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

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

3. The Aggregate Demand ScheduleP
P = Price Level;
CPI or GDP deflator
Q = Y = Real GDP; (real output)
AD = Agg. Demand;
From 4 sectors – HH, Bus, G, Foreign A P2 Q1 B P1 Q2
AD1
Q or R-GDP

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

5. Aggregate Demand What about: Can’t do “all else equal”
Interest effect
Foreign trade effect
Exchange rate effect
Can’t do “all else equal”
e.g. Will Prices - Consumption? No: P - Wages - Consumption!!!
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.

6. The Aggregate Demand ScheduleP
AD3
AD2
Increases in
C, I, G, net X
Decreases in
C, I, G, net X
AD1
Q or R-GDP

7. AS/AD, the Money Supply and Long Run Equilibrium
There is a “long run” Aggregate Supply, which is perfectly vertical at the “full employment” level of Real GDP.
ASLR
It is unaffected by changes in the price level, but is affected by a host of real variables… P1
Classical Model of the Economy
AD1
Q or R-GDP

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
Nominal wages are sluggish upwards:
A rise in prices has delayed effect on wages.
Nominal wages are inflexible downwards:
A fall in prices will result in employment and income.
Workers 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
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?
The 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 compensating higher wages, AS.
The temporary profit motive has been eliminated.

11. From SR to LR Aggregate Supply
AS3
AS2
An increase in AD triggers events. P
ASLR
AD2
AS1
Prices rise, wages lag, output rises.
Eventually, wages catch up and AS declines.
In LR, only prices rise. P3 P2 Q2 P1
AD1
Q or R-GDP Q*

12. AS/AD Model – Hints at 4 types of changes:
ASLR
Inflation with growth due to rising AD.
Depression with deflation due to falling AD.
Growth with deflation due to rising AS.
Depression with inflation due to falling AS. (stagflation)
AS1 P1
Only changes in ASLR are permanent.
AD1
Q or R-GDP Q*

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