Lecture notes for week 6

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University of Toronto Scarborough
Economics for Management Studies
Iris Au

THE AS-AD MODEL (CONTINUED) Outline N The derivation of the aggregate supply (AS) curve. N The adjustment mechanism of the AS-AD model. N Consider the effect of a disturbance in the AS-AD model and its implications on government policy. Derivation of the Aggregate Supply (AS) N We have already derived the AD curve. We need to derive the aggregate supply curve to complete the model. N Recap, what do we learn about the AD? o The AD curve indicates the equilibrium level of output on the demand side. o In other words, the AD curve indicates, at each different price level, the level of output that generates just enough AE (C + I + G + X – IM) so that all the output gets purchased (remember we derived the AD curve by setting Y = AE). N BUT , we need to consider what firms are willing to produce. o What we have not captured is whether, at that price levelirms will indeed be willing to produce that level of output. N Therefore, the aggregate supply (AS) curve should represent the amount of output that firms in the economy are willing to produce at each price level. N Question: What we learned about marginal cost (MC) in micro suggests that AS should be upward sloping. Does it hold true for the economy as a whole? N Answer: Once again we are looking at the entire economy not just one industry, the big picture matters (the level of unemployment and time frame—short run vs. long run)! Slope of the AS Curve Case 1: If There is a Lot of Unemployment N This means Y* is much lower than YFE(Y* < Y FE N If this is the case, we might expect that firms will be willing to supply more even if price does not increase much. o The AS curve will be relatively flat (i.e., elastic). Why? o Since there are quite a large number of unemployed workers, firms would find it easy to hire workers if they want to expand. Besides, firms probably have laid off workers in the last little while and have unused facilities. Case 2: If There is a Not Much Unemployment N This means Y* is bigger than FE(Y* > Y FE N If this is the case, we might expect that firms will be hard-pressed to supply much more even if price increases. o The AS curve will be relatively steep (i.e., inelastic). Why? o In order to expand production firms need to hire more workers. However, firms may find it difficult to hire additional workers, especially good, productive workers. Besides, it may not be feasible to have the existing workers work over time (it is either too expensive to the firms or the workers may not willing to do so). N Sometimes, we simply the AS curve as follow: o A vertical AS curve in the long run (when Y =FE). o A horizontal AS curve in the immediate run. N In the meantime, we assume AS curve is upward sloping—firms are willing to produce more when price rises. Putting AS & AD Together N AD is derived from setting AE to Y at different price levels. N For the AS curve: o When the price is low, firms are not willing to produce a lot Æ the level of AS is low. o When price begins to rise, firms are willing to produce more Æ the level of AS begins to increase. www.notesolution.com N When AS intersects AD, the economy is in equilibrium (pt A). Adjustment Process of the AS-AD Model N Question: How do we ensure that the economy ends up at this equilibrium (point A)? Case 1: Initial Price is Below Equilibrium Price, P< P* 0 Case 2: Initial Price is Above Equilibrium Price, P> P* www.notesolution.com Effects of a Change in AE in the AS-AD Model—Graphical Analysis Factors Affecting AE—A Revisit N The AE function is given by: AE = C (Y – T + TR) + I (r) + G + X (E) – IM (E, Y) N An increase in AE could due to one of the following: o A change in private sector’s behaviour—more consumption, more investment, more exports, and fewer imports. o An expansionary fiscal policy—more government spending, more transfer payments, and tax cuts. N A decrease in AE could due to one of the following: o A change in private sector’s behaviour—less consumption, less investment, less exports, and more imports. o A contractionary fiscal policy—less government spending, less transfer payments, and tax increases. Example—An Increase in Autonomous Exports (X 0increases) Suppose autonomous exports increases: How Much Output Will Increase When AE Rises? N An increase in AE would lead to an increase in Y*. N Question: How much Y* will increase? N Answer: Depends on the slope of the AS curve. Flat AS Steep AS
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