ECON 0110 Lecture 6: Lecture 6
Aggregate Supply-Aggregate Demand Model (AD-AS)
5 Key Elements of the AD-AS Model
The Aggregate Demand Curve (& shifts)
§
The Short-Run Aggregate Supply Curve (& shifts)
§
The Long-Run Aggregate Supply Curve
§
Short-Run Macroeconomic Equilibrium (Demand & Supply Shocks)
§
Long-Run Macroeconomic Equilibrium (Demand & Supply Shocks)
§
○
•
Aggregate Demand (AD)
Shows the relationship between the aggregate price level (GDP deflator) & the
quantity of aggregate output demanded by households, businesses, the
government and the rest of the world (real GDP)
○
Most economists agree that the Great Depression was the result of a massive
negative aggregate demand shock.
○
A negative demand shock for one good or service results in lower price and a
lower quantity for that good or service.
○
What does it mean for the economy as a whole to experience a negative
demand shock?
○
○
Notice that the aggregate demand curve is DOWNWARD SLOPING.
This is not because of the law of demand.
We are not dealing with a single good market, but rather the entire
macroeconomy
□
In a single good market, a movement along the demand curve
changes the price of the good holding the price of all other goods
constant.
□
In a single good market, a movement up the demand curve reduces
the quantity demanded mainly because people switch their
consumption to other goods.
□
§
○
In the macroeconomy, a movement along the aggregate demand curve
changes the price of all final goods and services.
○
In the macroeconomy, consumers deciding to switch their consumption to
other goods doesn't necessarily change the total quantity of final goods and
services they demanded.
○
•
Why does a change in the aggregate price level lead to a fall in the quantity of
all final goods and services demanded? Two reasons:
The Wealth Effect of a Change in the Aggregate Price Level
The effect on consumer spending caused by the effect of a change in
the aggregate price level on the purchasing power of consumer's
assets.
□
Intuition
If the aggregate price level increases, your assets cannot
purchase what they used to be to purchase so you feel less
wealthy.
®
You cut back on your consumption and so does everyone else
in the economy.
®
So, the aggregate demand decreases.
®
□
§
○
The Interest Rate Effect of a Change in the Aggregate Price Level
The effect on consumer spending and investment spending caused
by the effect of a change in the aggregate price level on the
purchasing power of consumers' and firms' money holdings.
□
Intuition
If the aggregate price level increases, households and firms
demand more money (cash and bank deposits) to make
transactions.
®
This drives up the interest rate, which reduces investment
spending (I) and consumer spending (C).
®
□
§
5 Factors that Shift the Aggregate Demand Curve
Changes in Expectations
If consumers become more OPTIMISTIC, aggregate demand
INCREASES.
□
If consumers become more PESSIMISTIC, aggregate demand
DECREASES.
Consumers base their spending not only on current income,
but expectations about future income.
®
Firms base their investment spending not only on their
current sales, but their expectations about future sales too.
®
Keynes called these waves of optimism and pessimism "animal
spirits."
®
□
§
Changes in Wealth
When assets INCREASE in real value (holding the aggregate price
level constant) consumers and firms spend MORE.
□
When assets DECREASE in real value (holding the aggregate price
level constant) consumers and firms spend LESS.
□
Part of the cause of the Great Depression was the stock market
crash of 1929.
□
Part of the Great Recession was the drop in real estate values.
□
So do changes in wealth shift the aggregate demand curve or cause
a movement along the aggregate demand curve?
It depends what causes the change in wealth.
A change in wealth resulting from a change in the
aggregate price level results in a movement along the
aggregate demand curve.
◊
A change in wealth resulting from any source other than
a change in the aggregate price level (e.g. stock market
boom) shifts the aggregate demand curve.
◊
®
□
§
○
Size of the Existing Stock of Physical Capital
The MORE physical capital a firm has, the LESS they will feel the
need to invest.
□
The LESS physical capital a firm has, the MORE they will feel the
need to invest.
□
§
Fiscal Policy
The use of government spending or tax policy to stabilize the
economy.
□
If the government changes their spending, it DIRECTLY shifts the
aggregate demand curve.
During WWII, government spending increased 400%.
®
During the Great Recession, the government increased
spending by $100 billion to improve infrastructure.
®
□
If the government changes taxes, this INDIRECTLY shifts the
aggregate demand curve through its effect on disposable income.
□
§
Monetary Policy
The use of the changes in the quantity of money to stabilize the
economy.
□
Decides how much money to print ---> controls the interest rate
□
When FED INCREASES the quantity of money in circulation, this
DECREASES the interest rate (holding the aggregate price level
constant) leading to HIGHER consumer and investment spending.
□
When FED DECREASE the quantity of money in circulation, this
INCREASES the interest rate (holding the aggregate price level
constant) leading to LOWER consumer and investment spending.
□
§
Rightward Shift (↑AD)
Leftward Shift (↓AD)
Optimistic
Pessimistic
↑Stock Price
↓ Stock Price
↑ Real Value Assets
↓ Real Value Assets
Print more $
Print less $
Natural Disaster
Big Investment Last Year
Govt. Inc Spending
Govt. Dec Spending
Tax Cut
Tax Raise
New Deal Project
Practice Problem
Determine the effect on aggregate demand of each of the following
events. Explain whether it represents a movement along the aggregate
demand curve (up or down) or a shift of the curve (leftward or
rightward).
