I. AD/AS Model• To Analyze changes in real GDP & price level

simultaneously• Provides insights on inflation, unemployment, &

economic growth• Aggregate Demand

– Amounts of real output– Buyers collectively desire– At each possible price level

• Aggregate Supply– Levels of real domestic output firms will produce– At each possible price level

II. Aggregate Demand Curve• Income & substitution effects do not apply • AD Curve – negative slope

– Real-Balances effect• Higher price level means real value of savings

decreases• Thus lowering consumption

– Interest-rate effect• High demand for $ leads to high interest rates• High interest rates limit investment spending• Thus leads to less real output

– Foreign purchases effect• US price level up then foreigners buy less US

goods

AGGREGATE DEMAND CURVE

Pri

ce le

vel

Real domestic output, GDP

AD

Pri

ce le

vel

Real domestic output, GDP

CHANGES IN AGGREGATE DEMAND

AD1

AD2

Aggregate DemandCan Increase

Pri

ce le

vel

Real domestic output, GDP

CHANGES IN AGGREGATE DEMAND

AD1AD3

…or Decrease

Aggregate DemandCan Increase

Determinants of AD• Change in consumer spending (C)

– Wealth effect– Consumer expectations– Household indebtedness– Personal income taxes

• Change in investment spending (Ig)– Real interest rates– Expected returns

• Future business conditions• Technology• Degree of excess capacity• Business taxes

• Change in government spending (G)• Net export spending (Xn)

– National income abroad– Exchange rates

III. Aggregate Supply• Long-run AS curve

– Vertical at full-employment level of real GDP

– Resource prices adjust to changes in PL – no incentive for firms to change output

• Short-run AS curve– Upward sloping– Rise in price level increases real output– Lag between product prices & resource prices

make it profitable for firms to increase output when PL rises

AGGREGATE SUPPLY

Pri

ce le

vel

Real domestic output, GDP

Short RunShort RunAS

AggregateSupply

Short-run

Qf

Full-Employment

AGGREGATE SUPPLY

Pri

ce le

vel

Real GDP

AS3

AS1

AS2

Increase InAggregate

Supply

Decrease InAggregate

Supply

Changes in Aggregate SupplyChanges in Aggregate Supply

AGGREGATE SUPPLYAGGREGATE SUPPLY

Pri

ce le

vel

Real GDP

Long RunLong RunASLR

Long-runAggregate

Supply

Qf

Full-Employment

ASAS - amount of real output firms will produce at each PL. Higher price levelsHigher price levels provide an incentiveincentive to produce more. AS has three ranges: 1. HorizontalHorizontal (KeynesianKeynesian) 2. IntermediateIntermediate 3. VerticalVertical (ClassicalClassical)

Pri

ce le

vel

Pri

ce le

vel

Real domestic output, GDPQ

HorizontaHorizontall

[Keynesian[Keynesian]]

RangeRange

Upsloping orUpsloping orIntermediateIntermediate

RangeRange

VerticalVertical[Classical][Classical]

RangeRange

ASAS

IV. Determinants of AS

• Input prices– Domestic

• Land• Labor• Capital

– Prices of imported resources– Market power (OPEC)

• Productivity = Total output/total inputs

• Legal-institutional environment– Business taxes and subsidies– Government regulation

Pric

e Le

vel

Real Domestic Output, GDP

Q

P AS

AD510

502514

EQUILIBRIUM AND CHANGESIN EQUILIBRIUM

92

100a b

EquilibriumReal Output

Pric

e Le

vel

Real Domestic Output, GDP

Q

P ASAD1

INCREASES IN AD: DEMAND-PULL INFLATION

P2

P1

AD2

Qf Q1 Q2

[[“Good News” – more jobs“Good News” – more jobs;; “Bad News” – higher “Bad News” – higher pricesprices]]

Pric

e Le

vel

Real Domestic Output, GDP

Q

P ASAD1

DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT

P1

AD2

QfQ1

a

c

b

[[“Good News”–lower prices“Good News”–lower prices;; “Bad News”–job “Bad News”–job losseslosses]]

Pric

e Le

vel

Real Domestic Output, GDP

Q

P AS1

AD1

DECREASES IN AS: COST-PUSH INFLATION

P2

QfQ1

a

b

AS2

P1

[“bad news” – job losses; “bad news” – inflation][“bad news” – job losses; “bad news” – inflation]

