1. AS/AD, the Multiplier, the Phillips Curve
Chapters 10 and 8

2. Aggregate Demand Aggregate Demand (AD)
Curve that shows the amount of real output (Real GDP) that buyers collectively desire to purchase at each possible price level
Demand for all goods combined (aggregate)

3. AD cont. Downward sloping curve
Not for the same reasons as demand (income and substitution effects)
Real-balances effect
Increases in PL erode savings and make people less likely to purchase things
Interest-rate effect
High prices raise interest rates and make it more difficult to get loans to make purchases or invest in a business
Foreign purchases effect
High domestic prices make it more likely that Americans will buy foreign products and foreigners will not buy American products

4. AD cont. Movement along a curve
PL changes lead to movements along the AD curve

5. AD cont. Changes in determinants of AD lead to shifts. C + I + G + Xn
If any increase without a change in PL, AD shifts
Consumer spending
Real consumer wealth
Stocks, bonds, housing, land
Consumer expectations
Expect wealth to increase or expect inflation
Household debt
Increases in debt raise AD
Taxes
Reducing personal income taxes raises AD
Demand-side Policies
Interest rates
Make it cheaper or more expensive to borrow money to consume

6. AD cont. Changes cont. Investment spending
The Demand of investment comes from the expected returns of investment
Future business conditions
Technology
Excess capacity
Increases lead to reduced expected returns
Business taxes
Increase taxes lowers expected returns
Interest rates
Effect of real interest rates
Increase in real interest rates reduces investment spending

7. AD cont. Changes cont. Government Spending Net exports
All increases in spending (transfer payments or goods and services) will raise AD as long as tax or interest rates do not change
Net exports
Rising national income abroad raises AD
Tastes for American goods
Exchange rates
Depreciating currency raises AD
Makes American goods cheaper
Makes foreign goods expensive

8. Aggregate Supply Aggregate Supply (AS)
Level of real domestic output producers will produce at a given price level
Short Run VS Long Run
SRAS is when input prices (usually nominal wage) do not match price level changes
LRAS is when input prices (usually nominal wages) do match price level changes

9. AS cont.
SRAS
Input prices like nominal wages do not immediately adjust to inflation
Sticky wages and prices theories
Say prices double. Will profit increase in the short run?
Why or why not?
Profit will increase, leading to greater output by firms. Thus, the curve is upward sloping.
Per-unit production cost=(total input cost)/(units of output)
Per unit costs rise as output expands, but the rate of increase rises as output gets closer to LRAS and then goes past it. Thus, the SRAS curve gets more vertical
Think about what this means on a PPC

10. AS cont. Shape of SRAS Curve Horizontal Vertical High unemployment
Price level and wages change slowly with output
Vertical
Low unemployment
Nominal wages adjust more quickly to changes in price level

11. AS cont.
Changes in SRAS
Anything that makes it harder or more expensive for businesses to produce causes SRAS to decrease and anything that makes it easier or less expensive to produce causes SRAS to increase.
Producer expectations about price
Same effects as their impacts on Supply
Input price changes
Domestic (land and labor) or international resources
Market or Monopoly power (OPEC) of sellers
Positive or Negative Supply Shocks
Legal-institutional environment
Business taxes and subsidies
“Supply-side” Economics
Business taxes change AD AND SRAS!
Regulation
Productivity

12. AS cont.
LRAS
As inflation occurs input prices and wages adjust, but it takes time
Thus, it is a long run change
Say prices double, will profit increase in the long run?
Why or why not?

13. AS cont.
Price does not affect output in the long run, so the LRAS curve is vertical at potential output for the economy
Think about what this means on a PPC

14. AS cont. Changes in LRAS and SRAS
Economic Growth leads to increases in LRAS and PPC
Availability of resources
Increases in capital stock due to increased investment in the long run
Policy incentives
Policies that provide incentives to quickly find a job or invest in capital or technology
Changes in the labor force participation rate
Productivity and Technology
Productivity=(total output)/(total input)
Increase in productivity leads to decrease in per-unit costs
Net Investment
Negative causes negative growth while positive causes positive growth
If capital depreciates faster than new investment occurs, then capital becomes less productive

15. Shifts and Equilibrium
Intersection point
Price Level
Real output
Both change with changes in SRAS, LRAS, or AD
Long-Run Equilibrium
When SRAS, LRAS, AD are in equilibrium

