1. LRAS
SRAS1
Price Level
SRAS
AD1 AD Yf
GDP, Income, Employment
Not to scare you…..but……
Aggregate Demand and Aggregate Supply Model (AD/AS)

2. Ch. 31: Aggregate Demand and Aggregate Supply
What causes short run fluctuations?
Can public policy prevent falling income and rising unemployment?
Can public policy reduce severity of recessions or depressions?
Key is to focus on short run fluctuations around the long run trends.

3. LRAS
SRAS1
Price Level
SRAS
AD1 AD Yf
GDP, Income, Employment

4. Understanding Short Run Fluctuations
1. Business Cycle – NOT regular or predictable

5. 2. Macroeconomic Quantities Fluctuate Together RGDP = most commonly used to monitor short run changes….. …..but RGDP tends to move with Income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales……….. ……..so, there is a lot more than RGDP to look at in the short run….

6. 3. As output falls, unemployment rises

7. Explaining Short Run Economic Fluctuations
“Classical Dichotomy”, “Monetary Neutrality” p. 705 – skip for now
Short Run model focused on …
Economy’s output (RGDP)
Price Level (CPI or GDP Deflator)

8. Price Level
SRAS AD Yf
GDP, Income, Employment
The good news………acts much the same as Supply and Demand from Micro
The bad news……this is Macro……..much more to the curves than in Micro

9. Aggregate Demand
shows VARIOUS amounts of goods and services that the entire economy desires to purchase
different from Micro D curve (individual choices for one good) ;
will NOT be able to apply income (normal/inferior) or substitution (substitute/compliment)effects****
c. Similar to law of Demand …..
Inverse relationship :
lower P level = larger real GDP
higher the P level = smaller real GDP

10. AD slopes downward: Wealth Effect
When prices go up = real wealth goes…..
down
When prices go down = real wealth goes…. Up
As PL decreases, consumers feel …..
“wealthier” and increase quantity of …..
goods and services demanded

11. AD slopes downward: Interest Rate Effect
As PL goes down = money demanded goes…
down
People will usually lend more (in form of …..
savings accts, bonds, etc.) = increase in the Supply of Loanable Funds
= interest rates go……
As interest rates go down = firms will …….
borrow more to invest (consumers in new housing)
So…..Interest rates down = Investment up = increase ….
quantity of goods and services demanded

12. AD slopes downward: Exchange Rate Effect
As PL goes down, interest rates go down
US investors seek higher returns elsehwere ..meaning? …
Want to invest where interest rates are higher to get better returns on bonds
As more US dollars leave, the Supply of US dollars in “Foreign Exchange Market” increases and in turn “DEPRECIATES” the dollar relative to value of other currencies *Important – DO NOT think about inflation in this context of “appreciation” or “depreciation”

13. Each dollar now buys fewer units of foreign currency = foreign goods become……
More expensive …..so the US Imports will ……
Decrease….and US Exports will …….
Increase ……and overall US Nx will…….
Increase …..and increases the ……..
Quantity of goods and services demanded

14. Simplify:
As PL goes down, Interest Rates go down, dollar depreciates, Nx go up, Qd of goods and services go up

15. Why does AD Shift? Very similar to D shifting in micro
Remember AD = C+I+G+Nx
So if any component of AD increases or decreases independently of PL, then AD shifts
C : want to save more or less, stock market boom increases wealth, increase or decrease in taxes paid
I : invest in new technology, optimism or pessimism about future, increase or decrease in business taxes or tax credits

16. AD shifting ..cont.. G : any increase or decrease in G spending
Nx : foreign nations experience a economic growth or recession…affect on AD?.....
any outside force which makes the US dollar “appreciate or depreciate” ….affect on AD? ….
Remember: “At any given price level, there is now more Aggregate Demand”

17. Aggregate Supply
How do we know that aggregate supply is upward sloping in the short run and vertical in the long run?
B. First, recall from microeconomics that output is a function of the inputs to production
i. Supplies of labor, capital, natural resources, and available technology –(these are not affected by the price level)
ii. The only way to increase output in the long run is to increase the levels of capital and labor.
iii. This is called increasing the capital stock--the result of investment--and increasing the labor force--the result of more people working

18. ***see example on bottom of pg. 712 to 713
iv. Therefore, in the long run, the aggregate supply curve is affected only by the levels of capital and labor and not by the price level. Thus, the long run aggregate supply is vertical with respect to the price level.
***see example on bottom of pg. 712 to 713

19. Why LRAS will Shift Think of what would shift PPF out pg. 713-714
LABOR
CAPITAL
NATURAL RESOURCES
TECHNOLOGICAL KNOWLEDGE

