Aggregate Demand (AD) and Aggregate Supply (AS) Model

Introduction  AE model is fixed price model, unrealistic  Need for a model that considers variable prices  Aggregate all individual product markets and equilibrium price levels for products  Create the AD-AS model

Need for a Model  Single product S&D models are insufficient –Why do prices fall in general? –What determines level of aggregate output? –What determines changes in level of aggregate output?  Economists created aggregate model –All prices of individual g/s combined –Combines equil. Q of all g/s into real domestic output

Aggregate Demand  Aggregate Demand--curve that shows how much domestic consumers will purchase at various price levels  Inverse relationship between PL and real domestic output  downward sloping AD curve  Why? –Not substitution or income effects –Wealth effect –Interest rate effect –Foreign purchase effect

PL Real GDP Aggregate Demand Curve PL1 GDP1 PL2 GDP2

Shifts of the AD Curve  “Other things” besides PL can cause a shift in AD –Change in consumer spending  Consumer wealth  Expectations  Consumer debt  Taxes –Change in investment spending  Interest rates  Profit expectations  Taxes (business)  Tech.  Amount of excess capacity –Change in govt. spending –Change in net export spending  Income abroad  Exchange rates AD1 AD2 AD3 Increase in AD Decrease in AD

Shifts and the Multiplier PL GDP 1 Real GDP (billions/$) PL1 GDP 2 Increase in AD AD 1 AD 2 { Initial Increase in Spending

Shifting AD  Any increase in total spending (C,I, G, Xn) will shift the AD right –Shift of AD = change in spending x multiplier

Aggregate Supply  AS  curve showing the level of real domestic output which will be produced at each level  All “other things equal,” movement L  R along the curve shows real output increases up to a point

Aggregate Supply Curve AS Horizontal Range Intermediate Range Vertical Range Price Level Real GDPGDP c GDP u PL1 PL2

Determinants of AS  The everything else part –Input prices –Productivity  Prod = total output/total inputs  Per unit prod costs = total input cost total output total output –Legal institutional environment

Shifts of the AS Curve AS 1 Price Level AS 3 AS 2 PL2 PL1 PL3 Decrease in AS Increase in AS Real GDP

Equilibrium GDP ASPrice Level PL e PL Real GDP AD GDP e

Shift of AD Curve ASPrice Level PL AD 1 AD 2 Real GDP GDP 1 GDP 2 AD 3 GDP 3

Shifts of AS  Recall determinants of AS  Lead to shifts of AS curve  Decrease of AS reflects cost push inflation

AS 1 Price Level AS 3 AS 2 Real GDP AD PL1 GDP1GDP3GDP2 PL2 PL3 Result of cost-push inflation

Ratchet Effect  Complications in vertical and int. ranges  ↓ AD does not restore original equilibrium price  Prices rise but are “sticky” or downwardly inflexible

Ratchet Effect? AS 1 Price Level PL 1 AD1 GDP e Real GDP AD2 PL 2 AS 2 GDP c A B C GDP r

Why?  Wage contracts  Morale, productivity  Training investments  Minimum wage  Menu costs  Price war fears