1. THE AGGREGATE DEMAND/ SUPPLY MODEL

2. The U.S. Great Depression
Output fell by 30%
Unemployment as high as 25%
Prices declined 30% in the first four years
Led to the development of modern macroeconomic theory
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3. Before: Classical Economics
Focused on long-run issues--growth
Self-regulating markets through the “invisible hand”
Prices would adjust during recessions
Economy would always return to its potential output in the long-run
Depression caused by institutions that prevented prices from falling, specifically:
Labor unions
Government
Advocated a laissez-faire (hands-off) economic policy

4. After: Keynesian Economics
John Maynard Keynes in The General Theory of Employment, Interest, and Money (1936)
Problems of the Depression required a short-run, rather than long-run, focus.

5. Keynesian Economics
Adjustments to equilibrium for a single market and the aggregate economy are different.
Short-run equilibrium income may differ from long-run potential income.
Paradox of thrift
In long run, saving leads to investment and growth.
In short run, saving may lead to a decrease in spending, output, and employment.
Aggregate demand management by government may be necessary.

6. Keynesian Economics and the AS/AD Model
Aggregate Demand Curve (AD)
Relates changes in the price level to changes in aggregate expenditures =
C + I + G + (X-M)
Short-Run Aggregate Supply Curve (SAS)
Relates changes in the price level to changes in aggregate supply.
Long-Run Aggregate Supply Curve (LAS)
Shows potential output at any point in time

7. The Aggregate Demand Curve
Price
level
Wealth, interest rate, and international effects P0
Multiplier effect P1 AD Y0 Y1 Ye
Real output

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

9. The Short-Run Aggregate Supply Curve
SAS
Price level
Real output

10. Shifts in the SAS Curve 1. Higher input prices 2. Higher import prices
3. Higher sales and excise
taxes
Price level
4. Reduced productivity
SAS0
Real output

11. Long-Run Aggregate Supply Curve
LAS
LAS1
LAS curve shows potential output
Vertical because potential output
is unaffected by the price level.
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

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

13. Short-Run Equilibrium: Changes in AD
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

14. Short-Run Equilibrium: Changes in SAS
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
SAS0
If SAS increases to SAS1,
equilibrium output
decreases to Y1 and the
price level increases to P1
(point G). P0 E E P0 AD Y0
Real output

15. 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

16. 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

17. Recessionary Gap
A recessionary gap is the amount by which equilibrium output is below potential output.
LAS
At point A, some resources are unemployed and the recessionary gap is YP – Y1. Y1 P0 A
SAS0
SAS0 A P0
Price level AD
Recessionary
gap Y1 YP
Real output

18. 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. C
SAS0 P0 AD
Inflationary
gap YP Y2
Real
output

19. Expansionary Fiscal Policy
Price level
Economy is at equilibrium at A, there is a recessionary gap Y0 – YP.
LAS
AD1 B
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

20. Contractionary Fiscal Policy
LAS
Economy is at equilibrium at B, there is an inflationary gap Y2 – YP.
AD2
Appropriate fiscal policy is to decrease government spending and/or increase taxes. B AS P2
Price level
AD0
AD0 decreases to AD2 and output returns to potential output YP and inflation is prevented. YP Y2
Real output

21. Macro Policy Problems Implementing fiscal policy
Slow legislative process
Slow and uncertain reaction by the economy
Avoiding “over-correcting”