Presentation on theme: "Objectives of the AD/AS Chapter"— Presentation transcript:
1 Objectives of the AD/AS Chapter 1. Define AD & AS.AD – AQD [RGDP] desired by the private, public, & foreignsector at various PLs [inverse] [Everyone’s demand for everything]AS – AQS [RGDP] firms will supply at various PLs [direct]2. Three reasons for the down-sloping AD curvea. interest rate effect b. real-balances effect c. foreign purchase effect3. Know the three ranges of the AS curve.4. Predict effects of an increase in AD inKeynesian, intermediate, & classical ranges.5. Predict effects of an increase/decrease in ASon output and price level.6. Know the four AD shifters [C+Ig+G+Xn].7. Know the three AS shifters [“REP”].8. Explain the ratchet effect of a decrease in AD.9. Compare the Classical/Keynesian Schools of Economics.
2 Aggregate Demand Aggregate Supply [Demand (AD) for everything by everyone] or[Amount of goods & services that will be demanded at various price levels by the private, public, andforeign sectors][AQD will be greater at lower price levels]Aggregate Demand[amount of goods and services that willbe produced by firms at various price levels][AQS will be greater at higher price levels]Aggregate SupplyAggregation – combining all prices into a singleaggregate price level and – combining all quantitiesinto aggregate quantities [AQS or real GDP]
3 Aggregate Demand & Aggregate Supply SRAS[REP]PriceLevelADLRAS[Production cost]CIG-XnPLeYeRDO [Real Domestic Output][C+Ig+G+Xn] When one of these variables change, either positively or negatively, the AD curve will move right or left.101010
4 Caused by a “Change in PL” Change In AQDChange In AQSMacro Law of Demand[Inverse]Macro Law of Supply[DIRECT ]ADASPL1PL1PL2PL2AQD1AQD2AQS2AQS1AQD or AQS is a point on the AD or AS curve [particular PL]AD or AS is the whole curve and represents all price levels.[Bunch of AQDS or AQS strung together on the same curve]
8 CIG-X [REP] YR Y* YI LRAS PL AD2 AS Shifters AD1 AD Shifters [C+Ig+G+Xn]ConsumptionInvestment (gross)Government Spending[infrastructure, militaryspending, health care]Net eXportsPLSRAS2AS Shifters[REP]Resource costEnvironment[legal-institutional]1. Subsidies,2. Business taxes,3. Business regs.ProductivityAD2AD1SRAS1CIG-XSRAS2AD2103YRY*YIRGDPAggregation – we are combining all prices into price level & combining all quantities into Real GDP(Y).Y indicates 3 things:1. Output[GDP]2. Income3. UnemploymentYR – Recession gapYI – Inflation gapY* – Full Employ.Don’t confuse FE outputwith the economy’smaximum output, whichis the larger output thatwould be produced ifeveryone were forcedto work as much aspossible.
9 Aggregate Demand & Aggregate Supply SRAS[REP]PriceLevelADLRAS[Production cost]CIG-XnPLeYeRDO [Real Domestic Output][C+Ig+G+Xn] When one of these variables change, either positively or negatively, the AD curve will move right or left.101010
10 Long-Run v. Short-RunLong-RunPeriod of time where input prices [wages] are completely flexible and adjust to changes in the PLIn the long-run, the level of Real GDP supplied is independent of the PLShort-RunPeriod of time where input prices [wages] are sticky and do not adjust to changes in the PLIn the short-run, the level of Real GDP supplied is directly related to the PL
11 Increase in AD Increase in AD YR YF [caused by “C+Ig+G+Xn”] SRAS LRAS Increase in ConsumptionIncrease in InvestmentIncrease in Gov. spendingA. On military spendingB. On the infrastructureC. On health care4. Increase in Net exports [Xn]A. Dollar depreciatesB. Trade partners Y’s risePrice LevelYRYFReal Domestic Output, RGDP
12 Decrease in AD Decrease in AD YR YF [caused by “C+Ig+G+Xn”] SRAS LRAS Decrease in ConsumptionDecrease in InvestmentDecrease in Gov. spendingA. On military spendingB. On the infrastructureC. On health care4. Decrease in Net exports [Xn]A. Dollar appreciatesB. Trade partners Y’s fallPrice LevelYRYFReal Domestic Output, GDP
