1 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter 5 Aggregate Supply and Demand

2 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The aggregate supply–aggregate demand (AS–AD) model is the basic tool for studying output fluctuations and the determination of price levels  The model describes the relationship between overall prices (GDP deflator) and output (real GDP) Aggregate Supply and Aggregate Demand

3 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand Under Alternative Supply Assumptions 5.4Supply-side Economics

4 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The AS curve describes, for each given price level, the quantity of output firms are willing to supply  The AS curve is upward sloping since firms are willing to supply more at higher prices  In the short run the AS curve is horizontal (the Keynesian AS curve)  In the long run the AS curve is vertical (the classical AS curve) 5.1 The Aggregate Supply Curve

5 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz The Aggregate Supply Curve

6 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The classical AS curve  Is vertical, indicating that the same amount of goods will be supplied whatever the price level  Assumption  The labour market is in equilibrium at full employment and all factors of production are fully utilised  Implication  Increases in AD do not increase output but merely raises prices The Classical AS Curve

7 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The level of output corresponding to full employment is called potential GDP  Potential GDP grows over time as the economy accumulates resources and new technologies  This shifts the AS curve to the right over time The Classical AS Curve

8 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The Keynesian AS curve  Is horizontal, indicating firms will supply whatever amount of goods is demanded at the existing price  Assumption  There is unemployment, so firms may obtain as much labour as they want at the current wage  Implication  AD determines the level of output, with prices ‘sticky’ in the short run The Keynesian AS Curve

9 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Vertical or Horizontal?

10 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  At levels of output below potential, the AS is quite flat, as there is little tendency for prices of goods and factors to fall  At levels of output above potential, the AS curve is steep and prices tend to rise continuously  Hence, the effect of changes in AD on output and prices depends on the level of actual output relative to potential output Vertical or Horizontal?

11 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Frictional unemployment  Unemployment due to individuals shifting between jobs and looking for new jobs  Structural unemployment  Unemployment due to a mismatch between the skills of the labour force and the skills demanded by firms  Unemployment is a consequence of technological improvements Types of Unemployment

12 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The natural rate of unemployment (NRU)  The frictional and structural unemployment associated with the full employment level of output  Current estimates of the NRU in Australia are about 6.5% Types of Unemployment

13 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand Under Alternative Supply Assumptions 5.4Supply-side Economics

14 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The AD curve  Shows the combinations of the price and output level at which the goods and money markets are in equilibrium  Is downward sloping because for a given level of nominal money, higher prices reduce the value of the real money supply, which reduces the demand for output  Increases in autonomous AD shifts the AD curve to the right 5.2 The Aggregate Demand Curve

15 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The AD relationship between price and output  Is dependent upon the real money supply  Real money supply is nominal money supply (  ) deflated by the price level (P)  That is:  /P  When P falls, the real money supply rises, interest rates fall and investment rises, causing AD to increase The Aggregate Demand Curve

16 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The quantity theory of money provides a simple analysis of the AD curve M  V = P  Y Where M is the nominal money supply and V is the velocity of money  If we assume that V and M are constant then an increase in output Y must be offset by a decrease in prices P The Aggregate Demand Curve

17 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand Under Alternative Supply Assumptions 5.4Supply-side Economics

18 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 5.3 AD Under Alternative Supply Assumptions

19 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Initial equilibrium is at E where AD and AS intersect (goods and money market equilibrium)  Assume an increase in AD, which shifts AD to AD’  The new equilibrium point is E’ where output has increased  Firms are willing to supply any amount of output at that level of price The Keynesian Case

20 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz The Classical Case

21 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Assume an increase in AD  At the initial level of prices, spending has increased and the economy would tend to move towards point E’  However, firms cannot obtain more labour as the economy is at full employment  Wages are bid up which increases the costs of production  The increase in costs is passed on as higher prices The Classical Case

22 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The increase in prices reduces real money stock and decreases spending  The economy moves up along AD’ until spending has decreased to the level consistent with full employment output at E”  Increases in AD only lead to higher prices, not increases in output The Classical Case

23 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3The Aggregate Demand Under Alternative Supply Assumptions 5.4Supply-side Economics

24 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  Shifting the AS to the right is preferred as it increases potential GDP  There is debate about how best to achieve this increase in AS  Supply-side economics (advocated by George Bush Senior) argue  Cutting taxes will significantly increase AS  This increase will be so large that total tax revenue will rise 5.4 Supply-side Economics

25 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz Supply-side Economics

26 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  The initial tax cut shifts AD to the right  The AS also shifts to the right over time because lower tax rates increase the incentive to work  However, the AD curve shifts by more than the AS curve, since consumer spending increases by more than the increase in potential GDP Supply-side Economics

27 Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz  In the short run  GDP has increased substantially (from E to E’)  This is primarily due to the AD effect  In the long run  The economy moves to E”  GDP has only increased by a small amount, total tax collection falls, the government’s budget deficit rises, and prices are permanently higher Supply-side Economics