MACRO E conomics Unit 7: The Real Sector: ADAS & Classical Theory Economist: Someone who sees something in practice and wonders if it would work in theory. -- Senator Ernest “Fritz” Hollings Created: by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License

MACRO E conomics Slide 2 Why Theory Matters “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.” -- John Maynard Keynes

MACRO E conomics AD-AS Model illustrates & analyzes theory using shifts in 3 curves:  AD – Aggregate Demand  SRAS –Short-Run Aggregate Supply  LRAS – Long Run Aggregate Supply

MACRO E conomics AD-AS Model is NOT same as micro supply-and-demand. Aggregates behave differently. Remember the fallacy of composition?

MACRO E conomics Use AD-AS Model to show: Level & changes in: real output (real GDP) price index How people respond to price level changes Capacity of the economy (PPF) Economic Conditions  Inflation  Recession & Unemployment  Stagflation  Deflation and depression

MACRO E conomics Understanding the AD-AS Model: Aggregate Demand-Aggregate Supply (actually it’s AD-SRAS-LRAS)

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Graphic Space is Real Output vs. Price Level

MACRO E conomics P Price Level (price index) Q Real Output (amount of real goods & services produced) Start Real Price Economy at some starting point.

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) start (now) Real Price after after real growth in GDP, but no inflation or deflation Real GDP aft er Economy Grows  shifts right

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price after decline in real GDP unemployment has increased because fewer resources are employed after Real GDP after Economy shrinks  moves left (recession)

MACRO E conomics Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price after Price Index after inflation Inflation Inflation  shift upward

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price after Price Index after deflation deflation Deflation  shift downward

MACRO E conomics Real Life: both prices & real GDP change “Stagflation”  shift up & left Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price after Price Index after inflation Inflation Real GDP after “stagflation”

MACRO E conomics Price Index after inflation Inflationary Growth  up & right Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price after Inflation Real GDP after

MACRO E conomics 2 Other Possibilities Prices decline & real GDP increase  down and to the right Prices decline & real GDP decrease  down and to left

MACRO E conomics Reactions to Changes in Prices Two relationships (curves) show how people react to inflation/deflation:  Aggregate Demand (AD)  Willingness to spend.  Short-Run Aggregate Supply (SRAS).  Willingness to sell.

MACRO E conomics AD is downward sloping because of 3 effects: Wealth & Fixed Incomes Interest Rate & Debt Payments International Trade

MACRO E conomics Q (or Y) Real Output (amount of real goods & services produced) P Price Level (price index) Real Price AD curve shows changes in willingness to buy real Q in response to changes in price level. AD Start

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price AD: Inflation reduces ability to buy

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price Deflation increases ability to buy.

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price AD: buyer reactions to inflation / deflation

MACRO E conomics Now: producers & sellers Inflation: all prices increase But, inflation is not highly visible. Single-product price changes are. Producers/sellers see price change of their product. perceive a real price increase when it is really inflation willing to produce & sell more goods Temporary reaction SRAS, or Short-Run Aggregate Supply. Eventually costs increase & qty returns to original

MACRO E conomics Q (or Y) Real Output (amount of real goods & services produced) P Price Level (price index) Real Price SRAS curve shows changes in desire to sell real Q in response to changes in price level. Start

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price SRAS: Price change “fools” producer

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price Deflation “fools” into reduced output.

MACRO E conomics Q (or Y) Real Output (amount of real goods & services produced) P Price Level (price index) Real Price SRAS curve Start

MACRO E conomics In a short-run equilibrium, the economy is always where SRAS=AD because the quantity of Real GDP we buy must equal the amount we sell. P Price Level (price index) Real Price start SR-AS AD Short-Run Equilibrium: Purchases = Sales  where AD intersects SRAS. Q (or Y) Real Output

MACRO E conomics AD and SRAS curves only show Real GDP vs Price Level changes. Other changes shift the curves.

MACRO E conomics AD curves shift (move) when changes such as…  Expectations about future  More optimism shifts AD right  More pessimism shifts AD left.  Growth in other countries boosts exports.  Government decisions change T or G

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) Start Real Price AD shift: more optimism or more G or lower T or more X AD before AD after

MACRO E conomics Next: Shifts in SRAS curve Factors that shift SRAS:  Changes in expectations about future economic conditions.  Technology improves.  Cost increases: Firms realize that resource prices have risen but they cannot pass the increase on to customers.

MACRO E conomics Input cost increases shift SRAS left/up – but there is a lag. SRAS: short-run reaction only  “fooled” by price change Once inflation is perceived, then SRAS curve shifts upward/left.

MACRO E conomics P Price Level (price index) Real Price start SR-AS start Sellers react to inflation Initial reaction Price Index after inflation Final reaction SR-AS after

MACRO E conomics P Price Level (price index) Real Price SR-AS start Improved technology can shift SRAS also. SR-AS after start

MACRO E conomics P Price Level (price index) Real Price start SR-AS start External input cost increases also shift SRAS - example: oil. SR-AS after

MACRO E conomics Both AD & SRAS are short-run reactions to price changes – ignoring physical capacity.

MACRO E conomics LRAS is missing piece representing capacity and resources.

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) LRAS: long-run aggregate supply (“capacity of economy” or “sustainable production rate” when all resources are employed) Production Possibilities determined by available resources / technology, not prices

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) LRAS: long-run aggregate supply any point in this region indicates the economy is not using all resources --- unemployment exists Economy left of LRAS  unemployment exists

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) LRAS: long-run aggregate supply Amount of unemployment Unemployment.

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) LRAS: long-run aggregate supply attempting to produce more than capacity, only possible for short run, actually draws down inventory What if we sell more than we can produce (SRAS > LRAS)?  reduce inventories

MACRO E conomics Q Real Output (amount of real goods & services produced) P Price Level (price index) LRAS 1 Long run growth is a shift in LRAS. LRAS 2

MACRO E conomics Putting them altogether. We’re now ready to put all three curves together. Short-run equilibrium is where SRAS = AD, but… Where is that relative to LRAS? Three possibilities…….

MACRO E conomics P Price Level (price index) Real Price start LRAS SR-AS AD Long-Run Full-Employment Equilibrium -- the goal

MACRO E conomics Recessionary Gap (also known as “contractionary gap”) P Price Level (price index) Real Price start LRAS SR-AS AD Real GDP if we had full employment Gap represents amount of unemployment

MACRO E conomics P Price Level (price index) Real Price start LRAS SR-AS AD Inflationary Gap (also known as Expansionary Gap)

MACRO E conomics LRAS: Beneficial Supply Shocks  Abundant harvests  Discovery of natural resources  Technology breakthroughs  Population growth & immigration

MACRO E conomics Shocks cause a gaps. “Supply shocks”  New technology  More people/resources  Destruction of people/resources  War  Natural Disaster

MACRO E conomics LRAS: Adverse Supply Shocks Examples  Drought  Natural Disasters  Suddenly reduced supply of any critical resource  Government instability  Terrorist attacks  War  Any permanent reduction of economy’s ability to produce real goods and services

MACRO E conomics Aggregate Demand Shocks Changes in:  confidence/optimism  perceived wealth  foreign economic events  fiscal policy (G or T)  monetary policy (interest rates)

MACRO E conomics Short-Run Aggregate Supply Shocks Changes in:  external input cost  short-run supply restrictions  uncertainty re: profits?

MACRO E conomics That’s it. Our AD-AS model is now complete.