13 The amounts of real output that buyers AGGREGATE DEMANDThe amounts of real output that buyers[householders, businesses, government, & foreigners]desire to purchase at each possible price level.Or, the “demand for everything by everyone”.AD curve is downsloping due to:Real Wealth [Money-balances] Effect[monthly flow of money and stock of accumulatedsavings balances like bonds & CDs “really” buy more]Interest-Rate Effect - businesses invest moreForeign Purchases Effect - foreigners buy more[There is no income or substitution effect.][You can’t substitute for the whole economy]ADPL1PL2AQD1AQD2
14 Law of Aggregate Demand [Change in AQD] AD Macro Law of Demand[cause] [effect]PL decr; AQD incr.PL incr; AQD decr.“AD” refers to whole curve.“AQD” is a pt on the curvebased on a particular PL.ADReasons For Downsloping “AD” Curve[if PL decreases, this happens]1. Interest Rate Effect – more Ig2. Real Wealth Effect – more “C”3. Foreign Purchase Effect - foreigners buy morePL1Change in AQD1. Price Level change2. Movement [up or downthe AD curve3. Pt to pt [along the AD curve]PLAQDPL2Inverse relationship“AD” refers to the “whole curve”. [“all PLs”]“AQD” refers to a “point on the curve”based on a “particular price level.”AQD1AQD2
15 C Ig G XN Change in AD AD2 AD1 AD3 AQD1 AQD3 RDO AQD2 Consumption PL 1. “Non price Level” change-either C, Ig, G, or Xn2. “Whole AD curve” shifts[There is a change in AQD but it is not caused bya change in price level.]ConsumptionMariah Carey ConcertIgAD2AD1AD3GPLLet there be moremilitary weaponsXNAQD1RDOChevy FerrariAQD3AQD2[Exports-Imports]
16 What Will Shift AD to The Right? PLChange in Consumer SpendingConsumer Wealth [increases/decreases] [stocks/houses] [stable prices]Consumer Expectations [about future prices (increases/decreases)Consumer Expectations about future income [positive/negative]Consumer Indebtedness [low/high]Personal Taxes [increase/decrease]Real Interest Rate [stable prices] [increase/decrease]Change in Investment SpendingHigh DebtReal Interest Rates [stable prices] [increase/decrease][Positive/Negative] Profit Returns[Business taxes [increase/decrease][Depleted/Excess] inventory stockpiles in the supply chain
17 Shifters of the AD Curve [continued]Shifters of the AD CurveGovernment Spending [purchases][either [increases/decreases] on [infra-structure, military, health care, etc.]Net Export SpendingAD1AD2National Income Abroad[either increases or decreases]Exchange Rates[Depreciation-increases AD; Appreciation-decreases AD]PLMore Exports[Our products are cheaper]Fewer Exports[Our products are more expensive]
18 Actual PL Higher Than Anticipated LRASPLSRASAD103Y*6%Real GDPWhile it may appear contradictory to talk about producing beyond the economy’s potential, remember that potential output does not mean zero unemployment.Rather, it means that the actual unemployment rate equals the natural rate of unemployment, approximately 94%-96% of the labor force working.
19 Actual PL Higher Than Anticipated That is, even in an economy producing its potential output, there is some unemployed labor & unused production capacity.Potential GDP can be thought ofas the economy’s normal capacity.Firms and workers are able, in the short run, to push output beyond the economy’s potential.*In the LR, the level of RGDP supplied is independent of PL.*In the SR, the level of RGDP supplied is dependent of PL.LRASSRASAD1PL2(106)AD3AD2PL1(103)PL3(100)YRYA9%Y*FYP6%YiYA3%
20 CIG-X Y3 Y Y2 Shifts in the AD Curve AD2 AD1 AD3 PL SRAS Price Level AQDAQDShortageSurplusRaise PLY3YY2Real Domestic Output181818
21 Macro Law of Supply ["Law of AS"] “AS” refers to the “whole AS curve” & refers to “all price levels”“AQS” refers to a “point on the AS curve” & refers to a “particular price level”ASChange in “AQS”1. Price Level change2. Movement (up/down) “AS” curve)3. Point to point (along “AS” curve)PL2PL1AQS1AQS2Reasons For Upsloping “AS” Curve1. There is increasing opportunity cost if firms don’t produce.2. Current producers produce more [overtime/more shifts]3. New producers are attracted to the market.
