1. THE AGGREGATE DEMAND/ AGGREGATE SUPPLY MODEL
Chapter 25
THE AGGREGATE DEMAND/ AGGREGATE SUPPLY MODEL

2. Today’s lecture will:
Discuss the historical development of modern macroeconomics.
Explain the shape of the aggregate demand curve and what factors shift the curve.
Explain the shape of the short-run aggregate supply curve and what factors shift the curve.

3. Today’s lecture will:
Explain the shape of the long-run aggregate supply curve.
Show the effects of shifts of the aggregate demand and aggregate supply curves on price level and output in both short run and long run.
Discuss the limitations of the macro policy model.

4. The U.S. Great Depression
A deep recession that began in 1929 and lasted for 10 years
Output fell by 30%
Unemployment rose to 25%
Led to emphasis on the the short-run and the demand side of the economy and the development of modern macroeconomic theory

5. Classical Economics Earlier economists who focused on long-run issues
Markets were self-regulating through the “invisible hand”
The economy would always return to its potential output and target employment in the long run
Blamed the Depression on labor unions and government policies that prevented prices from falling
Advocated a laissez-faire economic policy

6. Keynesian Economics
First outlined in 1936 by John Maynard Keynes in The General Theory of Employment, Interest, and Money
Problems of the Depression required a short-run, rather than long-run, focus.
Adjustments to equilibrium for a single market (micro) and the aggregate economy (macro) are different.

7. Keynesian Economics Equilibrium income fluctuates Paradox of thrift
Short-run equilibrium income may differ from long-run potential income.
Paradox of thrift
In the long run, saving leads to investment and growth.
In the short run, saving may lead to a decrease in spending, output, and employment.
Government aggregate demand management may be necessary.

8. Micro Supply/Demand Model
AS/AD Model
Macro AS/AD Model
Micro Supply/Demand Model
What’s on the axes?
Price level and total output for the economy
Price and output of one good
What gives the curves their shape?
No substitution possible
Substitution and opportunity cost

9. Components of the AS/AD Model
Aggregate Demand Curve (AD)
Relates changes in the price level with changes in aggregate expenditures, which are consumption, investment, government spending, and net exports.
Short-Run Aggregate Supply Curve (SAS)
Shows how a shift in AD affects the price level and real output in the short-run.
Long-Run Aggregate Supply Curve (LAS)
Shows the output that an economy can produce at full employment of labor and capital.

10. Slope of the AD Curve Price level
Wealth, interest rate, and international effects P0
Multiplier effect P1 AD Y0 Y1 Ye
Real output

11. Shifts in the AD Curve Foreign Income Exchange Rates Expectations
Distribution of Income
Government AD Management Policies
Fiscal policy
Monetary policy

12. Shifts in the AD Curve AD1 Price level P0 AD0 Real output
Initial effect = 100 increase in exports
AD1
Price level
Multiplier
effect = 200
200
100
Change in total expenditures = 300 P0
AD0
Real output

13. The Slope of the SAS Curve
Auction markets
Prices are determined by demand and supply
 prices   profits   quantity supplied
Posted-price markets
Prices are set by producers and don’t often change
Firms respond to changes in demand by adjusting output instead of prices

14. The Shifts in the SAS Curve
1. Input prices
SAS1
2. Expectations
3. Sales and excise taxes
4. Productivity
Price level
5. Import prices
SAS0
% change in prices =
% change in wages –
% change in productivity
Real output

15. LAS Curve The LAS curve shows the long-
run relationship between output
and the price level.
LAS
LAS1
The position of the LAS curve
depends on potential output –
the amount of goods and
services an economy can
produce when both capital and
labor are fully employed.
Price Level
The LAS is vertical because
potential output is unaffected
by the price level.
Increases in capital, resources,
growth-compatible institutions,
technology, and entrepreneur-
ship increase potential output
and shift LAS to the right.
Potential
output
Real
output

16. Low-level potential output High-level potential output
LAS Curve
LAS
Potential output is assumed to be the
middle of a range bounded by high
and low levels of potential output.
When resources are over-utilized
(point C), factor prices may be bid
up and the SAS shifts up.
The relationship between potential
and actual output determines shifts
in SAS. C B A
SAS
Price Level
When resources are under-utilized
(point A), factor prices may decrease
and SAS shifts down.
Underutilized
resources
Overutilized
resources
Real
output
Low-level potential output
High-level potential output
When LAS = SAS (point B), there is
no pressure for prices to rise or fall.

