1. 1 of 26 © 2014 Pearson Education, Inc. C H A P T E R O U T L I N E 12 The AD-AS Model: Recap* The Aggregate Demand (AD) Curve Why it has a negative slope? What can shift AD? The Aggregate Supply (AS) Curve LRAS Curve SRAS Curve The Equilibrium and How an Economy Restores the Equilibrium from a Disequilibrium with and without the help from the Government. *Part of the slide materials are excerpted and modified from class materials of Sylvain Barde and Edward McPhail. The URL of their websites respectively are http://sylvain.barde.free.fr and http://edwardmcphail.com

2. 2 of 26 © 2014 Pearson Education, Inc. The AS-AD model The Aggregate Demand curve The Aggregate Supply curve The AS-AD equilibrium

3. 3 of 26 © 2014 Pearson Education, Inc. The AD curve The AD curve shows the amount of goods and services demanded for a given price level. From the Keynesian Cross to AD curve: From P 0 to P 1, the price level rises. When the price level increases, people cannot buy as much with the same level of income as they could before the rise. Therefore, AE falls. From P 0 to P 2, the price level falls. When the price level decreases, people can buy more with the same level of income as they could before the fall in the price level. Therefore, AE rises.

4. 4 of 26 © 2014 Pearson Education, Inc. The AD curve The AD curve has a negative slope : a lower level of prices increases the aggregate demand for goods and services Beware: The negative slope of the AD curve is NOT linked to the negative slope of micro demand curves!!

5. 5 of 26 © 2014 Pearson Education, Inc. What shifts AD? Keynesian Cross tells us what shifts AD Note that AE = C + I + G + (X – M) Suppose that I rises and P remains constant, AE shifts up.

6. 6 of 26 © 2014 Pearson Education, Inc. What shifts AD? In the space of P-Q, such a change sees AD shfits to the right. Anything, other than P, which affects AE will shift AE curve and thus will shift AD curve.

7. 7 of 26 © 2014 Pearson Education, Inc. The AS-AD model The Aggregate Demand curve The Aggregate Supply curve The AS-AD equilibrium

8. 8 of 26 © 2014 Pearson Education, Inc. The AS curve The AS curve shows the amount of goods and services supplied for a given price level. Compared to the AD curve, one has to distinguish between the short run AS (SRAS) and the long run AS (LRAS): LRAS : In the long run, the productive capacity of the economy does not depend on prices SRAS : A change in prices changes the real cost of labour, affecting the productive capacity of the economy.

9. 9 of 26 © 2014 Pearson Education, Inc. The LRAS curve π Y The long run aggregate supply is vertical at Y potential. LRAS Y potential Fall in LRAS Increase in LRAS It means that Y potential is a function of other variables than price How much an economy can produce in the long run depends upon the amount of L, K, N and E.

10. 10 of 26 © 2014 Pearson Education, Inc. The SRAS curve The short run AS has a positive slope. In the short run, the wage rate is fixed. An increasing price indicates higher profits, which lead firms to produce more. SRAS P Y LRAS YpYp

11. 11 of 26 © 2014 Pearson Education, Inc. The AS-AD model The Aggregate Demand curve The Aggregate Supply curve The AS-AD equilibrium

12. 12 of 26 © 2014 Pearson Education, Inc. The AS-AD equilibrium Shocks to demand and supply lead to fluctuations at the macroeconomic level. By “shocks” economists mean exogenous variations to supply and demand A demand shock modifies aggregate demand: increase in G or T, change in M, etc. A supply shock modifies aggregate supply: increase in oil prices, change in technology, etc. Stabilisation policies are policies that attempt to keep output, inflation and employment around their long run equilibrium levels The aim is to minimise the fluctuations around equilibrium

13. 13 of 26 © 2014 Pearson Education, Inc. The AS-AD equilibrium SRAS P P *P * Y AD LRAS YnYn

14. 14 of 26 © 2014 Pearson Education, Inc. Y1Y1 A negative demand shock shifts the AD curve to the left, which reduces output and prices Y is lower  recession AD2 P 1P 1 B The AS-AD equilibrium SRAS P P *P * Y AD LRAS YnYn How can we return to the long run equilibrium ? A SRAS2 P 2P 2 If the government does nothing to help! Stimulate the SRAS by reducing the effective cost of factors (wages) and get to C C

15. 15 of 26 © 2014 Pearson Education, Inc. Y1Y1 A negative demand shock shifts the AD curve to the left, which reduces output and prices Y is lower  recession AD2 π 1 B The AS-AD equilibrium SRAS π π * Y AD LRAS YnYn How can we return to the long run equilibrium ? If the government does something (that is, fiscal policy and/or monetary policy) Stimulate AD to return to point A. A

16. 16 of 26 © 2014 Pearson Education, Inc. π 1 Y1Y1 The AS-AD equilibrium SRAS π π * Y AD LRAS YnYn A negative supply shock (increase in production costs) causes an increase in prices and a fall in output in the short run: This is called stagflation SRAS2 If the government does nothing! The high unemployment leads to a decrease in wage rates and the cost of other factors, which increases the SRAS and shifts it to the right. How can we return to the long run equilibrium ?

17. 17 of 26 © 2014 Pearson Education, Inc. π 2 π 1 Y1Y1 The AS-AD equilibrium SRAS π π * Y AD LRAS YnYn A negative supply shock (increase in production costs) causes an increase in prices and a fall in output in the short run: This is called stagflation SRAS2 AD2 How can we return to the long run equilibrium ? If the government does something (that is, fiscal policy and/or monetary policy) Stimulate AD to return to point A.