1. Chapter 10 AGGREGATE SUPPLY AND AGGREGATE DEMAND Part 2
Notes and teaching tips: 5, 9, 18, 30, 33, 37, 41, 44, and 48.
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Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Economics in the News features in your textbook as models.

2. The Multiplier and the Price Level in the Short-Run (From Chapter 11)
In Chapter 11 we derived the multiplier assuming P is fixed. Now we allow P to vary in the short-run. This reduces the size of the multiplier. The increase in investment shifts the AE curve upward and shifts the AD curve rightward. With no change in the price level, real GDP would increase to $18 trillion at point B.

3. The Multiplier and the Price Level in the Short-Run (From Chapter 11, Figure 11.10)
But the price level rises. The AE curve shifts downward…. Equilibrium expenditure decreases to $17.3 trillion… As the price level rises, real GDP increases along the SAS curve to $17.3 trillion. The multiplier in the short- run is smaller than when the price level is fixed.
The multiplier in the short run. By doing a careful job in explaining the effects of a change in autonomous expenditure on the AE curve, equilibrium expenditure, and the AD curve, you’ve laid the ground for your students to see how the multiplier is modified by a change in the price level in the adjustment to a new short-run equilibrium. Using Figure as the illustration, tell the story like this:
1. The initial equilibrium is at point A on AE0 and AD0.
2. An increase in autonomous expenditure shifts the AE curve to AE1 and shifts the AD curve to AD1.
3. At the initial equilibrium price level, equilibrium expenditure and real GDP are at point B.
4. The economy is still at point A, but the new expenditure equilibrium is at point B.
5. Because firms are producing at point A but planned expenditure has increased, an unplanned decrease in inventories occurs.
6. With lower than planned inventories, firms increase production and raise prices. The economy moves along the SAS curve as real GDP increases and the price level rises.
7. The rising price level lowers aggregate planned expenditure and the AE curve shifts downward from AE1 toward AE2.
8. So long as real GDP is to the left of the AD curve, aggregate planned expenditure exceeds actual expenditure, there is an unplanned decrease in inventories, and real GDP rises.
9. Eventually, real GDP increases and the price level rises to point C, where there is a new short-run equilibrium.

4. The Multiplier and the Price Level in the Long-Run (From Chapter 11, Figure 11.11)
Figure illustrates the long-run effects. At point C in part (b), there is an inflationary gap of $1.3 trillion. The economy is operating above full employment potential. The money wage rate starts to rise and the SAS curve starts to shift leftward.

6. The Multiplier and the Price Level in the Long-Run
The money wage rate will continue to rise and the SAS curve will continue to shift leftward, ... until real GDP equals potential GDP. In the long run, the multiplier is zero and the price level is much higher.
The multiplier in the long run. This analysis is a repeat of what you covered earlier in the AS-AD chapter and is reinforcement. The key point to emphasize is that there is no multiplier if we start at full employment.
The multiplier is not an empirically relevant concept until it is combined with information about the state of the economy relative to full employment.
Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Economics in the News feature in your textbook as a model.

7. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
Short-run equilibrium is at point C. If real GDP is below equilibrium GDP at point A, AD>AS => excess demand. Firms increase production and raise prices… If real GDP is above equilibrium GDP at point E, AS>AD, firms decrease production and lower prices.

9. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
These changes bring a movement along the SAS curve towards equilibrium. In short-run equilibrium, real GDP can be greater than or less than potential GDP. Potential GDP could be at 17 or 15.5

10. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
Long-Run Macroeconomic Equilibrium
Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP
-when the economy is on its LAS curve.
Intersection of the AD, SAS and LAS curves.
Over time, the economy tends to adjust to the long-run equilibrium, i.e., the economy “self- corrects”. How long does it take??
Long-run macroeconomic equilibrium. You can use the idea that there is only one LAS curve-but many SAS curves to explain long-run equilibrium. In long-run equilibrium, real GDP equals potential GDP on the one LAS curve. The money wage rate is at the level that makes the SAS curve the one of the infinite number of possible SAS curves that passes through the intersection of AD and LAS curves.
From the short run to the long run. Explain that market forces move the money wage rate to the long-run equilibrium level. At money wage rates below the long-run equilibrium level, there is a shortage of labor, so the money wage rate rises. At money wage rates above the long-run equilibrium level, there is a surplus of labor, so the money wage rate falls. At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labor and the money wage rate remains constant.
Shifting the SAS curve. Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult. But the notion that the SAS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of (output) prices, the SAS curve shifts leftward.
Avoid confusing students by using ‘up’ to correspond to a decrease in SAS. But do point out that that when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level. Most students find it easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve vertically upward.

11. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
Adjustment to long-run equilibrium. Initially, the economy is below-full employment equilibrium at point A and unemployment is high – a recessionary gap of $0.5 trillion. In the long run, the money wage falls, SAS shifts downward to the right until the SAS curve passes through the long-run equilibrium point at point B. A B
This adjustment is called the “self-correcting” or “self-regulating” mechanism.

13. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
Initially, the economy is at an above-full employment equilibrium at point C – inflationary gap 0f $0.5T.
In the long run, the money wage rate rises until the SAS curve passes through the long-run equilibrium point at point B.
The “self-correcting” or “self- regulating” mechanism. B C

14. Economic Growth and Inflation in the AS-AD Model
Because of labor force growth, capital growth, and technology advances, potential GDP increases. The LAS curve shifts rightward.
Classroom activity
Check out Economics in Action: U.S. Economic Growth and Inflation

16. Economic Growth and Inflation in the AS-AD Model
If AD increases by more than LAS, the AD curve shifts rightward faster than the rightward shift of the LAS curve. The price level increases. In the LR this occurs because of excessive growth in the money supply. B C A

17. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
The Business Cycle in the AS-AD Model
The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate,
- but the money wage does not change rapidly enough (price rigidity) to keep real GDP at potential GDP.
Equilibrium can occur
above full-employment equilibrium
at full-employment equilibrium
below full-employment equilibrium
Classroom activity
Check out Economics in Action: The U.S. Business Cycle

18. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
Figures (a) and (d) illustrate an above full- employment equilibrium. The amount by which real GDP exceeds potential GDP is called an inflationary gap. Figures (b) and (d) illustrate full-employment equilibrium.
(b)

20. Putting it Together - Explaining Macroeconomic Trends and Fluctuations
Figures (c) and (d) illustrate below full-employment equilibrium. The amount by which real GDP is less than potential GDP is called a recessionary gap. Finally, figure (d) shows how, as the economy moves from one type of short-run equilibrium to another, real GDP fluctuates around potential GDP in a business cycle.

21. Example: Effect of an Increase in Aggregate Demand
Starting from full employment at Point A: An increase in aggregate demand shifts the AD curve rightward. Firms increase production and the price level rises in the short run (Point B). B A
Putting the AS-AD model to work. Don’t neglect the predictions of the model. This is the payoff for the student. With this simple model, we can now say quite a lot about growth, inflation, and the cycle.
The price level doesn’t fall, and real GDP rarely falls. The AS-AD model predicts a fall in the price level when either aggregate demand decreases or aggregate supply increases. And the model predicts that real GDP decreases when either aggregate supply or aggregate demand decreases. Students are sometimes bothered by this apparent mismatch between the predictions of the model and the observed economy. The best way to handle this issue is to emphasize that in our actual economy, AS and AD almost always are increasing. When we use the model to simulate the effects of a decrease in either AS or AD, we’re studying what happens relative to the trends in real GDP and the price level. A fall in the price level in the model translates into a lower price level than would otherwise have occurred and a slowing of inflation. The story is similar for real GDP.
Classroom activity
Check out Economics in the News: Aggregate Supply and Aggregate Demand in Action

23. Effect of an Increase in Aggregate Demand
At the new short-run equilibrium (point B), there is an inflationary gap. In the long-run, the money wage rate begins to rise and the SAS curve starts to shift leftward. The price level continues to rise and real GDP continues to decrease until it equals potential GDP at Point C. C B A
AD0

25. Example: Negative Supply Shock
The effects of a rise in the price of oil - a “negative or adverse” supply shock The SAS curve shifts leftward. Real GDP decreases and the price level rises. The economy experiences stagflation – a recession with increasing prices. B A
- Is there a recessionary or
inflationary gap?
- What’s going to happen in the long-run?

27. Macroeconomic Schools of Thought
Macroeconomists can be divided into three broad schools of thought:
Classical
Keynesian
Monetarist

28. Macroeconomic Schools of Thought
The Classical View
A classical macroeconomist believes that the economy is self-regulating/self-correcting and always adjust on its own quickly to full employment.
The term “classical” derives from the name of the founding school of economics that includes Adam Smith, David Ricardo, and John Stuart Mill.
The new classical view is that business cycle fluctuations are the efficient responses of a well- functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change – supply oriented.

29. The Classical View
Aggregate Demand – Technological change is the most important source of fluctuations in AD and AS. A technological change that increases the productivity of capital, increases demand for plant and equipment. Aggregate Supply – Money wages are instantly and completely flexible. Technological change also shifts potential GDP and LAS. Policy – Taxes and regulation can stunt incentives and create inefficiency. Minimize the dis-incentive effects of taxes and regulation.

30. Macroeconomic Schools of Thought
The Keynesian View Keynesian macroeconomists believes the economy is likely to operate at less than full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required. The term “Keynesian” derives from the name of one of the twentieth century’s most famous economists, John Maynard Keynes. The new Keynesian view holds that not only is the money wage rate sticky but also are the prices of goods.

31. The Keynesian View
Aggregate Demand – Changes in AD drive economic fluctuations – demand oriented. Expectations are the main influence on AD. For example, pessimism about future profits causes a fall in I => AD falls and Y falls. Aggregate Supply – Money wages are very sticky downward. No self-correcting mechanism to close recessionary gap. Policy – Use fiscal and monetary policy to offset changes in AD.

32. Macroeconomic Schools of Thought
The Monetarist View A monetarist is a macroeconomist who believes that the economy is self-regulating and that it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady. The term “monetarist” was coined by Karl Brunner, to describe his own views and those of Milton Friedman. Think in terms of the Quantity Theory of Money. If Real GDP is growing at 3% per year money growth should be around 3% per year.

33. The Monetarist View Aggregate Demand – Aggregate Supply – Policy –
Quantity of money drives AD.
If Fed keeps grown in money supply steady, AD will be steady and fluctuations will be minimized. T
The economy will operate at full employment.
All recessions are the result of inappropriate monetary policy
Aggregate Supply –
Similar to Keynesians - money wages are very sticky downward. No self-correcting mechanism to close recessionary gap.
Policy –
Similar to classical view. Minimize tax and regulatory disincentives that can reduce potential GDP.
Steady growth in the money supply and no stabilization policy.