Not to scare you…..but……

Yf

SRASSRAS1

AD1

AD

LRASPrice Level

GDP, Income, Employment

Aggregate Demand and Aggregate Supply Model (AD/AS)

Ch. 31: Aggregate Demand and Aggregate Supply

• What causes short run fluctuations? • Can public policy prevent falling income and

rising unemployment? • Can public policy reduce severity of recessions

or depressions? • Key is to focus on short run fluctuations

around the long run trends.

Yf

SRASSRAS1

AD1

AD

LRASPrice Level

GDP, Income, Employment

Understanding Short Run Fluctuations

1. Business Cycle – NOT regular or predictable

2. Macroeconomic Quantities Fluctuate Together

RGDP = most commonly used to monitor short run changes…..

…..but RGDP tends to move with Income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales………..

……..so, there is a lot more than RGDP to look at in the short run….

• 3. As output falls, unemployment rises

Explaining Short Run Economic Fluctuations

• “Classical Dichotomy”, “Monetary Neutrality” p. 705 – skip for now

• Short Run model focused on …• Economy’s output (RGDP)• Price Level (CPI or GDP Deflator)

Yf

SRAS

AD

Price Level

GDP, Income, Employment

The good news………acts much the same as Supply and Demand from Micro

The bad news……this is Macro……..much more to the curves than in Micro

I. Aggregate Demanda. shows VARIOUS amounts of goods and services that

the entire economy desires to purchaseb.different from Micro D curve (individual choices for

one good) ; – will NOT be able to apply income

(normal/inferior) or substitution (substitute/compliment)effects****

c. Similar to law of Demand …..Inverse relationship : lower P level = larger real GDP higher the P level = smaller real GDP

AD slopes downward: Wealth Effect

• When PL goes up = real wealth goes…..• down• When PL goes down = real wealth goes….• Up • As PL decreases, consumers feel …..• “wealthier” and increase quantity of …..• goods and services demanded

AD slopes downward: Interest Rate Effect

• As PL goes down = money demanded goes…• down• People will usually lend more (in form of …..• savings accts, bonds, etc.) = increase in the Supply of

Loanable Funds • = interest rates go……• down• As interest rates go down = firms will …….• borrow more to invest (consumers in new housing) • So…..Interest rates down = Investment up = increase

….• quantity of goods and services demanded

AD slopes downward: Exchange Rate Effect

• As PL goes down, interest rates go down • US investors seek higher returns

elsehwere ..meaning? …• Want to invest where interest rates are higher to

get better returns on bonds • As more US dollars leave, the Supply of US dollars

in “Foreign Exchange Market” increases and …• in turn “DEPRECIATES” the dollar relative to value

of other currencies. ….• *Important – DO NOT think about inflation in

this context of “appreciation” or “depreciation”

• Each dollar now buys fewer units of foreign currency = foreign goods become……

• More expensive …..so the US Imports will ……• Decrease….and US Exports will …….• Increase ……and overall US Nx will…….• Increase …..and increases the ……..• Quantity of goods and services demanded

• Simplify: • As PL goes down, Interest Rates go down,

dollar depreciates, Nx go up, Qd of goods and services go up

Why does AD Shift?• Very similar to D shifting in micro • Remember AD = C+I+G+Nx • So if any component of AD increases or

decreases independently of PL, then AD shifts• C : want to save more or less, stock market

boom increases wealth or crash decreases wealth, increase or decrease in taxes paid

• I : invest in new technology, optimism or pessimism about future, increase or decrease in business taxes or tax credits

AD shifiting ..cont..

• G : any increase or decrease in G spending • Nx : foreign nations experience a economic

growth or recession…affect on AD?.....• any outside force which makes the US dollar

“appreciate or depreciate” ….affect on AD? ….» Remember: “At any given price level, there is now more

Aggregate Demand”

Aggregate SupplyA. How do we know that aggregate supply is upward sloping

in the short run and vertical in the long run? B. First, recall from microeconomics that output is a function

of the inputs to productioni. Supplies of labor, capital, natural resources, and available technology –(these are not affected by the price level) ii. The only way to increase output in the long run is to increase the levels of capital and labor.iii. This is called increasing the capital stock--the result of investment--and increasing the labor force--the result of more people working

iv. Therefore, in the long run, the aggregate supply curve is affected only by the levels of capital and labor and not by the price level. Thus, the long run aggregate supply is vertical with respect to the price level.

