in economic growth

• Policies that affect infrastructure and technology affect growth

ch 26: the aggregate demand/aggregate supply model...

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