AD- As Model Chapter 20

8/3/2019 AD- As Model Chapter 20

1/30

0

Classical EconomicsA Recap

Most economists believe classical theory

describes the world in the long run,but not the short run.

In the short run, changes in nominal variables

(like the money supply or P) can affectreal variables (like Yor the u-rate).

To study the short run, we use a new model.


2/30

1

The Model of Aggregate Demand andAggregate Supply

P

Y

AD

SRAS

P1

Y1

The pricelevel

Real GDP, thequantity of output

The modeldetermines the

eqm price level

and the eqm

level of output

(real GDP).

Aggregate

Demand

Short-Run

AggregateSupply


3/30

2

The Aggregate-Demand (AD) Curve

The ADcurve

shows the

quantity of

all g&s

demanded

in the economy

at any given

price level.

P

Y

AD

P1

Y1

P2

Y2


4/30

3

Why theADCurve Slopes Downward

Y= C+ I+ G+ NX

C, I, G, NX are

the components

of agg. demand.

Assume Gfixedby govt policy.

To understand

the slope of AD,

must determinehow a change in P

affects C, I, and NX.

P

Y

AD

P1

Y1

P2

Y2 Y1


5/30

4

The Wealth Effect (P and C)

Suppose Prises.

The dollars people hold buy fewer g&s,

so real wealth is lower.

People feel poorer, so they spend less.

Thus, an increase in Pcauses a fall in C

which means a smaller quantity of g&s

demanded.


6/30

5

The Interest-Rate Effect (P and I) Suppose Prises.

Buying g&s requires more dollars.

To get these dollars, people sell some of their bonds

or other assets, which drives up interest rates.

which increases the cost of borrowing to fundinvestment projects.

Thus, an increase in Pcauses a decrease in I

which means a smaller quantity of g&s demanded.


7/30

The Exchange-Rate Effect (P and NX)

Suppose Prises.

Interest rates go up (the interest-rate effect).

U.S. bonds more attractive relative to foreign bonds.

Foreign investors purchase more U.S. bonds,

but first must convert their currency into $which appreciates the U.S. exchange rate.

Makes U.S. exports more expensive to people

abroad, imports cheaper to U.S. residents. Thus, an increase in Pcauses a decrease in NX

which means a smaller quantity of g&s

demanded.6


8/30

7

The Slope of theADCurve: Summary

An increase in P

reduces the quantity

of g&s demanded

because:

P

Y

AD

P1

Y1

the wealth effect(Cfalls)

P2

Y2

the interest-rateeffect (Ifalls)

the exchange-rateeffect (NXfalls)


9/30

8

Why theADCurve Might Shift

Any event that changes

C, I, G, or NX except a change in P

will shift the ADcurve.

Example:A stock market boom

makes households feel

wealthier, Crises,

the ADcurve shifts right.

P

YAD1

AD2

Y2

P1

Y1


10/30

9

ADShifts Arising from Changes in C

people decide to save more:

Cfalls, ADshifts left

stock market crash:

Cfalls, ADshifts left

tax cut:

Crises, ADshifts right


11/30

10

ADShifts Arising from Changes in I

Firms decide to upgrade their computers:

Irises, ADshifts right

Firms become pessimistic about future demand:

Ifalls, ADshifts left

Central bank uses monetary policy to reduce

interest rates:

Irises, ADshifts right

Investment Tax Credit or other tax incentive: Irises, ADshifts right


12/30

11

ADShifts Arising from Changes in G

Congress increases spending on homeland

security:Grises, ADshifts right

State govts cut spending on road construction:

Gfalls, ADshifts left


13/30

12

ADShifts Arising from Changes in NX

A boom overseas increases foreign demand for

our exports:NXrises, ADshifts right

International speculators cause exchange rate to

appreciate:NXfalls, ADshifts left


14/30

13

The Aggregate-Supply (AS) Curves

The AScurve shows

the total quantity of

g&s firms produce

and sell at any given

price level.

P

Y

SRAS

LRAS

In the short run,

ASis

upward-sloping.

In the long run,

ASis vertical.


15/30

14

LRAS1980

UsingAD&AS to Depict LRGrowth and

Inflation

Over the long run,tech. progress shifts

LRASto the right

P

Y

AD1990

LRAS1990

AD1980

Y1990

and growth in themoney supply shifts

ADto the right.

Y1980

AD2000

LRAS2000

Y2000

P1980Result:

ongoing inflationand growth in

output.