16. Long-Run Equilibrium Price Level Short-run aggregate supply, AS
demand, AD A P Y
Quantity of
Output
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17. Shifts and Equilibrium cont.
When SRAS and AD are not in equilibrium with LRAS, a recessionary gap or inflationary gap occur.
Difference between potential and actual output
Recessionary Gap
SRAS/AD equilibrium is the left of LRAS
PPC Graph?
Economy is operating below full capacity
Unemployment is above NRU
Inflationary Gap
SRAS/AD equilibrium is the right of LRAS
Economy is operating above full capacity
Unemployment is less than NRU

18. AS/AD cont. Increase in AD Decrease in AD Demand-pull inflation
If we are at pull employment and businesses/governments/households increasing spending or invest AD shifts and causes PL to rise
Decrease in AD
Recession and unemployment
GDP decreases and inflation decreases

19. AS/AD cont. Increase in AS Decrease in AS
Increases in output and stability in prices
The best of all possible scenarios!
1990s
Decrease in AS
Cost-push inflation
Stagflation

20. A Contraction in Aggregate Demand
causes output to fall in the short run . . .
Price
Level
Short-run aggregate
supply, AS
Long-run
aggregate
supply
Aggregate
demand, AD
AS2
AD2
but over
time, the short-run
aggregate-supply
curve shifts . . . A P Y B P2 Y2
1. A decrease in
aggregate demand . . . C P3
and output returns
to its natural rate.
Quantity of
Output
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21. Savings/DI/Consumption
Gross income is income before taxes and disposable income is income after taxes.
Disposable Income = Consumption + Savings
Income has the biggest impact on savings
As all incomes rise, we expect total consumption to increase.
Dissaving
Spending more than income after taxes
Liquidate assets or borrow
Break-even income
Income at which households plan to consume their entire incomes

22. APC/APS Average Propensity to Consume (APC)
APC = (consumption) / (income)
Percentage of total income consumed
Average Propensity to Save (APS)
APS = (saving) / (income)
Percentage of total income saved
APC + APS = 1

23. MPC/MPS
Just because we save or consume at a certain level now does not guarantee we will consume/save at the same level if income increases or decreases in the future
Marginal Propensity to Consume (MPC)
Tells us how much more you will consume if you earn an additional dollar
MPC = (Change in consumption) / (Change in income)
Falls as individuals become wealthier. Why?
Marginal Propensity to Save (MPS)
Tells us how much you will save if you earn an additional dollar
MPS = (change in saving) / (change in income)
Rises as individuals become wealthier. Why?
MPC + MPS = 1

24. Changes in Consumption and Saving
DI changes consumption and savings, but other things can also change it
Wealth Effect
People see increases in their wealth (home prices rising, stocks and bonds rising) so they spend more
Expectations about recessions and expansions
Real Interest Rates
Household Debt
Changes consumption and savings in opposite directions
Taxation
Lowers both

25. The Multiplier Effect
Spending has a multiplier effect on the economy because consumption increases as income increases.
In other words, one person’s consumption becomes another’s income. There’s a multiplier effect!
Spending Multiplier = 1 / (1 – MPC)
AKA expenditures multiplier OR Simple Spending Multiplier
Tells us how any change spending (government, investment, exports, consumption) can ultimately change AD and GDP.
Taxing Multiplier = -MPC / (1-MPC)
Which is bigger, spending or taxing?
MPC determines the size of the multipliers!

26. Unemployment and Inflation
Society faces a short-run tradeoff between unemployment and inflation.
If aggregate demand expands, it can cause lower unemployment, but only at the cost of higher inflation.
If aggregate demand contracts, it can cause lower inflation, but at the cost of temporarily higher unemployment.

27. THE PHILLIPS CURVE
The Phillips curve illustrates the short-run relationship between inflation and unemployment.

28. The Phillips Curve Inflation Rate (percent Phillips curve per year) 4B 6 7 A 2
Unemployment
Rate (percent)
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29. Aggregate Demand, Aggregate Supply, and the Phillips Curve
The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

30. Aggregate Demand, Aggregate Supply, and the Phillips Curve
The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.
A higher level of output results in a lower level of unemployment.

31. How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve
Price
Inflation
Level
Short-run
aggregate
supply
High
aggregate demand
Rate
(percent
Phillips curve
per year)
Low aggregate
demand
(output is
8,000) B 4 6
8,000
(unemployment
is 4%)
106 B
(unemployment
is 7%)
7,500
102 A
(output is
7,500) A 7 2
Quantity
Unemployment
of Output
Rate (percent)
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32. The Long-Run Phillips Curve
In the 1960s, Friedman and Phelps concluded that inflation and unemployment are unrelated in the long run.
As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

