1. Macro Theory: Dr. D. Foster – ECO 285 – Macroeconomics The AS/AD Model Part 1 – The Basics Part 1 – The Basics Part 2 – The Keynesian View Part 2 – The Keynesian View

2. Warning.. Warning.. Warning Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! The “static” analysis only hints at dynamic interpretation.The “static” analysis only hints at dynamic interpretation. Ceteris Paribus assumption problematic to the point of being wholly inappropriate.Ceteris Paribus assumption problematic to the point of being wholly inappropriate. Keynesian model notes: Descriptive analysis. Descriptive analysis. No numerical interpretation. No numerical interpretation. Only AS/AD graphical representation. Only AS/AD graphical representation. Part 1 – The Basics Part 1 – The Basics

3. The Aggregate Demand Schedule AD 1 P Q or R-GDP B P1P1 Q2Q2 A P2P2 Q1Q1 P = Price Level; CPI or GDP deflator Q = real output; Real GDP AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign

4. Aggregate Demand The price level and real output demanded are inversely related.The price level and real output demanded are inversely related. A fall in the price level will increase quantity demanded.A fall in the price level will increase quantity demanded. Why? -- the Wealth EffectWhy? -- the Wealth Effect All prices and wages change.All prices and wages change. But, the fixed wealth is … well, still fixed!But, the fixed wealth is … well, still fixed! So, with lower prices we feel wealthier. Woo Hoo!So, with lower prices we feel wealthier. Woo Hoo! And, so we want to buy more stuff.And, so we want to buy more stuff.

5. Aggregate Demand What about:What about:  Interest effect  Foreign trade effect  Exchange rate effect AD can shift to the left or right.AD can shift to the left or right.  Increase AD – shift to the right.  Decrease AD – shift to the left.  Whenever C, I, G, net X increase/decrease.  Why? Due to changes in optimism & pessimism, and due to fiscal & monetary policies. Can’t do “all else equal.” e.g. Lower prices:  Consumption, but one price is wages!!! If they fall, then we’d see a  Consumption!!!

6. The Aggregate Demand Schedule AD 2 AD 1 P Q or R-GDP AD 3 Increases in C, I, G, net X Decreases in C, I, G, net X

7. Long Run Equilibrium between Aggregate Demand and Aggregate Supply There is an Aggregate Supply that reflects fully employed resource use. Output level: Q* or RGDP* or potential RGDP AD 1 P Q or R-GDP AS 1 P1P1 Shifts in AD can only change the price level and not real output (nor employment). Classical Model of the Economy

8. What affects the Aggregate Supply? Labor force participation. Labor productivity. Marginal tax rates on wages. Provision of government benefits that affect household incentives w.r.t. supply labor. State of technology. Capital stock. A change in these factors can  AS (shift right) or  AS (shift left)

9. Short Run Aggregate Supply – Wage Inflexibility sluggishNominal wages are sluggish upwards:  A rise in prices has delayed effect on wages. inflexibleNominal wages are inflexible downwards:  A fall in prices will result in  employment and  y. money illusionWorkers have money illusion:  Higher nominal wages are viewed as  real wage.  So, more workers available even though real wage has not risen.  e.g. if prices rise 5% and wages rise 3%…

10. Short Run Aggregate Supply The Short Run will adjust to the Long RunThe Short Run will adjust to the Long Run:  An  AD will  P and  Q, but only in the SR.  Prices rise but wages lag. Firms  employment and  output.  Eventually, workers realize their real wages (W/P) are falling, get comparable wage,  AS.  The temporary profit motive has been eliminated. What about:What about:  Sticky prices  Misperception  Intertemporal substitution Unnecessary complications to explain the SR AS. Inflexible wages is all we need. What happens if there is a  AD?

11. From SR to LR Aggregate Supply An increase in AD triggers events. Prices rise, wages lag, output rises. Eventually, wages catch up and AS declines. In LR, only prices rise. AD 1 P Q or R-GDP AS LR P1P1 AS 1 AD 2 P2P2 Q2Q2 Q* P3P3 AS 2 AS 3

12. AS/AD Model – Hints at 4 types of changes Inflation with growth due to rising AD.Inflation with growth due to rising AD. Depression with deflation due to falling AD.Depression with deflation due to falling AD. Growth with deflation due to rising AS.Growth with deflation due to rising AS. Depression with inflation due to falling AS. (stagflation)Depression with inflation due to falling AS. (stagflation) AD 1 P Q or R-GDP AS LR P1P1 AS 1 Q*

13. Macro Theory: Dr. D. Foster – ECO 285 – Macroeconomics The AS/AD Model Part 1 – The Basics Part 1 – The Basics Part 2 – The Keynesian View Part 2 – The Keynesian View