§
A rise in the interest rate caused by a change in monetary policy.
a.
A fall in the real value of money in the economy due to a higher
aggregate price level.
b.
News of a worse-than-expected job market next year.
c.
A fall in tax rates.
d.
A rise in the real value of assets in the economy due to a lower aggregate
price level.
e.
A rise in the real value of assets in the economy due to a surge in real
estate values.
f.
○
Short-Run Aggregate Supply (SRAS)
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that exists in the short run, the time period when
many production costs can be taken as FIXED
○
Short Run
The period of time during which some costs, particularly nominal wages,
are fixed.
§
○
NOTICE! The short-run aggregate supply curve is UPWARD SLOPING.
This is because nominal wages are stick in the short run.
§
Nominal Wage
The dollar amount of the wage paid.
□
§
Sticky Wages
Nominal wages that are slow to fall even in the face of high
unemployment and slow to rise even in the face of labor shortages
□
Due to contracts and informal agreements
□
§
○
○
Intuition
Fall in the price level
§
If the aggregate price level FALLS, the price received by the typical
producer DECREASES.
Because many production costs are fixed in the short run, the profit
for each unit of a good or service that is produces DECREASES.
□
This leads producers to REDUCE the quantity supplied in the short
run.
□
§
If the aggregate price level RISES, the price received by the typical
producer INCREASES.
Because many production costs are fixed in the short run, the profit
for each unit of a good or service that is produced INCREASES
□
This leads producers to INCREASE the quantity supplied in the
short run.
□
§
○
3 Factors that Shift the Short-Run Aggregate Supply Curve
Changes in Commodity Prices
Commodity
A standardized input bought and sold in bulk quantities (think
oil)
®
□
INCREASE in commodity prices INCREASE production costs across
the entire economy and REDUCE the quantity of aggregate output
supplied for any given aggregate price level.
Leftward Shift
®
□
DECREASE in commodity prices DECREASE production costs
across the entire economy and INCREASE the quantity of aggregate
output supplied for any given aggregate price level.
Rightward Shift
®
□
§
Changes in Nominal Wages
An economy-wide RISE in the cost of health care insurance
premiums paid by employers as part of employees' wages
INCREASES production costs.
Leftward Shift
®
□
An economy-wide DECLINE in the cost of healthcare insurance
premiums paid by employers as part of employees' wages
DECREASES production costs.
Rightward Shift
®
□
§
Changes in Productivity
An increase in productivity means that a worker can produce more
units of output with the same quantity of inputs.
□
An INCREASE in worker productivity (holding nominal wages
constant) INCREASES producers' profits.
Rightward Shift
®
□
A DECREASE in worker productivity (holding nominal wages
constant) REDUCES producers' profits.
Leftward Shift
®
□
Any economy-wide change (other than a change in the aggregate
price level) that changes producers costs will cause a shift.
□
§
○
Rightward Shift (↑SRAS)
Leftward Shift (↓SRAS)
↓Commodity Price
↑Commodity Price
↓Nominal Wage
↑Nominal Wage
↑Worker Productivity
↓Worker Productivity
○
•
Long-Run Aggregate Supply (LRAS)
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that would exist if all prices, including nominal
wages, were fully flexible.
○
Long Run
The period of time during which costs are fully flexible.
§
○
•
○
NOTICE! The long run aggregate supply curve is VERTICAL.
This is because nominal wages are flexible in the long run.
Wages can be renegotiated.
□
§
Changes in the aggregate price level in the long run will be accompanied
by proportional changes in all input prices, including nominal wages
§
○
Example
Suppose the aggregate price level is 15 and the quantity of output
supplied is $800 billion in 2009 dollars.
§
If all the prices in the economy are cut in half (including the price of the
inputs, which includes nominal wages), the price level is now 7.5.
§
Each producer will receive half the price for their good, but their costs of
producing the good are also cut in half.
§
Therefore, output will remain unchanged. It will still be $800 billion in
2009 dollars.
§
○
Potential Output
The level of real GDP the economy would produce if all prices, including
nominal wages, were fully flexible.
§
Where the LRAS touches the horizontal axis is the economy's potential
output.
§
○
Short-Run Macroeconomic Equilibrium
When the quantity of aggregate output supplied is equal to the quantity of
aggregate output demanded.
○
Short-Run Equilibrium Aggregate Price Level
The aggregate price level in the short-run macroeconomic equilibrium.
§
○
Short-Run Equilibrium Aggregate Output
The quantity of aggregate output produced in the short-run
macroeconomic equilibrium.
§
○
○
Demand Shock
An event that shifts the aggregate demand curve.
§
Negative Demand Shock
AD curve shifts to the LEFT
□
Causes the Great Depression.
The collapse of wealth and of business and consumer
confidence that followed the stock market crash of 1929 and
banking crisis of 1930-1931
®
□
§
○
•
Positive Demand Shock
AD curve shifts to the RIGHT
□
Ended the Great Depression
The huge increase in government purchases during WWII.
®
□
§
Supply Shock
An event that shifts the short-run aggregate supply curve.
§
Negative Supply Shock
AS curve shifts to the LEFT
□
Caused the recession of 1973-1975 and the 1980 recessions
World oil supplies were greatly disrupted and the price of oil
increased dramatically.
