AGGREGATE SUPPLY AGGREGATE DEMAND AS-AD MODEL

AS-AD Model Aggregate Supply (AS) captures the production and pricing decisions by firms. Aggregate Demand (AD) captures aggregate spending decisions. The AS-AD Model focuses on aggregate expenditures as the primary determinants of short-run income. It consists of three curves: Short-run aggregate supply curve (SRAS). Long-run aggregate supply curve (LRAS). Aggregate Demand Curve.

AS-AD Model Unlike the micro supply/demand model, the AS-AD Model deals with the general price level and aggregate output in the economy as opposed to single good prices & quantities historical model: starts at a particular point in time and says what will likely happen when changes affect the economy

AS-AD Model Assumptions Prices variable. Wages variable. Interest rate & MS variable. Level of economic activity determined by interaction of AD and AS.

AD Curve Indicates the various quantities of domestically produced goods & services that purchasers are willing to buy at different price levels. The AD curve slopes downward to the right due to: wealth effect: ↓P→↑real wealth→↑C interest rate effect: ↓P→i→↑(C&I) international effect: ↓P→RER depn→↑(X-M) multiplier effect

AD Curve Diagram Real GDP (Y) Price Level AD P2 Y1 Y2 P1 When general price level in the economy declines from P1 to P2, the quantity of goods & services purchased will increase from Y1 to Y2.

Shifts in AD A shift in the AD curve means that at every price level, total expenditures have changed Anything other than the price level that changes components of AD (C, I, G, (X-M)) will shift the AD curve There are five main shift factors Foreign income Exchange rates Expectations Distribution of income Government policies Due to the multiplier, the AD curve may shift by more than the amount of the initial shift factor.

Aggregate Supply Shows amount of goods and services that firms are willing to supply at different price levels The AS curve can have three ranges: Perfectly elastic part (Keynesian) – increase in AD increase output with no price increase. Intermediate (upward sloping) part – increase in AD increases both output and prices. Perfectly inelastic part (Classical) – increase in AD increase prices with no output increase. This is illustrated below

The AS Curve AS Price Level (P) Classical Intermediate Keynesian Real GDP (Y) Price Level (P) AS Keynesian Intermediate Classical

Short & Long-Runs When considering the AS curve, distinguish between the short-run and the long-run. Short-run: Period of time during which some prices, particularly those in resource markets, are set by prior contracts and agreements. Therefore, in the short-run, households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level. Long-run: Period of time of sufficient duration that people have the opportunity to modify their behavior in response to price changes.

SRAS Curve Indicates various quantities of goods and services that domestic firms will supply in response to changing demand conditions in the short run, ceteris paribus. Slopes upwards reflecting the fact that, in the short-run, an unanticipated increase in the price level will improve the profitability of firms. Firms respond to this increase in the price level with an expansion in output.

SRAS Curve Diagram Real GDP (Y) Price Level SRAS P105 P100 P95 Y1 Y2 Y3 In the SR, firms expand output as price level increases because higher prices improve profit margins since many components of costs will be temporarily fixed as the result of prior long-term commitments.

Shifts in the SRAS Curve Factors that lead to a shift in the SRAS include: Changes in input prices Changes in expectations about inflation Excise and sales taxes Import prices Productivity

LRAS Curve Relationship between the price level & output after decision makers have had sufficient time to adjust their prior commitments where possible. LRAS is related to the economy's production possibilities constraint. A higher price level does not loosen the constraints imposed by the economy's resource base, level of technology, and the efficiency of its institutional arrangements. Therefore, an increase in the price level will not lead to a sustainable expansion in output. Thus, the LRAS curve is vertical.

(full employment rate of output) LRAS Curve Diagram Real GDP (Y) Price Level LRAS YF (full employment rate of output) Potential GDP P2 P1 In the LR, a higher price level will not expand an economy’s rate of output. Once people have time to adjust their long-term commitments, resource markets (and costs) will adjust to the higher levels of prices and thereby remove the incentive of firms to continue to supply a larger output.

Shifts in the LRAS Curve The LRAS shifts for the same reasons that potential output shifts, i.e. due to changes in the Capital stock Available resources Growth-compatible institutions Technological progress Entrepreneurship An increase in the above shifts the LRAS to the right and vice versa

SR Equilibrium in the Economy Occurs at the price level where AS=AD. Amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply during the current period.

Short-Run Equilibrium Diagram 5/23/2018 Short-Run Equilibrium Diagram AD SRAS P Y Real GDP (Y) Price Level Below P, excess demand → P↑. Above P, excess supply →P↓.

Shift in the AD AD1 SRAS P Y Real GDP (Y) Price Level AD2 P1 Y1 A B

Shift in the SRAS AD SRAS1 P Y Real GDP (Y) Price Level SRAS Y1 P1 D C

Long-run Equilibrium At LR equilibrium: Potential GDP = maximum sustainable output. Economy is at FE. Unemployment = natural rate of unemployment. AD = SRAS = LRAS

(full employment rate of output) 5/23/2018 Long-Run Equilibrium AD100 P Real GDP (Y) Price Level Y LRAS YF (full employment rate of output) When the anticipated price level is attained, output YF = potential GDP. FE is achieved.

(full employment rate of output) Shift in AD AD1 P1 Real GDP (Y) Price Level Y LRAS YF (full employment rate of output) P2 AD2

Short & Long Run Framework 5/23/2018 Short & Long Run Framework SRAS100 AD100 P100 Real GDP (Y) Price Level Y LRAS YF (full employment rate of output) A SR & LR equilibrium; AD = SRAS = LRAS. Growth & unemployment at their target rates. Minimal or no inflation.

Recessionary Gap Price Level Real GDP (Y) P1 PF Y1 YF LRAS SRASo SRAS1 AD PF Real GDP (Y) Price Level Y LRAS YF P1 Y1 Recessionary gap SRAS1 B A

Recessionary Gap Wages & costs will fall due to excess supply of factors of production. SRAS shifts from SRAS0 to SRAS1 (laissez faire). However, Govt institutes policies that increase AD, thus eliminating the recessionary gap while maintaining a constant price level.

Inflationary Gap Price Level Real GDP (Y) SRAS0 AD1 PF LRAS YF P1 D C

Factor prices rise and SRAS shifts (laissez faire). Inflationary Gap Economy will not stay at C for long due to pressure on resources; factor prices bid up . Factor prices rise and SRAS shifts (laissez faire). However, Govt may not wait. Will institute AD policy.

Summary AS/AD Model SHAPE DETERMINANTS SHIFTS AD Downsloping: As price level declines, expenditure rises The wealth, interest rate, international and multiplier effects Sudden changes in C, I, G, or (X-M) caused by changes in foreign income, expectations, exchange rates, monetary & fiscal policy SRAS Upsloping: Price level rises as output increases. Firm behaviour. Most firms change production instead of price when demand changes. Some firms will raise prices when output increases Input price increases shift the SRAS up. Decreases in input prices shift the SRAS curve down LRAS Vertical: Price level changes have no effect on output. Potential output is output that the economy can produce when labour and capital are fully utilized. Not affected by prices Anything that increases potential output, such as increases in available resources & technological innovation