CHAPTER OUTLINE 13 The AD /AS Model Dr. Neri’s Expanded Discussion of AD / AS Fiscal Policy Fiscal Policy Effects in the Long Run Monetary Policy Shocks to the System Cost Shocks Demand-Side Shocks Expectations

Expanded Discussion of AD / AS Model

In the long run, real GDP is at full employment potential GDP. All wages and prices are flexible. As the price level rises, the money wage rate changes by the same percentage, the quantity of real GDP supplied remains at potential GDP. In this figure, full employment potential GDP is 16.0 trillion. Log Run Aggregate Supply

Changes in Aggregate Supply Aggregate supply changes if factors that influence production other than the price level changes. For example:  Changes in potential GDP  Changes in money wage rate  Changes in other cost of production such a resource cost.

Changes in LR Aggregate Supply Changes in Potential GDP When potential GDP increases, both the LRAS and SRAS curves shift rightward. Potential GDP changes for three reasons:  An increase in the full-employment quantity of labor  An increase in the quantity of capital (physical or human)  An advance in technology

The LRAS curve shifts rightward and the SRAS curve shifts along with the LAS curve. Increase in potential GDP

Changes in the Money Wage Rate  Short-run aggregate supply decreases and the SRAS curve shifts leftward.  Long-run aggregate supply does not change. SR Aggregate Supply

Explaining Macroeconomic Trends and Fluctuations Long-Run Macroeconomic Equilibrium Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—when the economy is on its LRAS curve. Long-run equilibrium occurs at the intersection of the AD curve, the LRAS curve, and the SRAS curve.

Explaining Macroeconomic Trends and Fluctuations This figure illustrates the adjustment to long-run equilibrium. Full employment potential = 16.0 Initially, the economy is below full employment equilibrium. In the long run, because of unemployment the money wage falls until the SAS curve passes through the long-run equilibrium point.

Explaining Macroeconomic Trends and Fluctuations Initially, the economy is at an above-full employment equilibrium. In the long run, the money wage rate rises until the SAS curve passes through the long-run equilibrium point

Economic Growth and Inflation in the AS-AD Model This figure illustrates economic growth. Because the quantity of labor grows, capital is accumulated, and technology advances, potential GDP increases. The LRAS curve shifts rightward. Explaining Macroeconomic Trends and Fluctuations

Suppose the quantity of money grows faster than potential GDP, aggregate demand increases by more than long-run aggregate supply. The AD curve shifts rightward faster than the rightward shift of the LAS curve. Explaining Macroeconomic Trends and Fluctuations

The Business Cycle in the AS-AD Model The business cycle occurs in the short-run because aggregate demand and the short-run aggregate supply fluctuate, and the money wage is fixed or does not change rapidly enough to keep real GDP at potential GDP. An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP. A full-employment equilibrium is an equilibrium in which real GDP equals potential GDP. A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP.

Fluctuations in Aggregate Demand – Demand Shock This figure shows the effects of an increase in aggregate demand. An increase in aggregate demand shifts the AD curve rightward. Firms increase production and the price level rises in the short run. Explaining Macroeconomic Trends and Fluctuations

At the short-run equilibrium, there is an inflationary gap. The money wage rate begins to rise and the SAS curve starts to shift leftward. The price level continues to rise and real GDP continues to decrease until it equals potential GDP. Explaining Macroeconomic Trends and Fluctuations Inflationary Gap

Fluctuations in Aggregate Supply – Supply Shock Increase in the price of oil. The SRAS curve shifts leftward. Real GDP decreases and the price level rises. The economy experiences stagflation. Explaining Macroeconomic Trends and Fluctuations

The Multiplier and the Price Level Aggregate Expenditure and Aggregate Demand The aggregate expenditure curve is the relationship between aggregate planned expenditure and real GDP, with all other influences on aggregate planned expenditure remaining the same. The aggregate demand curve is the relationship between the quantity of real GDP demanded and the price level, with all other influences on aggregate demand remaining the same.

Changes in Aggregate Expenditure and Aggregate Demand An increase in investment. The AE curve shifts upward … …and the AD curve shifts rightward … by an amount equal to the change in investment multiplied by the multiplier if P is held constant at 110 The Multiplier and the Price Level

Equilibrium Real GDP and the Price Level This figure shows the effect of an increase in investment in the short run when the price level changes. The Multiplier and the Price Level

The increase in investment shifts the AE curve upward and shifts the AD curve rightward. With no change in the price level, real GDP would increase to $18 trillion at point B. The Multiplier and the Price Level

But the price level rises. The AE curve shifts downward…. Equilibrium expenditure decreases to $17.3 trillion… As the price level rises, real GDP increases along the SAS curve to $17.3 trillion. The multiplier in the short run is smaller than when the price level is fixed. The Multiplier and the Price Level

This figure illustrates the long-run effects. At point C in part (b), there is an inflationary gap. The money wage rate starts to rise and the SAS curve starts to shift leftward. The Multiplier and the Price Level

The money wage rate will continue to rise and the SAS curve will continue to shift leftward,... until real GDP equals potential GDP. In the long run, the multiplier is zero. The Multiplier and the Price Level

28 of 23 © 2014 Pearson Education, Inc. The level of net taxes, T (taxes minus transfer payments) is an important fiscal policy variable along with government spending. The main point for this chapter is that both a decrease in T and an increase in G increase output (Y). Both result in a shift of the AD curve to the right. Fiscal Policy Effects – C/F presentation

29 of 23 © 2014 Pearson Education, Inc.  FIGURE 13.1 A Shift of the AD Curve When the Economy is on the Nearly Flat Part of the AS Curve In this case expansionary fiscal policy works well. There is an increase in output with little increase in the price level. When the economy is producing on the nearly flat portion of the AS curve, firms are producing well below capacity, and they will respond to an increase in demand by increasing output much more than they increase prices.