• ***see example on bottom of pg. 712 to 713

Why LRAS will Shift

• Think of what would shift PPF out• pg. 713-714• LABOR• CAPITAL • NATURAL RESOURCES• TECHNOLOGICAL KNOWLEDGE

A New Way to Depict Long-Run Growth and Inflation

Yf1 Yf2

PL 1. There are many forces that govern the economy in the long run…but most imprt. are technology and monetary policy

2. Tech progress increases production of goods/services ; shifting LRAS right

3. Fed increases money supply over time = increase spending and shifting AD right

4. Shows the Long Run trends in growth and inflation

PL2

PL1

Yf1 Yf2

PL

PL2

PL1The purpose of AD/AS model is to provide a framework for short run analysis.

As we develop short run analysis, we will not necessarily show the continuing growth of GDP.

Yf1

PL

PL2

PL1

The Short Run fluctuations in output and the price level should be viewed as deviations from the continuing long run trends

• Stated another way……1. LRAS is vertical and represents full employment

and full output (natural rate of unemployment) Real GDP is maximized.

2. Any changes in AD will affect only the price level. 3. In the long run, prices and wages are flexible. 4. This means that if products don’t sell and

employees become unemployed, the market will self correct

We will look at HOW the economy will self correct later…but first lets analyze the SRAS

Why AS slopes upward in short run• As PL rises, Q of goods and services supplied rises

(similar to Law of Supply in Micro) • Three theories help explain why AS is upward sloping

in short run • 3 theories but 1 common theme: Q of output supplied

deviates from its long run or natural level when the PL deviates from the PL that people expected.

• When PL is higher than expected, Output rises above its natural rate

• When PL is lower than expected, Output falls below its natural rate.

Misperceptions Theory

• Example • PL falls below expectations• Firms may feel the reward for production has

been lowered and reduce output • “Lower than expected PL causes misperceptions

about relative prices and these misperceptions induce suppliers to respond by decreasing Q of goods and services supplied”

• If PL rises above expectations……

Stick-Wage Theory• Nominal wages are sticky in the short run• Think long term contract at given wage • As PL falls below expectations, nominal wages are fixed,

but real wages rise. • Because real wages are major input cost, firms real costs

rise and begin to hire less and produce less• “As PL falls below expectations, nominal wages are sticky,

makes real wages and costs rise, production is less profitable and firms decrease quantity of goods and services supplied”

• If PL rises above expectations……

Sticky Price Theory• As PL falls below expectations, not all firms will react

immediately and so some Prices are sticky• The firms that do not lower Prices right away will have

relatively higher prices which will reduce sales ……• This induces firms to reduce production and employment• As PL falls unexpectedly, some firms leave prices higher

than desired which results in lower sales. Firms begin to decrease the quantity of goods and services supplied.

• If PL rises above expectations……

Shifting SRAS• If it shifted LRAS, then it must also shift SRAS• Labor, Capital, Natural Resources, Technology• One new variable…..• Expected Price Level

• If the Expected Price Level falls….(notice difference from the three theories) ….

• Firms expect wages and all input costs to fall and begin to increase the Quantity of goods and services supplied

• If the Expected Price Level rises……

AD/AS: Self Correcting in the Long Run

• The Effects of a Shift in AD• The economy self corrects; P and W change

but it is nominal (not real) and these changes offset eachother and purchasing power remains the same.

• = Classical view

• …but how long do we wait for self correcting? • This was the question being asked during the

Great Depression and one in which the Bush and Obama administrations definitively answered. …….discuss

• Lets look at how this model self corrects when AD increases

• Event increases (C, I, G, or Xn) = shift AD right • Evaluate = P and GDP (output is beyond full employment levels)…..how do

we know this is short run ? ….• Long run RGDP growth is only possible when LRAS shifts right• The current condition = Inflationary Gap ……why? • Nominal Wages don’t respond in short run = so Real Wages ….• decrease …explain?

Yf

• As “Long Run” nears and PL remain high, Nominal Wages begin to respond and increase….Explain?

• All input P have increased and now W increase = Shift Short Run AS left• Result= higher P but back at Yf and increase in Nominal W are offset by

increase in P level

Yf

• Now lets see how it self corrects when AD decreases

• Event decreases (C, I, G, or Xn) = shift AD left • Evaluate= P decrease, GDP decrease (below full employment levels) • = Recessionary Gap ….why? • As GDP and PL fall , Nominal Wages don’t respond in short run, so = Real Wages…..• increase• With lower Prices and output and Nominal wages “stuck” higher = decrease profits for firms• As the Long Run nears, Nominal W begin to decrease • All input P have decreased and now W decrease = shift Short Run AS right • Result = lower P level but back at Yf, and decrease in Nominal W are offset by lower P levels

Yf