1. Macro Aggregate Supply Lecture 21
Dr. Jennifer P. Wissink
©2018 Jennifer P. Wissink, all rights reserved.
April 16, 2018 1

2. Recall: The Macro Aggregate Demand Curve - AD
The Aggregate Demand (AD) curve is a curve that shows the relationship between aggregate output/income (Y) and the price level (PL) when the money market and goods market are both in equilibrium.
The Aggregate Demand (AD) curve is negatively sloped.
To derive the Aggregate Demand Curve, we examine what happens to aggregate output/income (Y) when the price level (PL) changes, assuming no changes in government spending (G), net taxes (T), or the monetary policy variable (Ms).
And no changes in exports and imports, which we are ignoring for now anyway. 2

3. Shifts in Aggregate Demand via Monetary Policy
An increase in Ms at a given price level shifts the aggregate demand curve to the right.
A decrease in Ms at a given price level shifts the aggregate demand curve to the left. 3

4. Shifts in Aggregate Demand via Fiscal Policy
An increase in G or a decrease in net T at a given price level shifts the aggregate demand curve to the right.
A decrease in G or an increase in net T at a given price level shifts the aggregate demand curve to the left. 4

5. How an increase in the money supply shifts AD to the right.5

6. The Macro Aggregate Supply Curve
The Aggregate Supply (AS) Curve is a graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy (Y) and the overall price level (PL).
It’s a bit odd. Just go with it. 6

7. The Aggregate Supply Curve: Warning
The aggregate supply curve is not a market supply curve or the sum of all the individual supply curves in the economy like in microeconomics.
Instead…
It refers to all firms in all kinds of markets – even price-setting firms (which do not even have individual supply curves).
When we draw a firm’s supply curve, we assume that input prices are constant. In macroeconomics, an increase in the overall price level means that at least some input prices will be rising as well.
Rather than an aggregate supply curve, you might want to think of it as a “price/output response” curve — a curve that traces out the price and output decisions of all the markets and firms in the economy under a given set of circumstances. 7

8. Aggregate Supply in the Short Run: SR-AS
In the short run, the aggregate supply curve (the price/output response curve) has a positive slope.
At low levels of aggregate output, the curve is fairly flat.
Then there is an “intermediate” range.
As the economy approaches capacity, the curve becomes nearly vertical.
At capacity, the curve is vertical.

9. Shifts in MACRO SR-AS
A cost shock, or supply shock, is a change in the economic environment that shifts the SR-AS curve.
SR-AS0
SR-ASN
Good Shock Y PL
SR-AS0
SR-ASN
Bad Shock Y PL

10. Factors That Shift the SR-AS Curve
Bad weather, natural disasters, destruction from wars
Good weather
Public policy waste and inefficiency over-regulation
Public policy supply-side policies
tax cuts
deregulation
Stagnation capital deterioration
Economic growth more capital more labor techno change
Higher costs higher input prices higher wage rates
Lower costs lower input prices lower wage rates
BAD SHOCKS Shift SR-AS Left Decreases in Aggregate Supply
GOOD SHOCKS Shift SR-AS Right Increases in Aggregate Supply
Factors That Shift the SR-AS Curve

11. The Equilibrium Price Level
The equilibrium price level is the PL where AD = SR-AS.
PL0 and Y0 correspond to equilibrium in the goods market and the money market and a set of price/output decisions on the part of all the firms in the economy.

12. Complete Macro Equilibrium12

13. Significant Macro Debates On…
What does the SR-AS really look like? PL
Where does AD intersect SR-AS?
How quickly does SR-AS shift in response to a change in the economic situation? Y

14. i>clicker question
If you were POTUS and you wanted expansionary fiscal policy to work really well (i.e., have the greatest multiplier impact), where would you hope AD currently intersects SR-AS? A. In the horizontal part. B. In the intermediate part. C. In the vertical part. D. Doesn’t matter. PL
SR-AS Y

15. Monetary &/or Fiscal Policy When SR-AS is Rather Flat
Expansionary Policy
Monetary OR Fiscal
Suppose we are on the “flatter” part of SR-AS.
AD shifts out (to the right).
Policy works well when the economy is on the flatter portion of the SR-AS curve, causing little change in PL relative to the output increase.
Note: assuming no shift in SR-AS for now.

16. Monetary &/or Fiscal Policy When SR-AS is Rather Steep
Expansionary Policy
Monetary OR Fiscal
Suppose we start out on the “steeper” part of SR-AS.
AD shifts out.
When the economy is operating near capacity, an increase in AD will result in an increase in the price level, PL, with little increase in output.
Note: still assuming no shift in SR-AS.

17. SR-AS Shifts
If inflation were assumed to be fully anticipated, then wage rates and other input prices would be expected to increase at exactly the same rate as the overall price level in the economy.
That would imply that the SR-AS would shift as soon as the AD shifted and the PL changed.
That would imply that nothing real in the economy would actually change.
Not good news if you want to see discretionary policy work.
But many argue that this is simply not the observed case.
So... there must be a lag between changes in input prices and changes in output prices, otherwise the SR-AS (the SR price/output response) curve would be vertical.
So... we operate with the idea that enough input prices tend to lag behind changes in output prices to make it so we can talk about an upward sloping SR-AS.
So... now we need to introduce the (macro) long run aggregate supply curve (LR-AS).

18. AD, LR-AS and SR-AS Curves in a No-Inflation Equilibrium
Recall: We assume that some/enough input costs lag behind price level changes in the short run, resulting in an upward sloping SR-AS curve.
In the long run, costs and the price level move in tandem, so once costs finally “catch up” and adjust, the LR-AS curve is vertical at what we will call YPotential or YFE.

19. Now Consider An Increase in AD: 1 of 2
Output can be temporarily pushed above YFE by higher aggregate demand.
The overall price level rises – we see inflation.
We move up/along the SR-AS as price levels rise, and some wages rise. (Note: other input prices and wages have not fully adjusted yet.)

20. Now Consider An Increase in AD: 2 of 2
When Y is pushed above YFE, there is upward pressure on costs, and this causes the SR-AS curve to shift to the left (a negative cost or supply shock).
Costs ultimately increase by the same percentage as the price level, and the quantity supplied ends up back at Y0 = YFE.
There is a higher price level in the economy but now the inflation is over.

21. SR-AS versus LR-AS We distinguish between the
short run AS curve (SR-AS)
long run AS curve (LR-AS).
SR-AS is positively sloped and…
tends to start out rather flat/horizontal at low levels of Y.
then has a section that’s positively sloped.
then tends to get very steep/vertical as we approach Y-capacity (which is different than Ypotential/YFE ).
will shift with cost/supply shocks (see chart again, the one with the pics).
LR-AS is vertical.
This is because eventually all prices adjust, including input prices.
Typically we assume the LR-AS is vertical at YPotential/YFE.
YPotential/YFE is the level of income/output where there is no inflation.
If Y>YFE then you’ll get rising price/wage levels and a shift in the SR-AS back to LR-AS, but now at a higher price level.
If Y<YFE then you’ll get falling price/wage levels and a shift in the SR-AS back to LR-AS, but now at a lower price level.

22. Bad News for Monetary & Fiscal Policy?
If LR-AS is vertical, then neither monetary policy nor fiscal policy has any long run effect on aggregate output.
In the long run, the multiplier effect of a change in MS, and/or G and/or T on aggregate output, Y, is zero.
So: lots of good questions and debate here:
How long does it take for SR-AS to shift?
Is the LR-AS really vertical?
And where exactly is YFE relative to current Y*?
Can policy (and what type of policy then?) change where LR-AS is?