The AS/AD Model Macro Theory: Part 1 – The Basics Part 2 – The Keynesian View Dr. D. Foster – ECO 285 – Macroeconomics

Warning .. Warning .. Warning Part 1 – The Basics Warning .. Warning .. Warning Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! The “static” analysis only hints at dynamic interpretation. Ceteris Paribus assumption problematic to the point of being wholly inappropriate. Keynesian model notes: Descriptive analysis. No numerical interpretation. Only AS/AD graphical representation.

The Aggregate Demand Schedule P P = Price Level; CPI or GDP deflator Q = real output; Real GDP AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign A P2 Q1 B P1 Q2 AD1 Q or R-GDP

Aggregate Demand The price level and real output demanded are inversely related. A fall in the price level will increase quantity demanded. Why? -- the Wealth Effect All prices and wages change. But, the fixed wealth is … well, still fixed! So, with lower prices we feel wealthier. Woo Hoo! And, so we want to buy more stuff.

Can’t do “all else equal.” Aggregate Demand What about: Interest effect Foreign trade effect Exchange rate effect Can’t do “all else equal.” e.g. Lower prices: Consumption, but one price is wages!!! If they fall, then we’d see a Consumption!!! AD can shift to the left or right. Increase AD – shift to the right. Decrease AD – shift to the left. Whenever C, I, G, net X increase/decrease. Why? Due to changes in optimism & pessimism, and due to fiscal & monetary policies.

The Aggregate Demand Schedule P AD3 AD2 Increases in C, I, G, net X Decreases in C, I, G, net X AD1 Q or R-GDP

Long Run Equilibrium between Aggregate Demand and Aggregate Supply There is an Aggregate Supply that reflects fully employed resource use. Output level: Q* or RGDP* or potential RGDP AS1 Shifts in AD can only change the price level and not real output (nor employment). P1 Classical Model of the Economy AD1 Q or R-GDP

What affects the Aggregate Supply? Labor force participation. Labor productivity. Marginal tax rates on wages. Provision of government benefits that affect household incentives w.r.t. supply labor. State of technology. Capital stock. A change in these factors can AS (shift right) or AS (shift left)

Short Run Aggregate Supply – Wage Inflexibility Nominal wages are sluggish upwards: A rise in prices has delayed effect on wages. Nominal wages are inflexible downwards: A fall in prices will result in employment and income. Workers have money illusion: Higher nominal wages (W) are viewed as real wage (W/P). So, more workers available even though real wage has not risen. e.g. if prices rise 5% and wages rise 3%…

Short Run Aggregate Supply What about: Sticky prices Misperception Intertemporal substitution Unnecessary complications to explain the SR AS. Inflexible wages is all we need. What happens if there is a AD? The Short Run will adjust to the Long Run: An AD will P and Q, but only in the SR. Prices rise but wages lag. Firms employment and output. Eventually, workers realize their real wages (W/P) are falling, get comparable wage, AS. The temporary profit motive has been eliminated.

From SR to LR Aggregate Supply An increase in AD triggers events. AS3 AS2 P ASLR AD2 AS1 Prices rise, wages lag, output rises. Eventually, wages catch up and AS declines. In LR, only prices rise. P3 P2 Q2 P1 AD1 Q or R-GDP Q*

AS/AD Model – Hints at 4 types of changes ASLR Inflation with growth due to rising AD. Depression with deflation due to falling AD. Growth with deflation due to rising AS. Depression with inflation due to falling AS. (stagflation) AS1 P1 AD1 Q or R-GDP Q*

The AS/AD Model Macro Theory: Part 1 – The Basics Part 2 – The Keynesian View Dr. D. Foster – ECO 285 – Macroeconomics