22 REP Change in AS PL AS3 AS1 AS2 So – AS Shifters are Environment AQS3 1. “Non price level change”. Either R, E, or P2. “Whole AS curve” shifts.3. AQS changes but is not caused by a change in PLAnything that lowersthe cost of productionwill shift AS right.AS Shifters(REP)1. Resource cost2. Environment [legal-institutionalenvironment for businesses change,affecting production costs[subsidies, bus. taxes, regulations]3. ProductivityAS3AS1AS2So – AS Shifters areREPIncrease in the availability of ResourcesPLYou save money. We don’t require dental or medical insurance. You don’t have to pay us a pension and we don’t take sick days. And – we can dance.1. Lower business taxes2. Decrease in regulationsIncrease in subsidiesEnvironment[Legal-institutional]AQS3AQS1AQS2Increase in Productivity
23 [Recessionary Gap, Inflationary Gap, or no gap] AD/AS[Recessionary Gap, Inflationary Gap, or no gap]LRASSRASAD1110AD3103AD2101RecessGapInflatGap1%YIYA$1111%YRYA$96%Y*YP$10[5%(“real”) cyclical unemployment]10% (5x2%=10%) Recess. GDP Gap[10%(5x2%) Inflationary GDP GapSR – output [product] prices increase/decrease but input[wages] prices remain fixed in the presence ofunanticipated inflation/disinflation [“sticky”]LR – both output [product] and input [wages] prices change.
24 Change in AS [caused by “REP”] PL Resource Cost Decrease in AS [“REP”]Resource Cost1. Increase in resource costEnvironment [legal-institutional]2. Decrease in subsidies3. Increase in bus. regulations4. Increase in business taxesProductivity5. Decrease in productivityADSRAS3SRAS1LRASSRAS2PLIncrease in AS [“REP”]Resource Cost1. Decrease in resource priceEnvironment [legal-inst.]2. Increase in subsidies3. Decrease in bus. regs.4. Decrease in bus. taxesProductivity5. Increase in productivityRegulations place compliance costs on businesses and reduce the SRAS.Ex: To reduce sulfur dioxide emissions, factories have to pay for smokestack scrubbers which mean less money to increase output.RGDPReal Domestic Output, RGDP
25 Decrease in the AS Curve SRAS2ADSRAS1PL2ShortagePL1Y2Y1Real GDP
26 Increase in the AS Curve ADSRAS1SRAS2PL1SurplusPL2Increase inProductivityY2Y2Real GDPA 1% increase in productivity can eliminate 1.2 million jobs.
27 Increase in AD & the LRAS Curve PriceLevelSRAS[Production cost]ADAD2PL2E2What if we haveunanticipated inflation?What happens in SR tooutput, employment,and price level?PL1YYIRGDP222222
28 The LRAS Curve LRAS SRAS2 AD SRAS1 Price Level Y AD2 PL2 PL1 [Production cost]E3PL1With unanticipated inflationwhat happens to output,employment and price levelin the LR?YRGDPThere is a Short Run Equilibrium [AD=SRAS]and a Long Run Equilibrium [AD = LRAS].222222
29 Decrease in AD and the LRAS Curve PriceLevelAD1SRAS[Production cost]With unanticipateddisinflation, what happensto output, employment,and price level in the SR?AD2PL1PL3E2YRYRGDP222222
30 The Long-Run AS Curve LRAS AD SRAS1 SRAS2 Y PL1 PL3 RGDP [Production cost]SRAS2With unanticipateddisinflation, what happensto output, employment,and price level in the LR?PL1PL3E3YRGDP222222
31 slopes upward because of sticky-wages and sticky-prices. The Long-Run AS CurveLRASADSRASThe LRAS curve is notinfluenced by PL.103 PLThe SRAS curve isinfluenced by PL andslopes upward because of sticky-wages and sticky-prices.Y*Quantity of OutputOutput atFull Employment232323
32 Decrease in AD LRAS SRAS AD1 AD2 PLe Ye YR Price Level SurplusPL2YeYRQuantity of Output434343
33 [Stagflation] Decrease in AS YF YR LRAS SRAS2 AD SRAS1 6% Price Level 110PleThis created cognitivedissonance among many.6%YFRDO10%YR474747
