2 Aggregate SupplyThe aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output.
3 Aggregate Supply Curve Aggregate Supply is the amount of real GDP that will be made available by sellers at various price levels.Aggregate Supply looks different in the Long Run and the Short Run:In the Long Run, classical economists assume the economy operates at full employment (maximum output), independent of the price level.In the Short Run, businesses will increase supply if the price level increases.3
4 Positive Relationship There is a positive relationship in the short run between price level and the quantity of aggregate output supplied.
5 The Aggregate Supply Curves The Slope of the Short-Run Aggregate Supply (SAS) CurveThe SAS curve is upward sloping because of:Auction marketsPrices are determined by demand and supply and supply curves are upward slopingPosted price marketsAlso called quantity-adjusting markets, markets in which firms respond to changes in demand by changing production instead of changing their pricesFirms tend to increase their markup when demand increases
6 Shifts in the SAS Curve Price level SAS1 SAS0 SAS2 Real output Shifts in the SAS are caused by changes in:Input pricesProductivityImport pricesExcise and sales taxesWhen production costs increase, the SAS curve shifts upIn general:%Δ in price level =%Δ in wages – %Δ in productivityPrice levelSAS1SAS0SAS2Real output
7 The Long-Run Aggregate Supply Curve The long-run aggregate supply (LAS) curve shows the long-run relationship between output and the price levelThe position of the LAS curve depends on potential output which is the amount of goods and services an economy can produce when both capital and labor are fully employedThe LAS curve is vertical because potential output is unaffected by the price level
8 The LAS CurvePrice levelPotential output is assumed to be in the middle of a range bounded by high and low levels of potential outputLASWhen resources are over- utilized (point C), factor prices may be bid up and the SAS shifts upSASOverutilized resourcesCWhen resources are under- utilized (point A), factor prices may decrease and SAS shifts downBUnderutilized resourcesAReal outputLow-level potential outputHigh-level potential output
9 Low-level potential output High-level potential output LASEstimating potential output isinexact, so it is assumed to be themiddle of a range bounded by ahigh level of potential output and alow level of potential output.When resources are over-utilized(point C), factor prices may be bidup and the SAS shifts up.CThe relationship betweenpotential and actual output – wherethe economy is on SAS – determinesshifts in SAS.BASASPrice LevelWhen resources are under-utilized(point A), factor prices may decreaseand SAS shifts down.UnderutilizedresourcesOverutilizedresourcesRealoutputLow-level potential outputHigh-level potential outputWhen LAS = SAS (point B), there isno pressure for prices to rise or fall.
10 Increases in the LAS are caused by increases in: Capital Resources Shifts in the LAS CurveIncreases in the LAS are caused by increases in:CapitalResourcesGrowth-compatible institutionsTechnologyEntrepreneurshipPrice levelLAS0LAS1LAS2Real output
11 LRASThe long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexibleDo you remember the debate between Classical and Keynes?
12 A Range for Potential Output and the LAS Curve The position of the long-run aggregate supply curve is determined by potential output.Potential output – the amount of goods and services an economy can produce when both labor and capital are fully employed.Was this in your textbook?
13 Long-Run Aggregate Supply Curve The long-run aggregate supply curve shows the quantity of aggregate output supplied when all prices, including nominal wages, are flexible. It is vertical at potential output, YP , because in the long run an increase in the aggregate price level has no effect on the quantity of aggregate output supplied.
14 Actual and Potential Output The above graph shows the performance of actual and potential output in the United States from 1989 to 2004.The black line shows estimates of U.S. potential output, produced by the Congressional Budget Office, and the blue line shows actual aggregate output. The purple-shaded years are periods in which actual aggregate output fell below potential output, and the green-shaded years are periods in which actual aggregate output exceeded potential output. As shown, significant shortfalls occurred in the recessions of the early 1990s and after Actual aggregate output was significantly above potential output in the boom of the late 1990s.
