The Aggregate Demand -- Aggregate Supply Model zFundamental inflexibility assumptions: W -- inflexible (short-run) -- flexible (long-run) P -- flexible i -- flexible. zOverriding theme -- policies affect the price level as well as real GDP.

Properties of Aggregate Demand (AD) Curve zDownward sloping. zExpansionary shifts in the IS or LM curves shift the AD curve rightward (fiscal or monetary policy). zContractionary shifts in the IS or LM curves shift the AD curve leftward (fiscal or monetary policy).

Properties of the Short-Run Aggregate Supply Curve zUpward sloping (W inflexible) zVariables that enhance production shift the SAS curve rightward. zVariables that hinder production shift the SAS curve leftward.

Shift variables -- SAS Curve zNominal Wage Rate (W) zCapital Stock zLabor Productivity zPrice of Energy

Properties of the Long-Run Aggregate Supply Curve zVertical at Y = Y N. zVariables that enhance production shift the LAS curve rightward. zVariables that hinder production shift the LAS curve leftward.

Shift Variables -- LAS Curve (Variables That Change Y N ) zCapital Stock zLabor Productivity (output)/(labor hours) zPrice of Energy zLabor Force zHousehold Attitudes Toward Work zTransfer Payments

Lengthening the Short-Run (Demand Policy) zEncourage long-term, non-indexed nominal wage contracts. zKeep inflation expectations down. -- seek gradual policy changes (“soft landing”) -- verbal reassurances on inflation zWatch closely for unusual increases in nominal wage rates.

Rational Expectations zRational Expectations -- People form expectations using all available information in the most efficient way. zTruly the “best guess.” zErrors between actual expected variables are totally unpredictable, and independent from the set of available information.

Rational Expectations, Continued zCorresponds to fundamental assumption on human behavior, rationality (according to the economic definition). zApplication -- efficient markets (Finance), and predicting movements in stock prices.

Supply Shocks zSupply Shock – large increase in the price of energy (US: 1973, 1978, 1990, 2007). -- shifts SAS curve leftward  P* , Y* .

Possible Policy Responses to Supply Shocks zExtinguishing Response (1973) – attempts to extinguish the increased inflation  practice contractionary demand policy. zValidating Response (1978) – attempts to protect output, keep the economy out of recession  practice expansionary demand policy. zDo nothing (2007) – best solution

Positive Supply Shifts zShifts both SAS curve and LAS curve rightward  P* , Y* , Y N  -- decrease price of energy -- increase labor productivity -- increase the capital stock.

The Record of US Labor Productivity zSteadily increasing over time zTripled since 1960 zIncreased after Great Recession, has leveled off (good sign for hiring?)