THE AGGREGATE MODEL
Aggregate Supply and Demand Model The AS-AD model helps us understand aggregate output (RGDP), employment, prices and the business cycle. Aggregate Demand shows the quantity of goods and services that households, firms, and the government want to buy at each price level. Aggregate Supply shows the quantity of goods and services that firms choose to produce and sell at each price level. Price Level 0 GDP Deflator LRAS SRAS AD Real GDP / Y quantity of aggregate output
Aggregate Demand
The Aggregate-Demand (AD) Curve The AD curve shows the quantity of goods & services that households, firms, the government, and foreigners want to buy at each price level. Y = C + I + G + Xn Inverse relationship between PL and Real GDP. If the price level: - Is high, real GDP is low - Is low real GDP is high Changes in price level cause a movement along the curve P 2 P 1 PL Y 2 Y 1 AD Y
The Slope of the AD Curve: Summary An increase in PL reduces the quantity of g&s demanded because: P 2 PL the wealth/real balance effect (C falls) P 1 the interest-rate effect (I falls) the net export/ exchange-rate effect (XN falls) Y 2 Y 1 AD Y
Why the AD Curve Slopes Downward PL The Wealth Effect / Real Balance Effect P 2 Suppose PL rises. The dollars people hold buy fewer g&s, so real wealth is lower. P 1 AD Result: C falls. Y 2 Y 1 Y
Why the AD Curve Slopes Downward The Interest-rate Effect Suppose PL rises. PL purchasing power decreases P 2 so people either save less or must borrow more to maintain their consumption reduction of the supply of P loanable money interest 1 rate rises ALSO, when the price level increases, lenders need to Y 2 charge higher nominal interest rates to get a REAL return on their loans. Higher interest rates Cand I falls. Y 1 AD Y
Why the AD Curve Slopes Downward The Net Export Effect / Exchange-Rate Effect Suppose PL rises. P 2 PL U.S. exports become more expensive to foreigners, who will then purchase fewer U.S. goods. Moreover, Americans buy more foreign goods as they now have become the cheaper substitute. P 1 Y 2 Y 1 AD Y Result: Xn falls.
Why the AD Curve Might Shift Any event that changes C, I, G, or Xn except a change in P will shift the AD curve. PL Example: A stock market boom makes households wealthier, C rises, the AD curve shifts right. A stock market crash makes households poorer, C falls, the AD curve shifts left. P 1 Y 1 AD 3 Y 2 AD 1 AD 2 Y
Why the AD Curve Might Shift Changes in C Income/wealth Changes in I PL Firms buy new computers, equipment, factories, etc. Changes in C and I Expectations, optimism/pessimism Interest rates Tax hikes/cuts/incentives AD 3 AD 1 AD 2 Y
Why the AD Curve Might Shift Changes in G Federal spending, e.g., defense State & local spending, e.g., roads, schools Changes in Xn PL Booms/recessions in countries that buy our exports Appreciation/depreciation of currency AD 3 AD 1 AD 2 Y
Aggregate Demand Consumers respond to high levels of debt by reducing their purchases of consumer goods. Price Level Component of AD? Consumption Change in AD? Increase or decrease? AD Resulting AD shift? 0 Real GDP
What happens to the AD curve if a ten-year-old investment tax credit expires. A. The AD curve shifts to the right. B. The AD curve shifts to the left. C. The economy moves down the AD curve. D. The economy moves up the AD curve. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What happens to the AD curve if the U.S. exchange rate falls. A. The AD curve shifts to the right. B. The AD curve shifts to the left. C. The economy moves down the AD curve. D. The economy moves up the AD curve. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What happens to the AD curve if a fall in prices increases the real value of consumers wealth. A. The AD curve shifts to the right. B. The AD curve shifts to the left. C. The economy moves down the AD curve. D. The economy moves up the AD curve. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What happens State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. A. The AD curve shifts to the right. B. The AD curve shifts to the left. C. The economy moves down the AD curve. D. The economy moves up the AD curve. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Answers A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The U.S. exchange rate falls. XN rises, AD curve shifts right. C. A fall in prices increases the real value of consumers wealth. Move down along AD curve (wealth-effect). D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right.
