AD/AS and the SUPPLY AND DEMAND MODEL

Our purpose is to illustrate how the supply and demand model can describe the macro product market. One of the impressive things about the supply and demand model is how many different kinds of situations it can describe. It has many uses.

1. x increases => p and q both increase We can start with the following observations: An increase of desired spending causes inflation and real growth to rise. 2. x decreases => p and q both decrease These are both examples of a “Change in Demand” We can say, “ A change of demand causes inflation and real growth to move in the same direction.”

xpq We want to draw a picture of this numerical example. The example asserts that if spending (aka Aggregate Demand, aka nominal GDP) is growing at 6%, we will have inflation (p) of 3% and real growth (q) of 3%. Recall that x = p + q We will often use these values as a starting point. The numbers are close to the averages for the US (The actual numbers are a bit less than this.) We furthermore want our example to assert that if x increases to 9%, we get p = 4 and q = 5.

We will now summarize these observations on the form of a supply and demand graph: Draw and label the axes. p q Real growth (q) is always on the horizontal (x-axis) Inflation (p) is always on the vertical (y-axis)

Draw a downward sloping 45° line; label it AD p q Draw a upward sloping line; label it AS AD AS Mark the point of intersection. This will be the market’s “equilibrium.” q0 p0

p q AD AS 3 3 xpq 633 We would expect both p and q to rise. Let’s say they rise to q = 5% and p = 4% 94 Suppose x (aggregate spending) now begins to rise at a rate of 9% 5 We can start with our example of x = 6%, with p and q both equal to 3%

p q AD 0 AS 3 3 Here’s how the graph illustrates this. xpq Move the AD curve up and to the right to illustrate an “increase of demand.” AD 1 Look at the point of intersection. It has moved to the right (q has risen) and up (p has risen). This is what we were trying to picture. When x (Spending/Aggregate Demand) rose, both inflation and real growth increased. 5 4

Using no numbers we can make the general statement: When AD rises, inflation and real growth both rise p q AD 0 AS q0q0 p0p0 AD 1 q1q1 p1p1 We can say and graph the opposite result When AD falls, inflation and real growth both fall. p q AD 1 AS q1q1 p1p1 AD 0 q0q0 p0p0

1. An increase of the cost of production – with no change of spending -- will cause inflation to rise and real growth to fall Let us now graph another set of observations: 2. A decrease of the cost of production – with no change of spending -- will cause inflation to fall and real growth to rise. More generally, a change of supply causes inflation and real growth to move in opposite directions.

As numerical examples we can use the following: An increase of Aggregate Supply caused by: xpq a decreased price of a FOP, or 2. an increased quantity of a FOP 3. an increased quality of a FOP xpq An decrease of Aggregate Supply caused by: 1. an increased price of a FOP, or 2. a decreased quantity of a FOP 3. a decreased quality of a FOP

To illustrate an increase of Aggregate Supply: shift the AS curve to the right p q AD AS 0 q0q0 p0p0 q1q1 p1p1 AS 1 p q AD AS 1 q1q1 p1p1 q0q0 p0p0 AS 0 To illustrate a decrease of Aggregate Supply shift the AS curve to the left These look backwards to a lot of people!!

AS => p ,q  AS => p ,q  AD => p ,q  AD => p ,q  LEARN THESE FOUR LAWS AND THE GRAPHS THAT GO WITH EACH OF THEM