®
□
Stagflation
The combination of inflation and falling aggregate output
®
Very unpleasant
Falling aggregate output leads to rising unemployment
and rising prices causes purchasing power to fall
◊
®
Price of things increases but income decreases
®
□
§
○
Positive Supply Shock
AS curve shifts to the RIGHT
□
Caused the U.S. growth from 1995-2000.
The increase use of the internet and other technologies caused
large productivity growth.
®
□
§
In-Class Assignment
Describe the short-run effects of each of the following shocks on the
aggregate price level on an on aggregate output.
§
The government sharply increases the minimum wage, raising the wages
of many workers.
a.
Solar energy firms launch a major program of investment spending.
b.
Congress raises taxes and cuts spending.
c.
Severe weather destroys crops around the world.
d.
○
Long-Run Macroeconomic Equilibrium
When the point of short-run macroeconomic equilibrium is on the long-run
aggregate supply curve.
○
All resources, mainly talking about labor, are being used.
Cyclical unemployment is 0%.
§
○
○
A demand or a supply shock can move the economy away from long-run
macroeconomic equilibrium.
○
•
Long-Run Macroeconomic Equilibrium: Negative Demand Shock
Suppose there is a decrease in business and consumer confidence resulting in
negative demand shock
○
The short-run macroeconomic equilibrium results in lower aggregate price
level and a lower equilibrium aggregate output level (P2& Y2)
AD shifts LEFT
§
SRAS shifts RIGHT
§
○
Recessionary Gap
When aggregate output is below potential output
§
Happens in the short run with negative demand shock
§
Y1-->Y2(Y2<Y1)
§
Underemployment ---> High Unemployment ---> Wages DECREASE
§
○
Nominal wages will eventually fall leading producers to increase output and
shifting SRAS to the right until the economy returns to long0run
macroeconomic equilibrium
With a permanently lower price level
§
○
○
•
Long-Run Macroeconomic Equilibrium: Positive Demand Shock
Suppose there is a wave of consumer optimism resulting in positive demand shock
○
The short-run macroeconomic equilibrium results in higher aggregate price level
and a higher equilibrium aggregate output level (P2& Y2)
AD shifts RIGHT
§
SRAS shifts LEFT
§
○
Inflationary Gap
When aggregate output is above potential output
§
Happens in the short run with positive demand shock
§
Y1-->Y2(Y2>Y1)
§
Overemployment ---> Low Unemployment ---> Wages INCREASE
§
○
Nominal wages will eventually rise leading producers to reduce output and shifting
SRAS to the left until the economy returns to long-run macroeconomic equilibrium
With a permanently higher price level
§
○
○
•
Long-Run Macroeconomic Equilibrium: Summary
Output Gap
The percentage difference between actual aggregate output and potential
output
§
Actual Aggregate Output - Potential Output
Potential Output
§
○
A negative output gap is a recessionary gap
○
A positive output gap is an inflationary gap
○
Self-Correcting
Shocks to aggregate demand affect output in the short run, but not the long
run
§
This is the economy in the long run
§
○
•
Conclusion
If the economy is self-correcting, why should the government intervene when there
is a recessionary or inflationary gap?
Most macroeconomists believe that the process of self-correction can take a
decade or longer.
§
Most, but not all, economists believe the government can help speed up this
process
§
○
One of Keynes's most famous quotes: "In the long run, we are all dead."
○
•
*100
Lecture 6
Tuesday,+June+12,+2018
3:26+PM
Aggregate Supply-Aggregate Demand Model (AD-AS)
5 Key Elements of the AD-AS Model
The Aggregate Demand Curve (& shifts)
§
The Short-Run Aggregate Supply Curve (& shifts)
§
The Long-Run Aggregate Supply Curve
§
Short-Run Macroeconomic Equilibrium (Demand & Supply Shocks)
§
Long-Run Macroeconomic Equilibrium (Demand & Supply Shocks)
§
○
•
Aggregate Demand (AD)
Shows the relationship between the aggregate price level (GDP deflator) & the
quantity of aggregate output demanded by households, businesses, the
government and the rest of the world (real GDP)
○
Most economists agree that the Great Depression was the result of a massive
negative aggregate demand shock.
○
A negative demand shock for one good or service results in lower price and a
lower quantity for that good or service.
○
What does it mean for the economy as a whole to experience a negative
demand shock?
○
○
Notice that the aggregate demand curve is DOWNWARD SLOPING.
This is not because of the law of demand.
We are not dealing with a single good market, but rather the entire
macroeconomy
□
In a single good market, a movement along the demand curve
changes the price of the good holding the price of all other goods
constant.
□
In a single good market, a movement up the demand curve reduces
the quantity demanded mainly because people switch their
consumption to other goods.
□
§
○
In the macroeconomy, a movement along the aggregate demand curve
changes the price of all final goods and services.
○
In the macroeconomy, consumers deciding to switch their consumption to
other goods doesn't necessarily change the total quantity of final goods and
services they demanded.
○
•
Why does a change in the aggregate price level lead to a fall in the quantity of
all final goods and services demanded? Two reasons:
The Wealth Effect of a Change in the Aggregate Price Level
The effect on consumer spending caused by the effect of a change in
the aggregate price level on the purchasing power of consumer's
assets.
□
Intuition
If the aggregate price level increases, your assets cannot
purchase what they used to be to purchase so you feel less
wealthy.
®
You cut back on your consumption and so does everyone else
in the economy.