V. “Sticky Prices” – prices inflexible (rigid) in a downward

direction• Wage Prices

• Morale, effort, productivity

• Minimum wage

• Menu costs

• Fear of price wars

ConsumptionConsumptionInvestmentInvestmentGov. SpendingGov. SpendingExportsExports

SavingSavingTaxesTaxesImportsImports

IncomeIncomeEmploymentEmploymentOutputOutput

Full EmploymentFull Employment[Frictional & structural][Frictional & structural]

An economy in equilibrium at FEAn economy in equilibrium at FE

InjectionsInjections

LeakagesLeakages

*Classicals – “A leakage down *Classicals – “A leakage down the drain of saving is returned the drain of saving is returned thru the spigot of investment.”thru the spigot of investment.”

Review of the Marginal Propensities

1. If consumption increases from 465 to 480 and disposable income increases from 490 to 510. What is the marginal propensity to consume?

2. If the marginal propensity to consume is 0.8 then what is the marginal propensity to save?

3. Why will the MPC + MPS always equal 1?

15/20 = .75

MPS = 0.2

Consuming or saving is an either-or proposition

Aggregate Expenditures Model

““MMultult” = 4” = 4 460 460 500500

AE(C+IgAE(C+Ig11))

AE(C

+Ig

AE(C

+Ig

+G

+G

))

AE(C+IgAE(C+Ig+G+G))

YYRR YY**

10 G10 G

390390 470470 550550 630630 Real GDP00

AEAE3 3 ((C+IgC+Ig+G+G+Xn+Xn) () (ComplexComplex Economy Economy) [) [MixedMixed--openopen]]

AEAE2 2 ((C+IgC+Ig+Xn+Xn)) ((PrivatePrivate--openopen) [X(40)-M(20)]) [X(40)-M(20)]AEAE11((C+IgC+Ig)[)[Basic EconomyBasic Economy][][PrivatePrivate(no(no G)-G)-ClosedClosed(no X or M)](no X or M)]

ConsumptionConsumption

+80+80 +80+80+80+80CC=390=390

((AEAE11)470)470

((AEAE22)550)550

((AEAE33)630)630

+20 Xn+20 Xn+20 G+20 G

+20 Ig+20 Ig

Real GDPReal GDP

45°45°

45°45°

BuildingBuilding

PrivatePrivate--openopen

Mixed Mixed - - openopen

Private-closedPrivate-closed

PrivatePrivate--openopen

MixedMixed--openopen

[[SimpleSimple [[BasicBasic]] economy toeconomy to ComplexComplex economy]economy]

[C+Ig+[C+Ig+GG++XnXn]]

[C + Ig][C + Ig]

[C + Ig +[C + Ig + XnXn]]

Private - closedPrivate - closed

I. AE Model / Keynesian Cross Model

• Aggregate Expenditures means total spending

• When AE fall – Total output & employment decrease

• When AE rise – Total output & employment increase

II. Mixed Economy

• AE = C + Ig + G + Xn• Increase in public spending shifts AE upward & produces

higher equilibrium GDP• In a mixed economy the Savings (Leakages) = planned

investment (Injections) – Sa + M + T = Ig + X + G

• Lump-sum tax (constant at each level of GDP) – Reduces C & S

• Proposed balanced budget requirement (G spending = G revenue) would eliminate discretionary fiscal policy

• Balance budget multiplier = 1 (equal increases in G & T) AE shift is equal to change in G or T

FULL-EMPLOYMENT GDPFULL-EMPLOYMENT GDP

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

490 510 530

AE0

Recessionary GapRecessionary Gap

AE1

530

510

490

Recessionary Gap= $5 Billion

Full Employment

FULL-EMPLOYMENT GDPFULL-EMPLOYMENT GDP

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

490 510 530

AE0

Inflationary GapInflationary Gap

AE2

530

510

490

Inflationary Gap= $5 Billion

Full Employment

III. Limitations

• No price-level changes

• Ignores premature demand-pull inflation

• Limits real GDP to the full-employment level of output

• Ignores cost-push inflation

• Does not allow for self-correction