30 of 23 © 2014 Pearson Education, Inc.  FIGURE 13.1 A Shift of the AD Curve When the Economy is on the Nearly Flat Part of the AS Curve P does not increase much => r does not increase much meaning little crowding out. The multiplier effect is relatively large.

31 of 23 © 2014 Pearson Education, Inc. Here, an expansionary fiscal policy does not work well. The multiplier is close to zero. Output is initially close to capacity, and attempts to increase it further mostly lead to a higher price level. With a higher price level, interest rates increase there is almost complete crowding out of planned investment.  FIGURE 13.2 A Shift of the AD Curve When the Economy is Operating at or Near Capacity

Fiscal Policy Effects in the Long Run If wages adjust quickly to match higher prices, then the long-run AS curve is vertical. In this case it is easy to see that fiscal policy will have no effect on output. The key question, much debated in macroeconomics, is how fast wages adjust to changes in prices. While most economists believe that wages are slow to adjust in the short run and therefore that fiscal policy has potential effects in the short run, the New classical economists believe that wage rate changes do not lag behind price changes. The new classical view is consistent with the existence of a vertical AS curve, even in the short run. At the other end of the spectrum is what is sometimes called the simple “Keynesian” view of aggregate supply. Those who hold this view believe there is a kink in the AS curve at capacity output

The Fed’s Response to the Z Factors p 250 – SKIP Shape of the AD Curve When the Fed Cares More About the Price Level than Output Aggregate Supply Curve, p SKIP

Inflation – Demand pull and Cost push. P.254 of Text. This is a much expanded discussion In the long run, inflation occurs if the quantity of money grows faster than potential GDP. In the short run, many factors can start an inflation, and real GDP and the price level interact. To study these interactions, we distinguish between two sources of inflation:  Demand-pull inflation  Cost-push inflation

Demand-Pull Inflation An inflation that starts because aggregate demand increases is called demand-pull inflation. Demand-pull inflation can begin with any factor that increases aggregate demand. Examples are an increase in the quantity of money, an increase in government expenditure, a tax cut, an increase in investment stimulated by an increase in expected future profits, an increase in exports.

Initial Effect of an Increase in Aggregate Demand Demand-pull inflation. Starting from full employment at $16.0 trillion, an increase in aggregate demand shifts the AD curve rightward. Inflation Cycles

The price level rises, real GDP increases, and we get an inflationary gap. The rising price level from 110 to 113 is the first step in the demand-pull inflation. Inflation Cycles Inflationary gap

Money Wage Rate Response Over time, the money wage rate rises and the SAS curve shifts leftward. The price level rises to 121 and real GDP decreases back to potential GDP. Inflation Cycles

A Demand-Pull Inflation Process This figure illustrates a demand-pull inflation spiral. Aggregate demand keeps increasing and the process just described repeats indefinitely. Inflation Cycles

Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it. Demand-pull inflation occurred in the United States during the late 1960s. Inflation Cycles

Cost-Push Inflation An inflation that starts with an increase in costs is called cost-push inflation. There are two main sources of increased costs: 1. An increase in the money wage rate 2. An increase in the price of raw materials, such as oil

Initial Effect of a Decrease in Aggregate Supply This figure illustrates the start of cost-push inflation. A rise in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward. Real GDP decreases and the price level rises from 110 to 117. Inflation Cycles

Aggregate Demand Response The initial increase in costs creates a one-time rise in the price level, not inflation. To create inflation, aggregate demand must increase. That is, the Fed must increase the quantity of money persistently.

This figure illustrates an aggregate demand response. Suppose that the Fed stimulates aggregate demand to counter the higher unemployment rate and lower level of real GDP. Real GDP increases and the price level rises even more to 121. Inflation Cycles

A Cost-Push Inflation Process If the oil producers raise the price of oil to try to keep its relative price higher,... and the Fed responds by increasing the quantity of money,... a process of cost-push inflation continues. Inflation Cycles

The combination of a rising price level and a decreasing real GDP is called stagflation. Cost-push inflation occurred in the United States during the 1970s when the Fed responded to the OPEC oil price rise by increasing the quantity of money. Inflation Cycles

Expected Inflation Suppose aggregate demand increases, but the increase is expected, so its effect on the price level is expected. Inflation Cycles

The money wage rate will increase quickly, without a lag. The AD curve shifts rightward and the SAS curve shifts leftward … so that the price level rises as expected and real GDP remains at potential GDP. Inflation Cycles

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