®
So, the aggregate demand decreases.
®
□
§
○
The Interest Rate Effect of a Change in the Aggregate Price Level
The effect on consumer spending and investment spending caused
by the effect of a change in the aggregate price level on the
purchasing power of consumers' and firms' money holdings.
□
Intuition
If the aggregate price level increases, households and firms
demand more money (cash and bank deposits) to make
transactions.
®
This drives up the interest rate, which reduces investment
spending (I) and consumer spending (C).
®
□
§
5 Factors that Shift the Aggregate Demand Curve
Changes in Expectations
If consumers become more OPTIMISTIC, aggregate demand
INCREASES.
□
If consumers become more PESSIMISTIC, aggregate demand
DECREASES.
Consumers base their spending not only on current income,
but expectations about future income.
®
Firms base their investment spending not only on their
current sales, but their expectations about future sales too.
®
Keynes called these waves of optimism and pessimism "animal
spirits."
®
□
§
Changes in Wealth
When assets INCREASE in real value (holding the aggregate price
level constant) consumers and firms spend MORE.
□
When assets DECREASE in real value (holding the aggregate price
level constant) consumers and firms spend LESS.
□
Part of the cause of the Great Depression was the stock market
crash of 1929.
□
Part of the Great Recession was the drop in real estate values.
□
So do changes in wealth shift the aggregate demand curve or cause
a movement along the aggregate demand curve?
It depends what causes the change in wealth.
A change in wealth resulting from a change in the
aggregate price level results in a movement along the
aggregate demand curve.
◊
A change in wealth resulting from any source other than
a change in the aggregate price level (e.g. stock market
boom) shifts the aggregate demand curve.
◊
®
□
§
○
Size of the Existing Stock of Physical Capital
The MORE physical capital a firm has, the LESS they will feel the
need to invest.
□
The LESS physical capital a firm has, the MORE they will feel the
need to invest.
□
§
Fiscal Policy
The use of government spending or tax policy to stabilize the
economy.
□
If the government changes their spending, it DIRECTLY shifts the
aggregate demand curve.
During WWII, government spending increased 400%.
®
During the Great Recession, the government increased
spending by $100 billion to improve infrastructure.
®
□
If the government changes taxes, this INDIRECTLY shifts the
aggregate demand curve through its effect on disposable income.
□
§
Monetary Policy
The use of the changes in the quantity of money to stabilize the
economy.
□
Decides how much money to print ---> controls the interest rate
□
When FED INCREASES the quantity of money in circulation, this
DECREASES the interest rate (holding the aggregate price level
constant) leading to HIGHER consumer and investment spending.
□
When FED DECREASE the quantity of money in circulation, this
INCREASES the interest rate (holding the aggregate price level
constant) leading to LOWER consumer and investment spending.
□
§
Rightward Shift (↑AD)
Leftward Shift (↓AD)
Optimistic
Pessimistic
↑Stock Price
↓ Stock Price
↑ Real Value Assets
↓ Real Value Assets
Print more $
Print less $
Natural Disaster
Big Investment Last Year
Govt. Inc Spending
Govt. Dec Spending
Tax Cut
Tax Raise
New Deal Project
Practice Problem
Determine the effect on aggregate demand of each of the following
events. Explain whether it represents a movement along the aggregate
demand curve (up or down) or a shift of the curve (leftward or
rightward).
§
A rise in the interest rate caused by a change in monetary policy.
a.
A fall in the real value of money in the economy due to a higher
aggregate price level.
b.
News of a worse-than-expected job market next year.
c.
A fall in tax rates.
d.
A rise in the real value of assets in the economy due to a lower aggregate
price level.
e.
A rise in the real value of assets in the economy due to a surge in real
estate values.
f.
○
Short-Run Aggregate Supply (SRAS)
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that exists in the short run, the time period when
many production costs can be taken as FIXED
○
Short Run
The period of time during which some costs, particularly nominal wages,
are fixed.
§
○
NOTICE! The short-run aggregate supply curve is UPWARD SLOPING.
This is because nominal wages are stick in the short run.
§
Nominal Wage
The dollar amount of the wage paid.
□
§
Sticky Wages
Nominal wages that are slow to fall even in the face of high
unemployment and slow to rise even in the face of labor shortages
□
Due to contracts and informal agreements
□
§
○
○
Intuition
Fall in the price level
§
If the aggregate price level FALLS, the price received by the typical
producer DECREASES.
Because many production costs are fixed in the short run, the profit
for each unit of a good or service that is produces DECREASES.
□
This leads producers to REDUCE the quantity supplied in the short
run.
□
§
If the aggregate price level RISES, the price received by the typical
producer INCREASES.
Because many production costs are fixed in the short run, the profit
for each unit of a good or service that is produced INCREASES
□
This leads producers to INCREASE the quantity supplied in the
short run.
□
§
○
3 Factors that Shift the Short-Run Aggregate Supply Curve
Changes in Commodity Prices
Commodity
A standardized input bought and sold in bulk quantities (think
oil)
®
□
INCREASE in commodity prices INCREASE production costs across
the entire economy and REDUCE the quantity of aggregate output
supplied for any given aggregate price level.
Leftward Shift
®
□
DECREASE in commodity prices DECREASE production costs
across the entire economy and INCREASE the quantity of aggregate
output supplied for any given aggregate price level.