P1990

P2000


16/30

15

Short Run Aggregate Supply (SRAS)

The SRAScurve

is upward sloping:

Over the period

of 1-2 years,

an increase in P

P

Y

SRAS

causes an

increase in the

quantity of g & s

supplied.Y2

P1

Y1

P2


17/30

16

Why the Slope ofSRASMatters

If ASis vertical,fluctuations in AD

do not cause

fluctuations in output

or employment.

P

Y

AD1

SRAS

LRAS

ADhi

ADlo

Y1

If ASslopes up,

then shifts in AD

do affect outputand employment.

Plo

Ylo

Phi

Yhi

Phi

Plo


18/30

17

Theories ofSRAS

In each,

some type of market imperfection

result:Output deviates from its natural rate

when the actual price level deviatesfrom the price level people expected.


19/30

18

Three Theories ofSRAS

P

Y

SRAS

YN

When P> PE

Y> YN

When P< PE

Y< YN

PEthe expectedprice level


20/30

19

1. The Sticky-Wage Theory

Imperfection:

Nominal wages are sticky in the short run,they adjust sluggishly.

Due to labor contracts, social norms.

Firms and workers set the nominal wage inadvance based on PE, the price level they

expect to prevail.


21/30

20

1. The Sticky-Wage Theory

If P> PE,

revenue is higher, but labor cost is not.Production is more profitable,

so firms increase output and employment.

Hence, higher Pcauses higher Y,so the SRAS curve slopes upward.


22/30

21

2. The Sticky-Price Theory

Imperfection:

Many prices are sticky in the short run.

Due to menu costs, the costs of adjustingprices.

Examples: cost of printing new menus,the time required to change price tags.

Firms set sticky prices in advance based

on PE

.


23/30

22

2. The Sticky-Price Theory

Suppose the Fed increases the money supply

unexpectedly. In the long run, Pwill rise.

In the short run, firms without menu costs canraise their prices immediately.

Firms with menu costs wait to raise prices.Meantime, their prices are relatively low,

which increases demand for their products,so they increase output and employment.

Hence, higher Pis associated with higher Y,so the SRAS curve slopes upward.


24/30

23

Ydeviates from YN when Pdeviates from PE.

Y = YN + a(P PE)

Output

Natural rateof output(long-run)

a > 0,

measures

how much Yresponds tounexpected

changes in P

Actualprice level

Expectedprice level


25/30

24

LRAS

SRAS

and LRAS

P

Y

SRAS

PE

Y = YN + a(P PE)

YN

In the long run,

PE = P

and

Y= YN.


26/30

25

Why the SRASCurve Might Shift

Everything that shifts

LRASshifts SRAS, too.

Also, PE shifts SRAS:

If PE rises,

workers & firms sethigher wages.

At each P,

production is lessprofitable, Yfalls,

SRASshifts left.

LRASP

Y

SRAS

PE

YN

SRAS

PE


27/30

26

The Long-Run Equilibrium

In the long-run

equilibrium,

PE = P,

Y= YN ,

and unemployment

is at its natural rate.

P

Y

AD

SRAS

PE

LRAS

YN


28/30

27CHAPTER 20 AGGREGATE DEMAND AND AGGREGATE SUPPLY

LRAS

YN

The Effects of a Shift inAD

Event: stock market crash

1. affects C, ADcurve2. Cfalls, so ADshifts left

3. SR eqm at B.

Pand Y lower,unemp higher

4. Over time, PE falls,

SRASshifts right,

until LR eqm at C.Y and unemp back

at initial levels.

P

Y

AD1

SRAS1

AD2

SRAS2P1 A

P2

Y2

B

P3 C


29/30


LRAS

YN

The Effects of a Shift in SRAS

Event: oil prices rise

1. increases costs,shifts SRAS(assume LRAS constant)

2. SRASshifts left

3. SR eqm at point B.Phigher, Y lower,unemp higher

From A to B,

stagflation,a period offalling outputand rising prices.

P

YAD1

SRAS1

SRAS2

P1 A

P2

Y2

B


30/30


LRAS

YN

Accommodating an Adverse Shift in SRAS

If policymakers do nothing,

4. Low employmentcauses wages to fall,

SRASshifts right,

until LR eqm at A.

P

YAD1

SRAS1

SRAS2

P1 A

P2

Y2

B

AD2

P3 C

Or, policymakers could

use fiscal or monetary

policy to increase AD

and accommodate the

ASshift:

Yback to YN, but

Ppermanently higher.

Documents

AD- As Model Chapter 20