1. Supply and Demand graphs- The Basics
Price
The purpose of this graph is to look at markets. Free Market Price and Quantity
Supply
P e
Demand
Q e Q

2. The Aggregate Market- The Basics
Long Run Aggregate Supply (LRAS) Qy
Qy= Quantity at full employment
Aggregate- all together (total)
Price Level
Measure of Inflation
Aggregate Supply (AS)
The purpose of this graph is to look at countries. Total supply and demand at full employment
P e
AD= Aggregate Demand
AD= GDP= C + I G + NX
Aggregate Demand (AD)
Q e
G.D.P real
employment
You 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 up
The law of supply is the same
There is a direct relationship- PL up, AS up, PL down AS down

3. Conflicting Views Classical Views Keynesian Views
F.A. Hayek
Neo-Classical
Austrian
Monetarist
Supply-siders
Less Government
John M. Keynes More Government
Micro not Macro
Keynesians
Neo-Keynesians Increase Gov’t
Demand-siders spending
Fiscal Policy
Equilibrium of market
Increase consumer or Investments
1. 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 problem
1. 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 output
3. “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 run
Savings-investment equality-any decrease in output because of savings is offset an increase in the demand for investment
This creates a different market – the money market
Investment is demand
Savings is Supply
Interest rates create equilibrium- Monetarist
4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending
5. 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 Market
Wages
(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 2
W e
Classical (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 1
Q 1
(AD) 1
(AD) Q
Employment

5. Aggregate Supply (The classical model)
The whole purpose of these graphs is to find the Price level, GDP, and unemployment
AS is vertical and at the same point of full employment
Classical economist believe that resources prices and wages are flexible
This model says that the government doesn’t need to get involved because the market will fix itself.
(AS) much like the LRAS
P.L.
(AD) 1
P 1
P e
What 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 y
G.D.P real
When 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 AD
There will be a reduction in price level and higher unemployment
P 1
Q 1
LRAS
P.L.
SRAS
Q 2
According to classical economist the SRAS will eventually increase as wages decrease and the price of resources decrease
This will give you a new quantity demanded back at full employment
SRAS 1
P e
(AD)
(AD) 1
This 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 y
G.D.P real
Whether or not the market will clear will also depend on the worker’s wage expectations.
Unions
Rational Expectations
Workers will revise their expectations instantaneously
Adapted Expectations
It may take workers weeks, months, or years but eventually they will adapt their wage expectations.
Min. Wage laws
Unemployment benefits

7. Aggregate Supply (The Keynesian Model)
LRAS
P.L. Y1
According 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) 1
P e
(AD)
Q y
full
G.D.P real

8. Aggregate Supply (The Keynesian Model)
LRAS
P.L.
(AD) 5
(AD) 4
(AD) 3
(AD) 2 Y1
According to Keynes, only with the help of the help of the government can Aggregate demand increase.
Demand side economics- focus on demand
Fiscal approach- government spending and taxation
Monetarist approach is to increase investments
(AD) 1
P e
Q y
full
G.D.P real
Any aid past Qy- is purely inflationary

9. Aggregate Supply – So what Model is correct?
They Both have some valid points
LRAS
Classical
Phase AD
When in the Classical Phase
The economy is operating at full employment
Any and all increase in AD will result in an increase in price and in increase in inflation
P.L.
Intermediate
Phase AD
When in the Intermediate Phase
As AD approaches the curve
An increase in AD and decrease in unemployment
Result in a gradual increase of price and some inflationary pressure
Keynesian
Phase AD
When in the Keynesian Phase
Output can increase with no change in price.
No increase in price level, no inflationary pressure, spare room to grow.
P e
Q y
full
G.D.P real

10. AS/AD/LRAS graphs- how it works during Expansion
If Aggregate Demand increases
(AS) 1
(LRAS) Qy
P.L.
(AD) 1
Both Prices and GDP will increase.
(AS)
P 2 C
In the long run – an increase in price will not lead to an increase in output.
Why?
P 1
Q 1 B
P e A
Because as prices increase so does the price of resources including labor, wages, and materials.
(AD)
Q e
G.D.P real
As 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 RecessionQy
If Aggregate Demand decreases.
P.L.
(AS)
Both Price Level and output will decrease.
(AS 1)
P 2
In the long-run a decrease in price will not lead to a decrease in output.
Why?
(AD) 1
P e A
Q 1
P 1 B
Because as prices decrease so does the price of resources including labor, wages, and materials. C
(AD)
Q e
G.D.P real
As 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
Potential
GDP
Economic
Activity
Inflationary Gap
Recessionary Gap
Time (years)
The Government can steer the economy in different ways
Laws and Regulations- stabilizers
Fiscal Policy- changes in government spending or taxation to influence the economy
Monetary policy- changes in monetary supply to influence the economy

13. AS/AD/LRAS graphs- Inflationary Gap
Actual GDP > Potential GDP
Output is beyond full employment
Price
Level
LRAS AS
Unemployment very low
Prices very high
Government wants to limit inflation by reducing demand
AD 2 P2 P1
How do they do it?
AD 1
GDP real
Q y FE Q1
Fiscal Policy:
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C I G NE
Monetary 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 GDP
Output is below full employment
Price
Level
LRAS
Government wants to limit unemployment by increasing demand
AD 2 P2
High unemployment AS P1
How do they do it?
AD 1
GDP real Q1
Q y FE
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C I G NE
Fiscal 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/LRASv
Supply side economics
Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.
This increases potential output
3. There are a number of methods
Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment benefits
Invest in education
Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)
Lower corporate tax rates
Invest in infrastructure
4. Eliminate safety nets and allow for profit and loss

19. Phillips Curve and problems with curve