Rightward Shift
®
□
§
Changes in Nominal Wages
An economy-wide RISE in the cost of health care insurance
premiums paid by employers as part of employees' wages
INCREASES production costs.
Leftward Shift
®
□
An economy-wide DECLINE in the cost of healthcare insurance
premiums paid by employers as part of employees' wages
DECREASES production costs.
Rightward Shift
®
□
§
Changes in Productivity
An increase in productivity means that a worker can produce more
units of output with the same quantity of inputs.
□
An INCREASE in worker productivity (holding nominal wages
constant) INCREASES producers' profits.
Rightward Shift
®
□
A DECREASE in worker productivity (holding nominal wages
constant) REDUCES producers' profits.
Leftward Shift
®
□
Any economy-wide change (other than a change in the aggregate
price level) that changes producers costs will cause a shift.
□
§
○
Rightward Shift (↑SRAS)
Leftward Shift (↓SRAS)
↓Commodity Price
↑Commodity Price
↓Nominal Wage
↑Nominal Wage
↑Worker Productivity
↓Worker Productivity
○
•
Long-Run Aggregate Supply (LRAS)
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that would exist if all prices, including nominal
wages, were fully flexible.
○
Long Run
The period of time during which costs are fully flexible.
§
○
•
○
NOTICE! The long run aggregate supply curve is VERTICAL.
This is because nominal wages are flexible in the long run.
Wages can be renegotiated.
□
§
Changes in the aggregate price level in the long run will be accompanied
by proportional changes in all input prices, including nominal wages
§
○
Example
Suppose the aggregate price level is 15 and the quantity of output
supplied is $800 billion in 2009 dollars.
§
If all the prices in the economy are cut in half (including the price of the
inputs, which includes nominal wages), the price level is now 7.5.
§
Each producer will receive half the price for their good, but their costs of
producing the good are also cut in half.
§
Therefore, output will remain unchanged. It will still be $800 billion in
2009 dollars.
§
○
Potential Output
The level of real GDP the economy would produce if all prices, including
nominal wages, were fully flexible.
§
Where the LRAS touches the horizontal axis is the economy's potential
output.
§
○
Short-Run Macroeconomic Equilibrium
When the quantity of aggregate output supplied is equal to the quantity of
aggregate output demanded.
○
Short-Run Equilibrium Aggregate Price Level
The aggregate price level in the short-run macroeconomic equilibrium.
§
○
Short-Run Equilibrium Aggregate Output
The quantity of aggregate output produced in the short-run
macroeconomic equilibrium.
§
○
○
Demand Shock
An event that shifts the aggregate demand curve.
§
Negative Demand Shock
AD curve shifts to the LEFT
□
Causes the Great Depression.
The collapse of wealth and of business and consumer
confidence that followed the stock market crash of 1929 and
banking crisis of 1930-1931
®
□
§
○
•
Positive Demand Shock
AD curve shifts to the RIGHT
□
Ended the Great Depression
The huge increase in government purchases during WWII.
®
□
§
Supply Shock
An event that shifts the short-run aggregate supply curve.
§
Negative Supply Shock
AS curve shifts to the LEFT
□
Caused the recession of 1973-1975 and the 1980 recessions
World oil supplies were greatly disrupted and the price of oil
increased dramatically.
®
□
Stagflation
The combination of inflation and falling aggregate output
®
Very unpleasant
Falling aggregate output leads to rising unemployment
and rising prices causes purchasing power to fall
◊
®
Price of things increases but income decreases
®
□
§
○
Positive Supply Shock
AS curve shifts to the RIGHT
□
Caused the U.S. growth from 1995-2000.
The increase use of the internet and other technologies caused
large productivity growth.
®
□
§
In-Class Assignment
Describe the short-run effects of each of the following shocks on the
aggregate price level on an on aggregate output.
§
The government sharply increases the minimum wage, raising the wages
of many workers.
a.
Solar energy firms launch a major program of investment spending.
b.
Congress raises taxes and cuts spending.
c.
Severe weather destroys crops around the world.
d.
○
Long-Run Macroeconomic Equilibrium
When the point of short-run macroeconomic equilibrium is on the long-run
aggregate supply curve.
○
All resources, mainly talking about labor, are being used.
Cyclical unemployment is 0%.
§
○
○
A demand or a supply shock can move the economy away from long-run
macroeconomic equilibrium.