15 Short-Run Equilibrium in the AD/AS Model Price levelShort-run equilibrium is where the SAS and AD curves intersect and point E is short-run equilibriumA shift in the aggregate demand curve to the right changes equilibrium from E to F, increasing output from Y0 to Y1 and increasing price level from P0 to P1SASP1P0FAD1EAD0Real outputY0Y1
16 Short-Run Equilibrium in the AD/AS Model Price levelA shift up in the short-runaggregate supply curve changes equilibrium from E to G, decreasing output from Y0 to Y2 and increasing price level from P0 to P2SAS1P2SAS0P0GEADReal outputY2Y0
17 Long-Run Equilibrium in the AD/AS Model Long-run equilibrium is where the LAS and AD curves intersectPrice levelLASA shift in the aggregate demand curve changes equilibrium from E to H, increasing the price level from P0 to P1 but leaving output unchangedHP1EP0AD1AD0Real outputYP
18 Application: A Recessionary Gap in the AD/AS Model Price levelA recessionary gap is the amount by which equilibrium output is below potential outputSAS1LASAt point A, some resources are unemployed and the recessionary gap is YP – Y1SAS0AP1Eventually wages and prices decrease and SAS shifts down to return the economy to a long and short-run equilibrium at EEP0GapAD0Y1YPReal output
19 Application: An Inflationary Gap in the AD/AS Model Price levelAn inflationary gap is the amount by which equilibrium output is above potential outputLASAt point B, resources are being used beyond their potential and the inflationary gap is Y2 – YPSAS0EP0SAS2BEventually wages and prices increase and SAS shifts to return the economy to a long and short-run equilibrium at EP2GapAD0YPY2Real output
20 From the Short Run to the Long Run Leftward Shift of the Short-run Aggregate Supply CurveThe initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2.
21 From the Short Run to the Long Run Rightward Shift of the Short-run Aggregate Supply CurveAt the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. This reflects the fact that the short-run aggregate supply curve has shifted to the right, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve.
22 Aggregate Demand Policy A primary reason for government policy makers’ interest in the AS/AD model is that monetary or fiscal policy shifts the AD curveMonetary policy involves the Federal Reserve Bank changing the money supply and interest ratesFiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the economy
23 Application: Expansionary Fiscal Policy in the AD/AS Model Price levelIf the economy is at point A, there is a recessionary gap equal to YP – Y0LASThe appropriate fiscal policy is to increase government spending and/or decrease taxesP1EP0AAD shifts to the right and output returns to potential output YP and pricesincrease to P1AD1GapAD0Y0YPReal output
24 Application: Contractionary Fiscal Policy in the AD/AS Model Price levelLASIf the economy is point B, there is an inflationary gap Y2 – YPThe appropriate fiscal policy is to decrease government spending and/or increase taxesBP2P1AD shifts to the left, output returns to potential output YP and inflation is preventedEAD0GapAD2YPY2Real output
25 Limitations of the AS/AD Model The AS/AD model assumes away many possible feedback effects that can significantly affect the macroeconomy and lead to quite different conclusionsImplementing fiscal policy through changing taxes and government spending is a slow legislative processThere is no guarantee that government will do what economists say is necessary
26 Limitations of the AS/AD Model Potential output (the level of output that the economy is capable of producing without generating inflation) is difficult to estimateWe do have ways to get a rough idea of where it isThere are many other possible interrelationships in the economy that the model does not take into accountThe aggregate economy can become dynamically unstable, so a shock can set in motion changes that will not automatically be self-correcting
27 Limitations of the AS/AD Model There are two ways to think about the effectiveness of fiscal policy: in the model and in realityThe effectiveness of fiscal policy depends on the government’s ability to perceive and to react appropriately to a problemCountercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycleFine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or potential level of income
28 Chapter SummaryThe key idea of the Keynesian AS/AD model is that in the short run the economy can deviate from potential outputThe AS/AD model consists of the aggregate demand curve, and the short-run aggregate supply curve, and the long-run aggregate supply curveShort-run equilibrium is where the SAS and AD curves intersect; Long-run equilibrium is where the AD and LAS curves intersectAggregate demand management policy attempts to influence the level of output in the economy
29 Chapter SummaryFiscal policy works by providing a deliberate countershock to offset unexpected shocks to the economyMacroeconomic policy is difficult to conduct because:Implementing fiscal policy is a slow processWe don’t really know where potential output isThere are interrelationships not included in the modelThe economy can become dynamically unstable