34 Point to Point movements NS 1-41. The process of combining all individual product prices and quantities into a single unit is (deduction/conglomeration/aggregation). 2. The AD curve shows the amount of (real/nominal) domestic output which will be purchased at each possible (price/price level). 3. The AD curve is always (up/down) sloping & shows a(an) (direct/inverse) relationship between output & (price/price level). 4. The income & substitution effects (do/do not) apply to the AD curve. The 3 explanations for the downsloping AD curve are the interest rate effect, foreign purchase effect, & (econ/real-balances) effect.Change in AQDPrice Level ChangePoint to Point movementsADPL1PL2AQDPLAQD1AQD2
35 Three Reasons For Downward Sloping AD Curve Real Wealth [Money-balances] Effect –economy’s monetary wealth. If we buya fixed bundle of goods & services every month (food/clothing/ shelter), at lowerprices, it now takes less money.money. Our accumulated savingsbalances [401k, CDs, bonds] willpurchase more.Three Reasons For Downward Sloping AD CurvePL1PL2QD1 QD2Market BasketInterest Rate Effect – lower interest ratesincrease investment and consumption.Foreign Purchase Effect – withlower U.S. prices, both Americans &foreigners buy more American goods.
36 NS 5-7 AD Higher PL Lower PL 5. The interest rate effect suggests that an increase in the PLwill (incr/decr) the demand for money, (incr/decr) interestrates and (increase/decrease) consumption and investmentwhich would cause a(an) (increase/decrease) in (AD/AQD).6. The real-balances effect indicates a higher price level will(increase/decrease) the real value of money, (increase/decrease)consumption, and therefore (increase/decrease) (AD/AQD).7. The foreign purchase effect suggests that an increase in PLrelative to other countries (increase/decrease) our exports and(incr/decr) our imports which would (incr/decr) (AD/AQD).ADPL2PL1Higher PLLower PLAQD AQD1
37 Y, Employment, and PL after Correction SRAS2SRASLRASSRAS3AD1110AD3AD2103101RecessGapInflatGap11%YRYA$91%YIYA$11[5%(“real”) cyclical unemployment]10% (5x2%=10%) Recess. GDP Gap6%Y*YP$10[10%(5x2%) Inflationary GDP GapInput prices have responded to unanticipated changes in outputprices in LR. [They respond to unanticipated inflation or disinflation.Two sets of prices are changing in LR - output and input.
38 What Will Shift The AD Curve Right? [C+Ig+G+Xn]Consumer Spending Increases1. Aggregate wealth increases independent of PL[stocks, bonds, land, houses, etc.]2. Expectations of surging future inflation3. Consumer indebtedness is fairly low4. Consumer taxes are decreased5. Interest rates are decreased [independent of PL]ASAD2AD1PLInvestment Spending Increases1. Interest rates are decreased [independent of PL]2. Positive profit expectations3. Factory inventories are down4. *Business taxes are reduced [*will also shift AS]Y1Y2100 Bases MayFace ClosureMilitary base cutswould start in 2010.100 of the nation’s425 bases would beclosed, saving over$75 billion annually.Government Spending IncreasesGovernment spending increases on health care,military bases, infrastructure, etc.Health care, infrastruc., militaryNet Export Spending Increases1. Foreign incomes increase [will buy more there and here]2. Dollar depreciates [our exports are cheaper]
39 What Will Shift The AS Curve Right [“REP]? Resource Cost Decrease (domestic)Land – new raw materials (oil) are found.Labor–labor force increases or wages decrease.Capital stock or entrepreneurial ability increases.The number of sellers of resources increase.AS1AS2ADPL1PL2Resource Cost Decrease (overseas)Imported resources decrease in price.Dollar appreciates [foreign inputs are cheaper].OPEC nations cheat by producing more oil.Y1Y2Environment[Legal-Institutional Environment for businesses change]1. Subsidies are increased.2. Regulations on businesses are decreased.3. *Business taxes decrease.Productivity IncreasesTechnological breakthrough leads to an increasein productivity [more outputs from same inputs].*Notice that a decrease in business taxes increasesboth AD & AS.