33. The Long-Run Phillips Curve
Inflation
Rate
Long-run
Phillips curve B
High
inflation
1. When AD
Increases,
the rate of
inflation
Increases…
but unemployment
remains at its natural rate
in the long run.
Low
inflation A
Natural rate of
Unemployment
unemployment
Rate
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34. How the Phillips Curve is Related to Aggregate Demand and Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve
Price
Long-run aggregate
Inflation
Long-run Phillips
Level
Rate
supply
curve
1. An increase in
aggregate demand
and
increases the
inflation rate . . .
AD2 P2 B B
raises
the price
level . . . A P A
Aggregate
demand, AD
Natural rate
Quantity
Natural rate of
Unemployment
of output
of Output
unemployment
Rate
but leaves output and unemployment
at their natural rates.
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35. Expectations and the Short-Run Phillips Curve
Expected inflation measures how much people expect the overall price level to change.
In the long run, expected inflation adjusts to changes in actual inflation. (Think SRAS shifting to get us back to Long Run Equilibrium)

36. How Expected Inflation Shifts the Short-Run Phillips Curve
but in the long run, expected
inflation rises, and the short-run
Phillips curve shifts to the right.
Inflation
Rate
Long-run
Short-run Phillips curve
with high expected
inflation
Phillips curve C
Short-run Phillips curve
with low expected
inflation B
1. Increase in AD moves
the economy up along the
short-run Phillips curve . . . A
Natural rate of
Unemployment
unemployment
Rate
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37. The Natural Experiment for the Natural-Rate Hypothesis
The view that unemployment eventually returns to its natural rate, regardless of the rate of inflation, is called the natural-rate hypothesis.
Historical observations support the natural-rate hypothesis.

38. The Natural Experiment for the Natural Rate Hypothesis
The concept of a stable Phillips curve broke down in the in the early ’70s.
Stagflation
During the ’70s and ’80s, the economy experienced high inflation and high unemployment simultaneously.

39. The Phillips Curve in the 1960s
Inflation Rate
(percent per year) 10 8 6
1968 4
1966
1967 2
1965
1962
1964
1961
1963 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
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40. The Breakdown of the Phillips Curve
Inflation Rate
(percent per year) 10 8 6
1973
1970
1971
1969 4
1968
1972
1966
1967 2
1965
1962
1964
1961
1963 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
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41. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS
The short-run Phillips curve can shift due to changes in expectations.
The short-run Phillips curve also shifts because of shocks to aggregate supply.
Major adverse changes in aggregate supply can worsen the short-run tradeoff between unemployment and inflation.
An adverse supply shock gives policymakers a less favorable tradeoff between inflation and unemployment.

42. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS
A supply shock is an event that directly alters the firms’ costs, and, as a result, the prices they charge.
This shifts the economy’s aggregate supply curve. . .
. . . and as a result, the Phillips curve.

43. An Adverse Shock to Aggregate Supply
(a) The Model of Aggregate Demand and Aggregate Supply
(b) The Phillips Curve
Price
Inflation
giving policymakers
a less favorable tradeoff
between unemployment
and inflation.
Level
AS2
Rate
Aggregate
PC2 B
supply, AS
1. An adverse
shift in aggregate
supply . . . B P2 Y2
and
raises
the price
level . . . P A Y A
Aggregate
demand
Phillips curve, P C
Quantity
Unemployment
lowers output . . .
of Output
Rate
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44. SHIFTS IN THE PHILLIPS CURVE: THE ROLE OF SUPPLY SHOCKS
In the 1970s, policymakers faced two choices when OPEC cut output and raised worldwide prices of petroleum.
Fight the unemployment battle by expanding aggregate demand and accelerate inflation.
Fight inflation by contracting aggregate demand and endure even higher unemployment.

45. The Supply Shocks of the 1970s
Inflation Rate
(percent per year) 10
1981
1980
1975
1974
1979 8
1978 6
1977
1976
1973 4
1972 2 1 2 3 4 5 6 7 8 9 10
Unemployment
Rate (percent)
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46. THE COST OF REDUCING INFLATION
To reduce inflation, AD would need to shift to the left.
This leads to a rise in unemployment.

47. Disinflationary Monetary Policy in the Short Run and the Long Run
1. A decrease in AD moves
the economy down along the
short-run Phillips curve . . .
Inflation
Long-run
Rate
Phillips curve
Short-run Phillips curve
with high expected
inflation A
Short-run Phillips curve
with low expected
inflation C B
but in the long run, expected
inflation falls, and the short-run
Phillips curve shifts to the left.
Natural rate of
Unemployment
unemployment
Rate
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48. THE COST OF REDUCING INFLATION
To reduce inflation, an economy must endure a period of high unemployment and low output.
The economy experiences lower inflation but at the cost of higher unemployment.