Presentation on theme: "Supply and Demand graphs- The Basics"— Presentation transcript:
1 Supply and Demand graphs- The Basics PriceThe purpose of this graph is to look at markets. Free Market Price and QuantitySupplyP eDemandQ eQ
2 The Aggregate Market- The Basics Long Run Aggregate Supply (LRAS)QyQy= Quantity at full employmentAggregate- all together (total)Price LevelMeasure of InflationAggregate Supply (AS)The purpose of this graph is to look at countries. Total supply and demand at full employmentP eAD= Aggregate DemandAD= GDP= C + I G + NXAggregate Demand (AD)Q eG.D.P realemploymentYou may find it amazing how a fairly simple graph can be interpreted in so many different ways.Learning the basics of the graph will provide you an opportunity to learn fiscal and monetary policy in different ways.The law of demand is the same.There is an inverse relationship- PL up, AD down, PL down AD upThe law of supply is the sameThere is a direct relationship- PL up, AS up, PL down AS down
3 Conflicting Views Classical Views Keynesian Views F.A. HayekNeo-ClassicalAustrianMonetaristSupply-sidersLess GovernmentJohn M. Keynes More GovernmentMicro not MacroKeynesiansNeo-Keynesians Increase Gov’tDemand-siders spendingFiscal PolicyEquilibrium of marketIncrease consumer or Investments1. Prices and Wages are flexible – markets quickly and efficiently achieve equilibrium. When applied to the resource market full employment is maintained- unemployment is not a long term problem1. Prices and Wages are Sticky- Prices and wages respond slowly to changes in supply and demand and this results in shortages and surplus- especially with labor.2. Increase Aggregate Demand to increase GDP- is influenced by a host of economic decisions both public and private.2. Say’s Law- supply creates it own demand- aggregate product of goods and service produces enough income to exactly purchase all output3. “In the Long Run we are all dead”- care more about Short run and not so much about the long run. Changes in AD have greater short run effect on real GDP and employment but not as much on price. What is true in the short run isn’t always true in the long runSavings-investment equality-any decrease in output because of savings is offset an increase in the demand for investmentThis creates a different market – the money marketInvestment is demandSavings is SupplyInterest rates create equilibrium- Monetarist4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending5. Steer the Market- advocated stabilization policies such as tax, government spending, laws, and regulation in order to defend against the sudden and unpredictable changes in the business cycle
4 AS/AD/LRAS graphs- Classical vs Keynesian models Labor MarketWages(AS)Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at the same wage. This creates a surplus of supply of workers which will remain until demand increases.Quantity demanded is less than the quantity supplied.Q 2W eClassical (Monetarist)- believe that when demand for employment decreases- wages will fall and the market will clear (return to equilibrium). Some people will choose not to work but most will eventually lower their wages.W 1Q 1(AD) 1(AD)QEmployment
5 Aggregate Supply (The classical model) The whole purpose of these graphs is to find the Price level, GDP, and unemploymentAS is vertical and at the same point of full employmentClassical economist believe that resources prices and wages are flexibleThis model says that the government doesn’t need to get involved because the market will fix itself.(AS) much like the LRASP.L.(AD) 1P 1P eWhat will happen to price as AD falls?The classical model suggest that the economy fixes itself and that prices and resources price will fall to create a new equilibrium.(AD)Q yG.D.P realWhen Aggregate demand falls what happens to. . .Price?Employment?Wage (remember wages are price)?GDP real?