○
•
Long-Run Macroeconomic Equilibrium: Negative Demand Shock
Suppose there is a decrease in business and consumer confidence resulting in
negative demand shock
○
The short-run macroeconomic equilibrium results in lower aggregate price
level and a lower equilibrium aggregate output level (P2& Y2)
AD shifts LEFT
§
SRAS shifts RIGHT
§
○
Recessionary Gap
When aggregate output is below potential output
§
Happens in the short run with negative demand shock
§
Y1-->Y2(Y2<Y1)
§
Underemployment ---> High Unemployment ---> Wages DECREASE
§
○
Nominal wages will eventually fall leading producers to increase output and
shifting SRAS to the right until the economy returns to long0run
macroeconomic equilibrium
With a permanently lower price level
§
○
○
•
Long-Run Macroeconomic Equilibrium: Positive Demand Shock
Suppose there is a wave of consumer optimism resulting in positive demand shock
○
The short-run macroeconomic equilibrium results in higher aggregate price level
and a higher equilibrium aggregate output level (P2& Y2)
AD shifts RIGHT
§
SRAS shifts LEFT
§
○
Inflationary Gap
When aggregate output is above potential output
§
Happens in the short run with positive demand shock
§
Y1-->Y2(Y2>Y1)
§
Overemployment ---> Low Unemployment ---> Wages INCREASE
§
○
Nominal wages will eventually rise leading producers to reduce output and shifting
SRAS to the left until the economy returns to long-run macroeconomic equilibrium
With a permanently higher price level
§
○
○
•
Long-Run Macroeconomic Equilibrium: Summary
Output Gap
The percentage difference between actual aggregate output and potential
output
§
Actual Aggregate Output - Potential Output
Potential Output
§
○
A negative output gap is a recessionary gap
○
A positive output gap is an inflationary gap
○
Self-Correcting
Shocks to aggregate demand affect output in the short run, but not the long
run
§
This is the economy in the long run
§
○
•
Conclusion
If the economy is self-correcting, why should the government intervene when there
is a recessionary or inflationary gap?
Most macroeconomists believe that the process of self-correction can take a
decade or longer.
§
Most, but not all, economists believe the government can help speed up this
process
§
○
One of Keynes's most famous quotes: "In the long run, we are all dead."
○
•
*100
Lecture 6
Tuesday,+June+12,+2018
3:26+PM
Aggregate Supply-Aggregate Demand Model (AD-AS)
5 Key Elements of the AD-AS Model
The Aggregate Demand Curve (& shifts)
§
The Short-Run Aggregate Supply Curve (& shifts)
§
The Long-Run Aggregate Supply Curve
§
Short-Run Macroeconomic Equilibrium (Demand & Supply Shocks)
§
Long-Run Macroeconomic Equilibrium (Demand & Supply Shocks)
§
○
•
Aggregate Demand (AD)
Shows the relationship between the aggregate price level (GDP deflator) & the
quantity of aggregate output demanded by households, businesses, the
government and the rest of the world (real GDP)
○
Most economists agree that the Great Depression was the result of a massive
negative aggregate demand shock.
○
A negative demand shock for one good or service results in lower price and a
lower quantity for that good or service.
○
What does it mean for the economy as a whole to experience a negative
demand shock?
○
○
Notice that the aggregate demand curve is DOWNWARD SLOPING.
This is not because of the law of demand.
We are not dealing with a single good market, but rather the entire
macroeconomy
□
In a single good market, a movement along the demand curve
changes the price of the good holding the price of all other goods
constant.
□
In a single good market, a movement up the demand curve reduces
the quantity demanded mainly because people switch their
consumption to other goods.
□
§
○
In the macroeconomy, a movement along the aggregate demand curve
changes the price of all final goods and services.
○
In the macroeconomy, consumers deciding to switch their consumption to
other goods doesn't necessarily change the total quantity of final goods and
services they demanded.
○
•
Why does a change in the aggregate price level lead to a fall in the quantity of
all final goods and services demanded? Two reasons:
The Wealth Effect of a Change in the Aggregate Price Level
The effect on consumer spending caused by the effect of a change in
the aggregate price level on the purchasing power of consumer's
assets.
□
Intuition
If the aggregate price level increases, your assets cannot
purchase what they used to be to purchase so you feel less
wealthy.
®
You cut back on your consumption and so does everyone else
in the economy.
®
So, the aggregate demand decreases.
®
□
§
○
The Interest Rate Effect of a Change in the Aggregate Price Level
The effect on consumer spending and investment spending caused
by the effect of a change in the aggregate price level on the
purchasing power of consumers' and firms' money holdings.
□
Intuition
If the aggregate price level increases, households and firms
demand more money (cash and bank deposits) to make
transactions.
®
This drives up the interest rate, which reduces investment
spending (I) and consumer spending (C).
®
□
§
5 Factors that Shift the Aggregate Demand Curve
Changes in Expectations
If consumers become more OPTIMISTIC, aggregate demand
INCREASES.
□
If consumers become more PESSIMISTIC, aggregate demand
DECREASES.
Consumers base their spending not only on current income,
but expectations about future income.
®
Firms base their investment spending not only on their
current sales, but their expectations about future sales too.
®
Keynes called these waves of optimism and pessimism "animal
spirits."
®
□
§
Changes in Wealth
When assets INCREASE in real value (holding the aggregate price
level constant) consumers and firms spend MORE.
□
When assets DECREASE in real value (holding the aggregate price
level constant) consumers and firms spend LESS.
□
Part of the cause of the Great Depression was the stock market
crash of 1929.
□
Part of the Great Recession was the drop in real estate values.
□
So do changes in wealth shift the aggregate demand curve or cause
a movement along the aggregate demand curve?
It depends what causes the change in wealth.
A change in wealth resulting from a change in the
aggregate price level results in a movement along the
aggregate demand curve.
◊
A change in wealth resulting from any source other than
a change in the aggregate price level (e.g. stock market
boom) shifts the aggregate demand curve.
◊
®
□
§
○
Size of the Existing Stock of Physical Capital
The MORE physical capital a firm has, the LESS they will feel the
need to invest.
□
The LESS physical capital a firm has, the MORE they will feel the
need to invest.
□
§
Fiscal Policy
The use of government spending or tax policy to stabilize the
economy.
□
If the government changes their spending, it DIRECTLY shifts the
aggregate demand curve.
