Macro Short-Run AS/AD Model Essentials Up to this point, our discussions of unemployment, inflation, output, and income have revolved around how we measure these indicators of economic performance. Now we want to focus on understanding how real-world events and government policy changes might change these measures of economic performance. Our tool for understanding how these events and policy changes affect inflation, unemployment, and output will be the aggregate supply and demand model. Aggregate to add up, aggregation usually implies that the things being added up are similar, but not exactly identical Short-Run Aggregate Supply/Aggregate Demand Model Similar to our basic supply and demand model Output of all goods, measured by Real GDP, is on the horizontal axis Confusingly, we use on the horizontal axis as the symbol for Real GDP The price level (PL), often measured by the GDP Deflator, is on the vertical axis PL E AD
Aggregate Demand - the quantity of real domestic product that households, firms, government agencies, and foreign buyers wish to purchase at each price level, ceteris paribus AD = C + I + G + (X-M) Components of AD Consumption (C) essentially all spending by households on final goods and services, with the exception of new homes Investment (I) spending by households on new homes, spending by firms on new capital equipment, additions to inventories by firms Government Purchases (G) purchases of goods and services by the government, (this does not include transfer payments) Net Exports (X-M) spending by foreign citizens on our final goods and services minus spending by our citizens on foreign final goods and services Short-Run Aggregate Supply - the quantity of real domestic product firms are willing to produce at each price level, ceteris paribus Slope of the curve Generally speaking, has a positive slope Higher prices of final goods and services lead to higher profits for firms if input costs are sticky o Input costs are often assumed to be sticky due to the fact that wages and prices of other inputs are often fixed by long-term contracts Slope of is a bone of contention that is responsible for a number of disagreements in modern macroeconomics o Important because the steepness affects the outcome of policy changes o Classical thought argues that it is very steep, even vertical o Keynesian argues that it is much flatter, even horizontal at times o Keynesian section represents a revision of thought resulting from the Great Depression
Shape of the AD curve Remember, AD = C + I+ G + (X-M) Generally speaking, we believe that AD has a negative slope for 3 reasons. 1) Wealth, or real balances, effect 2) Interest rate effect 3) Foreign purchases effect/net export effect Wealth effect acts through consumer expenditures (C) as the price level falls, the quantity of goods and services that your nominal wealth will purchase increases (purchasing power, or real wealth, increases) this is true for wealth held in the form of bank deposits, etc. so, as P decreases, real wealth rises, we feel richer and spend more so consumption rises and AD increases Net export, or foreign purchases, effect we buy foreign goods because they are cheaper than domestic goods same holds true for foreigners if our PL falls compared to the PL in other countries, our goods become more attractive residents of other countries, so our exports rise simultaneously, their goods become less attractive to us, so our imports fall as a result, (X-M) rises so, as our PL decreases compared to the PL in other countries, (X-M) rises and therefore AD rises Interest rate effect (see money market graph) the AD curve drawn assuming the supply of money is fixed as the price level falls, fewer dollars are needed to purchase goods and services demand for dollars falls o in the money market, this means the money demand curve shifts back the result is that the price of dollars falls price of the dollar is known as the interest rate capital projects and home ownership become more affordable as interest rates drop investment rises as the interest rate falls so, as PL falls, MD decreases, interest rates fall, investments rise, and AD increases
i S Money Market i 0 i 1 D 1 D 0 Q Why is the Short-Run AS/AD model useful? The Short-Run AS/AD model can be used to predict how real world events and economic policies might change output, unemployment, and inflation by examining changes in and E. PL 1 0 1 E E 0 AD 1 AD 0 Demand Pull Inflation An outward shift of the AD curve, perhaps due to a tax cut, causes inflation, but also increases output and reduces unemployment. This is known as demand pull inflation. Demand Pull Inflation
1 0 PL E 1 E 0 AD 0 Cost Push Inflation An inward shift of the AS curve, usually due to an adverse supply shock, causes inflation, along with reduced output and lower unemployment. This is known as cost push inflation or stagflation. Cost Push Inflation What factors would shift the AD curve? remember AD = C+I+G+(X-M) anything that affects the desire of HH, firms, the government, or foreign citizens will shift the AD curve Consumption determinants 1) Changes in real wealth - stock market gains 2) Expectations - regarding wealth, income, etc. 3) Indebtedness - flip side of wealth 4) Taxes - on wealth, income Investment determinants 1) Interest rates 2) Expectations regarding the profitability of projects 3) Business taxes - esp. capital gains and ITC's 4) Technological change 5) Degree of excess capacity Government spending determinants 1) Whatever the government decides to spend!
Net exports determinants 1) Foreign national income 2) Exchange rates 3) Tariffs and quotas What factors shift the curve? Input prices and wages - not the general price level Productivity - new technology allows greater output at constant price Legal/institutional environment - largely tax structure, regulations also important The Short-run AS/AD Model Notes Remember that the short-run is a period of time for which resource prices are fixed The intersection of and AD give us short-run equilibrium Is everything great at SR equilibrium? Short-run equilibrium is not actually very informative SR equilibrium merely says that AS=AD, It doesn t tell us whether our current level of output is high or low. We need a benchmark against which we can judge the performance of the economy Return to an idea from the PPF, Potential GDP Consider the concept of productive efficiency o Requires us making full use of resources, including labor o Essentially it entails production without waste Recall our discussion of costs of unemployment If we are on the frontier we are producing a level of output we call potential GDP Potential GDP The level out output possible when we fully use our resources To be at PGDP we have to be at full-employment Symbolize PGDP with P Add this to the graph
PL AD E P Economy exhibiting a recessionary gap Recessionary/Contractionary Gap Whenever E < P, you have a recessionary gap Current output is less than potential Since P requires full employment, having a E less than P also means you have high unemployment on your hands
PL AD P E Economy exhibiting an inflationary gap Inflationary/Expansionary Gap Whenever E > P, you have an inflationary gap Current output is greater than potential Since P requires full employment, having a E greater than P also means you have abnormally low unemployment on your hands