40 REP Change in AS PL Productivity increase AS3 AS1 AS2 1. “Non price level change”. Either R, E, or P2. “Whole AS curve” shifts.3. AQS changes but is not caused by a change in PLAnything that lowersthe cost of productionwill shift AS right.AS Shifters(REP)1. Resource cost2. Environment [legal-institutionalenvironment for businesses change,affecting production costs.[subsidies, bus. taxes, regulations]3. ProductivityAS3AS1AS2So – AS Shifters areREPIncrease in the availability of ResourcesPLYou save money. We don’t require dental or medical insurance. You don’t have to pay us a pension and we don’t take sick days. And – we can dance.1. Lower business taxes2. Decrease in regulationsIncrease in subsidiesEnvironment[Legal-institutional]AQS3AQS1AQS2Productivity increase
41 Increase in AD Increase in AD YR YF [caused by “C+Ig+G+Xn”] SRAS LRAS 1. Increase in Consumptiona. aggregate wealth increasesb. expected increase in inflationc. positive future incomed. low consumer debte. decrease in consumer taxesf. decrease in interest rates2. Increase in Investmenta. decrease in interest ratesb. positive profit expectationsc. inventories are lowd. *business taxes are reduced3. Increase in Government spendinga. on the militaryb. on the infrastructurec. on health care4. Increase in Net exports [Xn]A. Dollar depreciatesB. Trade partners incomes riseSRASAD2LRASAD1Price LevelYRYFReal Domestic Output, GDP
42 Decrease in AD Decrease in AD YR YF [caused by “C+Ig+G+Xn”] SRAS LRAS 1. Decrease in Consumptiona. aggregate wealth decreasesb. expected decrease in inflationc. negative future incomed. large consumer debte. increase in consumer taxesf. increase in interest rates2. Decrease in Investmenta. increase in interest ratesb. negative profit expectationsc. excess inventoriesd. *business taxes are increased3. Decrease in Government spendinga. on the militaryb. on the infrastructurec. on health care4. Decrease in Net exports [Xn]A. Dollar appreciatesB. Trade partners incomes fallSRASAD1LRASAD2Price LevelYRYFReal Domestic Output, GDP
43 Increase in AS [caused by “REP”] PL Increase in AS [“REP”] AD Resource Cost [domestic]a. More land, labor,capital & entrepreneursb. # of sellers increasec. Hiring fewer union workersResource Cost [overseas]c. Imported input prices decreased. Dollar appreciatesEnvironment [legal-institutional]a. Increase in subsidiesb. Decrease in bus. regulationsc. *Decrease in business taxesProductivityIncrease in productivityADAS1AS2PLRGDP
44 Decrease in AS [caused by “REP”] PL Decrease in AS [“REP”] Resource Cost [domestic]a. Land, labor, & capitalbecome more scarceb. Hiring more union workersc. Number of sellers decreaseResource Cost [overseas]c. Imported input prices increased. Dollar depreciatesEnvironment [legal-institutional]a. Decrease in subsidiesb. Increase in bus. regulationsc. *Increase in business taxesProductivityDecrease in productivityADAS3AS1PLRGDP
45 NS 33-422222[“REP”]D___33. Decrease in the availability of key natural resources (R)?___34. Increase in resource productivity (P)?___35. Increase in foreign spending on our products (Xn)?___36. Substantial reduction in government spending (G)?___37. Declines in the prices of imported resources (R)?___38. Declines in the incomes of our trading partners (Xn)?___39. Improvement in business profit expectations (Ig)?___40. Stock market plunge affects consumer wealth (C)?___41. There is an increase in interest rates [stable prices] (C & Ig)?___42. Consumer indebtedness is very low (C)?Extra:___43. Increased government regulations are forced on businesses (E)?___44. The government increases subsidies to all farmers (E)?CABCBABBADC
46 Points of Emphasis for AD/AS Questions 1. Wages (labor), this is resource cost, so AS shifter.2. Increase/decrease in union workers hired –they get paid more – so labor, so AS shifter.3. Appreciation/depreciation of a currency [either AD or AS]a. Resource cost is part of REP, so it is AS shifter.b. Exports are part of C+Ig+G+Xn, so it is AD shifter.4. Regulations and subsidies [legal-institutionalEnvironment], part of REP, so they are AS shifters.5. For all C+Ig+G+Xn, does the situation result inan increase or decrease in AD & therefore GDP?6. For REP, think of production costs –if producers make more money, there is an increase in AS,if producers make less money – there is a decrease in AS.
