Modeling Demand and Supply Shocks using Aggregate Demand (AD) and Aggregate Supply (AS) Outline “Short-run” versus the long run. AD and AS Together: “Short-run” equilibrium Demand shocks in the short-run The long-run AS curve Adjustment to “long run” equilibrium Supply shocks in the short-run Long-run effects of supply shocks
Professors Hall and Lieberman call the Keynesian model a “short-run” model. Why? Because it is possible for the economy to be in equilibrium, but at the same time real GDP can be above or below potential or full employment GDP
45 0 AE Real GDP ($Trillions) Y1Y1 Y FE Y2Y2 0 AE 1 AE 2 AE 3 E H K Point K is a short- run equilibrium since Y 1 < Y FE Point H is a short- run equilibrium since Y 2 > Y FE Point E is a long- run equilibrium since equilibrium GDP corresponds to Y FE Long-run equilibrium occurs when the economy is in equilibrium at full employment Full employment GDP
Short run equilibrium is a combination of price level and GDP consistent with both AS and AD curves
Price Level Real GDP ($Trillions) 0 AD AS E B F Why is point E a short-run equilibrium? At point B, the price level is 140 and AS = $14 trillion. But equilibrium GDP is equal to $6 trillion when the price level is 140—we know this from the AD curve. At point E, the price level is consistent with an output level of $10 along both AS and AD curves
Price Level Real GDP ($Trillions) 0 AD 1 AS Effect of a Demand Shock AD E H J Increase in government spending Issue: Why did the economy move from point E to point H— instead of E to J?
GG GDP Multiplier Effect AD curve shifts rightward Unit cost PP Money Demand Interest rate a and I P GDP Movement along new AD curve Movement along AS curve Net result: GDP increases, but by less due to the effect of an increase in the price level
Price Level Real GDP ($Trillions) 0 AD 2 AS Effect of a decrease in the money supply AD E K S 100
M GDP AD curve shifts Leftward Unit cost P Money Demand Interest rate a and I P GDP Movement along new AD curve Movement along AS curve Net result: GDP decreases, but by less due to the effect of an decrease in the price level Interest rate a and I P
Price Level Real GDP ($Trillions) 0 Long run AS curve: A vertical line indicating all possible output and price level combinations the economy could end up in the long run Long run AS curve Y FE
Some economists (including Hall & Lieberman) believe the economy is “self- correcting”—that is, forces are present that push the economy to long-run (or full-employment) equilibrium. (How does it work?)
Price Level Real GDP ($Trillions) 0 AD 1 AS 1 Long Run AS Curve Y FE Y3Y3 Y2Y2 AD 2 AS 2 P1P1 P3P3 P2P2 P4P4 E H J K Let AD shift from AD 1 to AD 2
Positive demand shock P and Y Change in short-run equilibrium Y > Y FE Wage Rate Unit Cost PP Y until Y =Y FE Long-run adjustment process
The following factors could shift the (short-run) aggregate supply schedule up to the left: An increase in the price of a basic commodity—e.g., petroleum, natural gas, wheat, soybeans. An increase in average money wages and benefits not restricted to just one industry or sector of the economy. An increase in the average markup over unit cost not restricted to just one industry or sector of the economy.
Price Level Real GDP ($Trillions) 0 AD 2 AS 1 Effect of an increase in petroleum prices AD E S 100 AS 2 130
Price of One Barrel of 34 0 crude oil Source: The Petroleum Economist I’d call that a shock, wouldn’t you? The story of Joseph (see Old Testament) suggests buffer stocks as the remedy for supply-shock inflation
Productivity ( ) means the average output of a worker per year, or alternatively: = GDP/N where N is total employment and Y is real GDP. depends on the efficiency with which labor is employed in the production of goods & services
Let denote average annual compensation of employees (including benefits). Thus unit labor cost (UCL) is defined as: ULC = / Notice that compensation can rise with no effect on ULC, so long as productivity keeps pace
Source: % change, annual rate