20. A New Way to Depict Long-Run Growth and InflationPL
1. There are many forces that govern the economy in the long run…but most imprt. are technology and monetary policy
PL2
PL1
2. Tech progress increases production of goods/services ; shifting LRAS right
Yf Yf2
3. Fed increases money supply over time = increase spending and shifting AD right
4. Shows the Long Run trends in growth and inflation

21. PL
PL2
PL1
The purpose of AD/AS model is to provide a framework for short run analysis.
As we develop short run analysis, we will not necessarily show the continuing growth of GDP.
Yf Yf2

22. PL
The Short Run fluctuations in output and the price level should be viewed as deviations from the continuing long run trends
PL2
PL1
Yf1

23. Stated another way……
1. LRAS is vertical and represents full employment and full output (natural rate of unemployment) Real GDP is maximized.
2. Any changes in AD will affect only the price level.
3. In the long run, prices and wages are flexible.
4. This means that if products don’t sell and employees become unemployed, the market will self correct
We will look at HOW the economy will self correct later…but first lets analyze the SRAS

24. Why AS slopes upward in short run
As PL rises, Q of goods and services supplied rises (similar to Law of Supply in Micro)
Three theories help explain why AS is upward sloping in short run
3 theories but 1 common theme: Q of output supplied deviates from its long run or natural level when the PL deviates from the PL that people expected.
When PL is higher than expected, Output rises above its natural rate
When PL is lower than expected, Output falls below its natural rate.

25. Misperceptions Theory
Example
PL falls below expectations
Firms may feel the reward for production has been lowered and reduce output
“Lower than expected PL causes misperceptions about relative prices and these misperceptions induce suppliers to respond by decreasing Q of goods and services supplied”
If PL rises above expectations……

26. Sticky-Wage Theory Nominal wages are sticky in the short run
Think long term contract at given wage
As PL falls below expectations, nominal wages are fixed, but real wages rise.
Because real wages are major input cost, firms real costs rise and begin to hire less and produce less
“As PL falls below expectations, nominal wages are sticky, makes real wages and costs rise, production is less profitable and firms decrease quantity of goods and services supplied”
If PL rises above expectations……

27. Sticky Price Theory
As PL falls below expectations, not all firms will react immediately and so some Prices are sticky
The firms that do not lower Prices right away will have relatively higher prices which will reduce sales ……
This induces firms to reduce production and employment
As PL falls unexpectedly, some firms leave prices higher than desired which results in lower sales. Firms begin to decrease the quantity of goods and services supplied.
If PL rises above expectations……

28. Shifting SRAS If it shifted LRAS, then it must also shift SRAS
Labor, Capital, Natural Resources, Technology
One new variable…..
Expected Price Level
If the Expected Price Level falls….(notice difference from the three theories) ….
Firms expect wages and all input costs to fall and begin to increase the Quantity of goods and services supplied
If the Expected Price Level rises……

29. AD/AS: Self Correcting in the Long Run
The Effects of a Shift in AD
The economy self corrects; P and W change but it is nominal (not real) and these changes offset eachother and purchasing power remains the same.
= Classical view

30. …but how long do we wait for self correcting?
This was the question being asked during the Great Depression and one in which the Bush and Obama administrations definitively answered. …….discuss
Lets look at how this model self corrects when AD increases

31. Event increases (C, I, G, or Xn) = shift AD right
Evaluate = P and GDP (output is beyond full employment levels)…..how do we know this is short run ? ….
Long run RGDP growth is only possible when LRAS shifts right
The current condition = Inflationary Gap ……why?
Nominal Wages don’t respond in short run = so Real Wages ….
decrease …explain? Yf

32. As “Long Run” nears and PL remain high, Nominal Wages begin to respond and increase….Explain?
All input P have increased and now W increase = Shift Short Run AS left
Result= higher P but back at Yf and increase in Nominal W are offset by increase in P level Yf

33. Now lets see how it self corrects when AD decreases

34. Yf Event decreases (C, I, G, or Xn) = shift AD left
Evaluate= P decrease, GDP decrease (below full employment levels)
= Recessionary Gap ….why?
As GDP and PL fall , Nominal Wages don’t respond in short run, so = Real Wages…..
increase
With lower Prices and output and Nominal wages “stuck” higher = decrease profits for firms
As the Long Run nears, Nominal W begin to decrease
All input P have decreased and now W decrease = shift Short Run AS right
Result = lower P level but back at Yf, and decrease in Nominal W are offset by lower P levels Yf