During WWII, government spending increased 400%.
®
During the Great Recession, the government increased
spending by $100 billion to improve infrastructure.
®
□
If the government changes taxes, this INDIRECTLY shifts the
aggregate demand curve through its effect on disposable income.
□
§
Monetary Policy
The use of the changes in the quantity of money to stabilize the
economy.
□
Decides how much money to print ---> controls the interest rate
□
When FED INCREASES the quantity of money in circulation, this
DECREASES the interest rate (holding the aggregate price level
constant) leading to HIGHER consumer and investment spending.
□
When FED DECREASE the quantity of money in circulation, this
INCREASES the interest rate (holding the aggregate price level
constant) leading to LOWER consumer and investment spending.
□
§
Rightward Shift (↑AD)
Leftward Shift (↓AD)
Optimistic
Pessimistic
↑Stock Price
↓ Stock Price
↑ Real Value Assets
↓ Real Value Assets
Print more $
Print less $
Natural Disaster
Big Investment Last Year
Govt. Inc Spending
Govt. Dec Spending
Tax Cut
Tax Raise
New Deal Project
Practice Problem
Determine the effect on aggregate demand of each of the following
events. Explain whether it represents a movement along the aggregate
demand curve (up or down) or a shift of the curve (leftward or
rightward).
§
A rise in the interest rate caused by a change in monetary policy.
a.
A fall in the real value of money in the economy due to a higher
aggregate price level.
b.
News of a worse-than-expected job market next year.
c.
A fall in tax rates.
d.
A rise in the real value of assets in the economy due to a lower aggregate
price level.
e.
A rise in the real value of assets in the economy due to a surge in real
estate values.
f.
○
Short-Run Aggregate Supply (SRAS)
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that exists in the short run, the time period when
many production costs can be taken as FIXED
○
Short Run
The period of time during which some costs, particularly nominal wages,
are fixed.
§
○
NOTICE! The short-run aggregate supply curve is UPWARD SLOPING.
This is because nominal wages are stick in the short run.
§
Nominal Wage
The dollar amount of the wage paid.
□
§
Sticky Wages
Nominal wages that are slow to fall even in the face of high
unemployment and slow to rise even in the face of labor shortages
□
Due to contracts and informal agreements
□
§
○
○
Intuition
Fall in the price level
§
If the aggregate price level FALLS, the price received by the typical
producer DECREASES.
Because many production costs are fixed in the short run, the profit
for each unit of a good or service that is produces DECREASES.
□
This leads producers to REDUCE the quantity supplied in the short
run.
□
§
If the aggregate price level RISES, the price received by the typical
producer INCREASES.
Because many production costs are fixed in the short run, the profit
for each unit of a good or service that is produced INCREASES
□
This leads producers to INCREASE the quantity supplied in the
short run.
□
§
○
3 Factors that Shift the Short-Run Aggregate Supply Curve
Changes in Commodity Prices
Commodity
A standardized input bought and sold in bulk quantities (think
oil)
®
□
INCREASE in commodity prices INCREASE production costs across
the entire economy and REDUCE the quantity of aggregate output
supplied for any given aggregate price level.
Leftward Shift
®
□
DECREASE in commodity prices DECREASE production costs
across the entire economy and INCREASE the quantity of aggregate
output supplied for any given aggregate price level.
Rightward Shift
®
□
§
Changes in Nominal Wages
An economy-wide RISE in the cost of health care insurance
premiums paid by employers as part of employees' wages
INCREASES production costs.
Leftward Shift
®
□
An economy-wide DECLINE in the cost of healthcare insurance
premiums paid by employers as part of employees' wages
DECREASES production costs.
Rightward Shift
®
□
§
Changes in Productivity
An increase in productivity means that a worker can produce more
units of output with the same quantity of inputs.
□
An INCREASE in worker productivity (holding nominal wages
constant) INCREASES producers' profits.
Rightward Shift
®
□
A DECREASE in worker productivity (holding nominal wages
constant) REDUCES producers' profits.
Leftward Shift
®
□
Any economy-wide change (other than a change in the aggregate
price level) that changes producers costs will cause a shift.
□
§
○
Rightward Shift (↑SRAS)
Leftward Shift (↓SRAS)
↓Commodity Price
↑Commodity Price
↓Nominal Wage
↑Nominal Wage
↑Worker Productivity
↓Worker Productivity
○
•
Long-Run Aggregate Supply (LRAS)
Shows the relationship between the aggregate price level and the quantity of
aggregate output supplied that would exist if all prices, including nominal
wages, were fully flexible.
○
Long Run
The period of time during which costs are fully flexible.
§
○
•
○
NOTICE! The long run aggregate supply curve is VERTICAL.
This is because nominal wages are flexible in the long run.
Wages can be renegotiated.
□
§
Changes in the aggregate price level in the long run will be accompanied
by proportional changes in all input prices, including nominal wages
§
○
Example
Suppose the aggregate price level is 15 and the quantity of output
supplied is $800 billion in 2009 dollars.
§
If all the prices in the economy are cut in half (including the price of the
inputs, which includes nominal wages), the price level is now 7.5.
§
Each producer will receive half the price for their good, but their costs of
producing the good are also cut in half.
§
Therefore, output will remain unchanged. It will still be $800 billion in
2009 dollars.