17. Short-Run Equilibrium
Short-run equilibrium is
where SAS = AD0 (point
E).
AD1 Y0 E P0
AD0
Price level Y1 P1 F
If AD increases to AD1,
equilibrium output
increases to Y1 and the
price level increases to P1.
SAS P0 E
AD0 Y0
Real output

18. Short-Run Equilibrium
Short-run equilibrium is
where SAS0 = AD (point
E). Equilibrium output is
Y0 and the price level is
P0.
Price level G
SAS1 Y1 P1 Y0 P0
SAS0 E
SAS0
If SAS increases to SAS1,
equilibrium output
decreases to Y1 and the
price level increases to P1
(point G). E P0 AD Y0
Real output

19. Long-Run Equilibrium AD1 LAS Price level Long-run equilibrium is
point E where AD0 = LAS.
Equilibrium output is at
potential output YP and
the price level is Po. H P1 E P0
An increase in AD to AD1
increases the price level
to P1 but output is un-
changed at YP.
AD0 YP
Real output

20. Integrating Short-Run and Long-Run Frameworks
The economy is in long-run and short-run equilibrium at point E where AD=SAS=LAS and output is YP and the price level is P0.
LAS
SAS E
Price level
AD grows at the same rate as potential output, so that unemployment and inflation are very low. P0 AD YP
Real output

21. Recessionary Gap
A recessionary gap is the amount by which equilibrium output is below potential output.
LAS
If the economy is at point A, some resources are unemployed and the recessionary gap is YP – Y1. Y1 P0 A
SAS0
SAS0 A P1 B P0
Price level
If resources are unemployed for a long time, eventually wages and prices decrease. SAS shifts down to SAS1 and the economy is in long-run and short-run equilibrium at B.
SAS1 AD
Recessionary
gap Y1 YP
Real output

22. Inflationary Gap
LAS
An inflationary gap is the amount by which equilibrium output is above potential output.
Price level
If the economy is at point C, resources are being used beyond their potential and the inflationary gap is Y2 – YP.
SAS2 D P2 Y2
SAS0 P0 C C
SAS0 P0 AD
If resources are used beyond their potential, eventually wages and prices increase. SAS shifts up to SAS2 and the economy is in long-run and short-run equilibrium at D at a higher price level, P2.
Inflationary
gap YP Y2
Real
output

23. Expansionary Fiscal Policy
Price level
If the economy is at equilibrium at point A, there is a recessionary gap Y0 – YP.
LAS
AD1 B
The appropriate fiscal policy is to increase government spending and/or decrease taxes. P1 YP
SAS P0 A A
AD increases to AD1 and output returns to potential output YP and prices increase slightly to P1.
AD0 Y0
Real output

24. Contractionary Fiscal Policy
LAS
If the economy is at equilibrium at point B, there is an inflationary gap Y2 – YP.
AD2
The appropriate fiscal policy is to decrease government spending and/or increase taxes. B AS P2
Price level
AD0
AD decreases to AD2 and output returns to potential output YP and inflation is prevented. YP Y2
Real output

25. Macro Policy Problems
Implementing fiscal policy – changing taxes and government spending - is a slow legislative process
Potential output – the level of output that the economy is capable of producing without generating inflation – is difficult to estimate.

26. AS/AD Summary
The Classical economists’ long-run focus and laissez-faire approach was incapable of solving the problems of the Great Depression in the 1930s.
Keynesian economic theory, which emphasizes short-run fluctuations and advocates an activist government policy, developed solutions to the Depression.
The Keynesian AD/AS model is composed of the AD, SAS, and the LAS curves.

27. AS/AD Summary The AD curve has a negative slope because of
the wealth effect
the interest rate effect
the international effect
the multiplier effects
The AD curve shifts when there are changes in
foreign income
exchange rates
expectations
distribution of income
monetary and fiscal policy

28. AS/AD Summary
The SAS curve has a positive slope because some firms adjust quantity and some adjust price when AD changes.
The LAS curve is vertical at potential output.
The LAS curve shifts out if there is an increase in
available resources
capital
labor
technology
growth compatible institutions

29. AS/AD Summary Short-run equilibrium is where AD = SAS.
Long-run equilibrium is at potential output (YP) where AD = LAS.
The economy may be at short-run equilibrium, but not long-run equilibrium.
If short-run equilibrium is above YP, there is an inflationary gap and SAS eventually shifts up to return the economy to YP at a higher price level.
If short-run equilibrium is below YP, there is a recessionary gap and SAS eventually shifts down to return the economy to YP at a lower price level.

30. AS/AD Summary
Aggregate demand management policy is the government’s use of economic policy to control the level of aggregate spending.
Fiscal policy involves changing government spending and/or taxes to change aggregate demand.
To eliminate a recessionary gap, fiscal policy should increase government spending and/or decrease taxes.
To eliminate an inflationary gap, fiscal policy should decrease government spending and/or increase taxes.

31. Review Exercise 25-1
Suppose that the economy is in short-run equilibrium below potential output. Show and explain the appropriate fiscal policy.
Short-run equilibrium
below potential output
at A.
Price level
Real output
LAS YP
The appropriate fiscal policy is to increase government spending and/or decrease taxes.
AD1 B P1
SAS Y0 A P0
AD0
AD increases to AD1 and output returns to potential output YP and prices increase slightly to P1.

32. Review Exercise 25-2
Suppose that the economy is in short-run equilibrium below potential output. Show and explain the adjustment to long-run equilibrium if there is no fiscal policy.
If the economy is at point A, some resources are unemployed and the recessionary gap is YP – Y1.
Real output
Price level YP
LAS AD Y1
SAS0 P0 A
If resources are unemployed for a long time, eventually wages and prices decrease. SAS shifts down to SAS1 and the economy is in long-run and short-run equilibrium at B. P1 B
SAS1