6 Aggregate Supply (The classical model) If there is a decrease in ADThere will be a reduction in price level and higher unemploymentP 1Q 1LRASP.L.SRASQ 2According to classical economist the SRAS will eventually increase as wages decrease and the price of resources decreaseThis will give you a new quantity demanded back at full employmentSRAS 1P e(AD)(AD) 1This will occur as long as wages can adjust. What can keep wages artificially elevated? Or in other words what can keep the market from clearing?Q yG.D.P realWhether or not the market will clear will also depend on the worker’s wage expectations.UnionsRational ExpectationsWorkers will revise their expectations instantaneouslyAdapted ExpectationsIt may take workers weeks, months, or years but eventually they will adapt their wage expectations.Min. Wage lawsUnemployment benefits
7 Aggregate Supply (The Keynesian Model) LRASP.L.Y1According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t change and output will remain low.When output is below full employment, the price level doesn’t fall because wages/resource prices don’t fall (wages are sticky)(AD) 1P e(AD)Q yfullG.D.P real
8 Aggregate Supply (The Keynesian Model) LRASP.L.(AD) 5(AD) 4(AD) 3(AD) 2Y1According to Keynes, only with the help of the help of the government can Aggregate demand increase.Demand side economics- focus on demandFiscal approach- government spending and taxationMonetarist approach is to increase investments(AD) 1P eQ yfullG.D.P realAny aid past Qy- is purely inflationary
9 Aggregate Supply – So what Model is correct? They Both have some valid pointsLRASClassicalPhaseADWhen in the Classical PhaseThe economy is operating at full employmentAny and all increase in AD will result in an increase in price and in increase in inflationP.L.IntermediatePhaseADWhen in the Intermediate PhaseAs AD approaches the curveAn increase in AD and decrease in unemploymentResult in a gradual increase of price and some inflationary pressureKeynesianPhaseADWhen in the Keynesian PhaseOutput can increase with no change in price.No increase in price level, no inflationary pressure, spare room to grow.P eQ yfullG.D.P real
10 AS/AD/LRAS graphs- how it works during Expansion If Aggregate Demand increases(AS) 1(LRAS)QyP.L.(AD) 1Both Prices and GDP will increase.(AS)P 2CIn the long run – an increase in price will not lead to an increase in output.Why?P 1Q 1BP eABecause as prices increase so does the price of resources including labor, wages, and materials.(AD)Q eG.D.P realAs a result the Aggregate supply will shift to the left (decrease) and we will find ourselves back at full employment.
11 AS/AD/LRAS graphs- how it works during Recession QyIf Aggregate Demand decreases.P.L.(AS)Both Price Level and output will decrease.(AS 1)P 2In the long-run a decrease in price will not lead to a decrease in output.Why?(AD) 1P eAQ 1P 1BBecause as prices decrease so does the price of resources including labor, wages, and materials.C(AD)Q eG.D.P realAs a result the Aggregate supply will shift to the right (increase) and we will find ourselves back at full employment.
12 Inflationary and Recessionary Gaps- Steering the Market PotentialGDPEconomicActivityInflationary GapRecessionary GapTime (years)The Government can steer the economy in different waysLaws and Regulations- stabilizersFiscal Policy- changes in government spending or taxation to influence the economyMonetary policy- changes in monetary supply to influence the economy
13 AS/AD/LRAS graphs- Inflationary Gap Actual GDP > Potential GDPOutput is beyond full employmentPriceLevelLRASASUnemployment very lowPrices very highGovernment wants to limit inflation by reducing demandAD 2P2P1How do they do it?AD 1GDP realQ yFEQ1Fiscal Policy:Gov’t can decrease gov’t spending or increase tax on consumers. AD = C I G NEMonetary Policy:Federal Reserve can decrease money supply or increase interest rates. AD = C I G NE
14 AS/AD/LRAS graphs- Recessionary Gap Actual GDP < Potential GDPOutput is below full employmentPriceLevelLRASGovernment wants to limit unemployment by increasing demandAD 2P2High unemploymentASP1How do they do it?AD 1GDP realQ1Q yFEGov’t can increase gov’t spending or decrease tax on consumers. AD = C I G NEFiscal Policy:Monetary Policy:Federal Reserve can increase money supply or decrease interest rates. AD = C I G NE
15 Supply-side theory in AS/AD/LRAS vSupply side economicsSupports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.This increases potential output3. There are a number of methodsIncrease labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment benefitsInvest in educationLower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)Lower corporate tax ratesInvest in infrastructure4. Eliminate safety nets and allow for profit and loss