§
○
Potential Output
The level of real GDP the economy would produce if all prices, including
nominal wages, were fully flexible.
§
Where the LRAS touches the horizontal axis is the economy's potential
output.
§
○
Short-Run Macroeconomic Equilibrium
When the quantity of aggregate output supplied is equal to the quantity of
aggregate output demanded.
○
Short-Run Equilibrium Aggregate Price Level
The aggregate price level in the short-run macroeconomic equilibrium.
§
○
Short-Run Equilibrium Aggregate Output
The quantity of aggregate output produced in the short-run
macroeconomic equilibrium.
§
○
○
Demand Shock
An event that shifts the aggregate demand curve.
§
Negative Demand Shock
AD curve shifts to the LEFT
□
Causes the Great Depression.
The collapse of wealth and of business and consumer
confidence that followed the stock market crash of 1929 and
banking crisis of 1930-1931
®
□
§
○
•
Positive Demand Shock
AD curve shifts to the RIGHT
□
Ended the Great Depression
The huge increase in government purchases during WWII.
®
□
§
Supply Shock
An event that shifts the short-run aggregate supply curve.
§
Negative Supply Shock
AS curve shifts to the LEFT
□
Caused the recession of 1973-1975 and the 1980 recessions
World oil supplies were greatly disrupted and the price of oil
increased dramatically.
®
□
Stagflation
The combination of inflation and falling aggregate output
®
Very unpleasant
Falling aggregate output leads to rising unemployment
and rising prices causes purchasing power to fall
◊
®
Price of things increases but income decreases
®
□
§
○
Positive Supply Shock
AS curve shifts to the RIGHT
□
Caused the U.S. growth from 1995-2000.
The increase use of the internet and other technologies caused
large productivity growth.
®
□
§
In-Class Assignment
Describe the short-run effects of each of the following shocks on the
aggregate price level on an on aggregate output.
§
The government sharply increases the minimum wage, raising the wages
of many workers.
a.
Solar energy firms launch a major program of investment spending.
b.
Congress raises taxes and cuts spending.
c.
Severe weather destroys crops around the world.
d.
○
Long-Run Macroeconomic Equilibrium
When the point of short-run macroeconomic equilibrium is on the long-run
aggregate supply curve.
○
All resources, mainly talking about labor, are being used.
Cyclical unemployment is 0%.
§
○
○
A demand or a supply shock can move the economy away from long-run
macroeconomic equilibrium.
○
•
Long-Run Macroeconomic Equilibrium: Negative Demand Shock
Suppose there is a decrease in business and consumer confidence resulting in
negative demand shock
○
The short-run macroeconomic equilibrium results in lower aggregate price
level and a lower equilibrium aggregate output level (P2& Y2)
AD shifts LEFT
§
SRAS shifts RIGHT
§
○
Recessionary Gap
When aggregate output is below potential output
§
Happens in the short run with negative demand shock
§
Y1-->Y2(Y2<Y1)
§
Underemployment ---> High Unemployment ---> Wages DECREASE
§
○
Nominal wages will eventually fall leading producers to increase output and
shifting SRAS to the right until the economy returns to long0run
macroeconomic equilibrium
With a permanently lower price level
§
○
○
•
Long-Run Macroeconomic Equilibrium: Positive Demand Shock
Suppose there is a wave of consumer optimism resulting in positive demand shock
○
The short-run macroeconomic equilibrium results in higher aggregate price level
and a higher equilibrium aggregate output level (P2& Y2)
AD shifts RIGHT
§
SRAS shifts LEFT
§
○
Inflationary Gap
When aggregate output is above potential output
§
Happens in the short run with positive demand shock
§
Y1-->Y2(Y2>Y1)
§
Overemployment ---> Low Unemployment ---> Wages INCREASE
§
○
Nominal wages will eventually rise leading producers to reduce output and shifting
SRAS to the left until the economy returns to long-run macroeconomic equilibrium
With a permanently higher price level
§
○
○
•
Long-Run Macroeconomic Equilibrium: Summary
Output Gap
The percentage difference between actual aggregate output and potential
output
§
Actual Aggregate Output - Potential Output
Potential Output
§
○
A negative output gap is a recessionary gap
○
A positive output gap is an inflationary gap
○
Self-Correcting
Shocks to aggregate demand affect output in the short run, but not the long
run
§
This is the economy in the long run
§
○
•
Conclusion
If the economy is self-correcting, why should the government intervene when there
is a recessionary or inflationary gap?
Most macroeconomists believe that the process of self-correction can take a
decade or longer.
§
Most, but not all, economists believe the government can help speed up this
process
§
○
One of Keynes's most famous quotes: "In the long run, we are all dead."
○
•
*100
Lecture 6
Tuesday,+June+12,+2018
3:26+PM
Document Summary
Shows the relationship between the aggregate price level (gdp deflator) & the quantity of aggregate output demanded by households, businesses, the government and the rest of the world (real gdp) Most economists agree that the great depression was the result of a massive negative aggregate demand shock. A negative demand shock for one good or service results in lower price and a lower quantity for that good or service. Notice that the aggregate demand curve is downward sloping. This is not because of the law of demand. We are not dealing with a single good market, but rather the entire macroeconomy. In a single good market, a movement along the demand curve changes the price of the good holding the price of all other goods constant. In a single good market, a movement up the demand curve reduces the quantity demanded mainly because people switch their consumption to other goods.