47 __1. Consumers fear a widespread depression. AD/AS Practice Quiz 1__1. Consumers fear a widespread depression.__2. Britain and Japan increase their purchases of U.S.agricultural products.__3. Our exports are affected by a depreciation of the dollar.__4. There is a huge increase in government spendingfor health care.__5. Interest rates increase although prices are stable.__6. 20% increase in the personal income tax.__7. An increase in labor productivity.__8. A 15% decrease in nominal wages.__9. Appreciation of the dollar affects imported resources.__10. Canada, Mexico, & Japan come out of recessionand buy more American cars.[“REP”]BAAABBCCCA
48 [“REP”] AD/AS Practice Quiz 2 B A B A B A C A C D D B C ___1. A widespread fear of depression on the part of consumers.___2. A large purchase of wheat by Russia, one of our trade partners.___3. Our exports are affected by an appreciation of the dollar.___4. A reduction in interest rates although price level remains constant.___5. A huge cut in government expenditures for health care.___6. Consumer expectations of a rapid rise in the price level.___7. The complete disintegration of OPEC, causing oil prices to fall by ½.___8. A 10% reduction in personal income tax rates.___9. An increase in labor productivity.___10. A 12% increase in nominal wages.___11. Imported resources are affected by a depreciation of the dollar.___12. A sharp decline in the national incomes of our trading partners.___13. A decline in the % of the U.S. labor force which is unionized.BABABACACDDBC
49 AD/AS Quiz 3 A. Incr in AD B. Decr in AD C. Incr in AS D. Decr in AS [C + Ig + G +Xn] [“REP”]1. Car producers have new regulations imposed on themthat require pollution devices on the tailpipes to cut pollution.2. Positive business profit expectations affect investment.3. A 50% increase in the value of stocks affect consumer spending.4. The government will start paying health care for the nations35 million poor.5. Although the price level is constant, the Fed raises interest rates.6. Government spending is affected by the closing of 50 militarybases and decreasing Armed Forces personnel by 250,000 men.7. The dollar appreciates by 20% which affect the price ofimported resources.8. Congress cuts personal income taxes by 10% which affectconsumer spending.9. Investment is affected after factory inventories are beingdepleted. [“hot economy”]10. Productivity (over a 6 month period) triples in the economy.AD/AS Quiz 31. D A A A B B C A A C
50 AD/AS Quiz 4 Incr in AD B. Decr in AD C. Incr in AS D. Decr in AS [C + Ig + G + Xn] [“REP”]1. Regulations on car producers are suspended that requiredpollution devices on all auto tailpipes.2. Negative business profit expectations affect investment.3. A 12% increase in wages impact business profits.4. The government will spend $1 billion on the “High 10” atHwy 190 and Central Expressway.5. Although the price level is constant, the Fed drops interest rates.6. Government spending is affected by the construction of a10-lane highway between Washington D. C. and Crawford, Texas.7. The dollar depreciates by 10% which affect U.S. resource cost.8. Congress raises personal income taxes by 10% whichaffect consumer spending.9. Investment is affected after the economy goes into a verybad recession.10. Canada, Mexico, and Japan buy 50 million more tons ofcorn.AD/AS Quiz 41. C B D A A A D B B A
51 AD/AS Quiz 5 A. Incr in AD B. Decr in AD C. Incr in AS D. Decr in AS [C+Ig+G+Xn] [REP]Which diagram above portrays:___1. A decrease in consumer spending?___2. The impact on net exports caused by increases in thenational incomes of our major trading partners?___3. A large increase in the price of imported oil whichimpact the resource cost of businesses?___4. A large increase in government spending on our highways.___5. A substantial increase in wages that businesses paytheir workers?___6. The effect on investment if there are negative businessprofit expectations? [“We are heading into a recession.”]___7. A decrease in interest rates even though there is nochange in price level?___8. The government picking up the tuition tab for all of thenation’s private school students who have made a “90”or above in high school economics?___9. A major increase in productivity?___10. 25% stock market increase over a two month period?AD/AS Quiz 51. B A D A D B A A C A