28 Aggregate Supply
The Aggregate-Supply (AS ) Curves The AS curve shows the quantity of goods and services that firms choose to produce and sell at each price level. AS is: upward-sloping in short run vertical in long run P LRAS SRAS In the SR, at least one input is fixed. Ex. wage contract and rental agreements. The LR is a period of time long enough for firms to change any of their inputs. Ex. Contracts can be renegotiated after they expire. Y
Short Run Aggregate Supply (SRAS) The SRAS curve is upward sloping. In the short run, nominal wages and resource prices will NOT increase ( sticky ) as price levels increase. If a firm makes 100 units that each sell for $1 and the only cost is $80 of labor. How much is profit? PL doubles and now the firm sells 100 units that sell for $2, TR=$200. How much is profit? P 2 P 1 P Y 1 Y 2 SRAS Y With higher profits, the firm has the incentive to increase production.
Change in Productivity Technology Human Capital skills, training, experience of workers Changes in Input Prices Why the SRAS Curve Might Shift Prices of domestic and imported resources Supply shocks Change in Actions of the Government (NOT Gov t Spending) Taxes/Subsidies Government Regulations P SRAS 3 Expectations for Inflation SRAS 1 SRAS 2 If suppliers think goods will sell at a higher price in the future, they will hold their inventory and the SRAS will shift left. Y
Shifts of the SRAS Factors That Shift the Aggregate Supply Curve 32 of 47 Shifts to the Right Increases in Aggregate Supply Lower costs lower input prices lower wage rates Economic growth more capital more labor technological change Public policy supply-side policies tax cuts deregulation Good weather Shifts to the Left Decreases in Aggregate Supply Higher costs higher input prices higher wage rates Stagnation capital deterioration Public policy waste and inefficiency over-regulation Bad weather, natural disasters, destruction from wars
Short-run Aggregate Supply Unions are more effective so that wage rates increase. Price Level AS Determinant of AS? Input costs or productivity? Change in AS? Increase or decrease? Resulting AS curve? 0 Real GDP
B A D A D B A A C A major increase in productivity. A 34
Why LRAS Is Vertical In the long run, wages and resource prices WILL increase as price levels increase. The firm has TR of $100 an uses $80 of labor and earns a profit of $20. P 2 PL LRAS In LR, if the PL doubles, workers will demand a COLA. P 1 Now TR=$200 and labor costs double to $160 Profit = $40, but REAL profit is unchanged. Y Y If REAL profit doesn t change the firm has no incentive to increase output. An increase in PL has no effect on the LRAS
LRAS determined by the economy s stocks of labor, capital, and natural resources, and the level of technology. The natural rate of output (Y N ) is the amount of output the economy produces when unemployment is at its natural rate. Y N is also called potential output or full-employment output. Why LRAS Is Vertical P 2 P 1 P LRAS Y N Y
Why the LRAS Curve Might Shift P LRAS 1 LRAS 2 Shifts when the quantity and quality of resources available change Discovery of new productive resources Increase in the population or labor force Improved production processes Growth of capital stock (investments made by firms). If LRAS shifts in either direction, SRAS shifts with it Y N Y N Y
The Long-Run Equilibrium In long-run equilibrium, AD = SRAS = LRAS, so PL LRAS PL = P E, SRAS Y = Y N, P E The economy is producing at the potential output and unemployment is at its natural rate. Y N AD Y
Short-run Equilibrium (its really disequilibrium) Short-run Equilibrium/Current Real GDP intersection of AD and SRAS Current output is greater than or less than the LRAS (potential GDP/full employment)
The Recessionary Gap The Short-Run Effects of Stable Aggregate Supply and a Decrease in Aggregate Demand The gap that exists whenever equilibrium real GDP per year is less than fullemployment real GDP as shown by the position of the LRAS curve P 1 P 2 P LRAS B A SRAS 1 AD 1 Y 2 Y N AD 2 Y
The Inflationary Gap The Effects of Stable Aggregate Supply with an Increase in Aggregate Demand The gap that exists whenever equilibrium real GDP per year is greater than fullemployment real GDP as shown by the position of the LRAS curve. Also causes demandpull inflation
Inflationary Gap Recessionary Gap
Cost-Push Inflation (Stagflation) Inflation caused by decreases in short-run aggregate supply P LRAS SRAS 2 P 2 B SRAS 1 P 1 A Y 2 Y N AD 1 Y
Practice Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a longrun equilibrium. A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment.
Check for Understanding Describe the short -run effects of each of the following shocks on the aggregate price level and on aggregate output. a. The government sharply increases the minimum wage, raising the wages of many workers. b. Solar energy firms launch a major program of investment spending. c. Congress raises taxes and cuts spending. d. Severe weather destroys crops around the world.