2 Overview of the AD – AS Model The Aggregate Demand – Aggregate Supply Model (AD-AS) is a basic model of the macroeconomy that can be used to explain and understand many macroeconomic events.The term “aggregate” in the title means “total”. The Aggregate Demand (AD) side of the model is the total amount of output demanded at a specific price level in the economy.The Aggregate Supply(AS) side of the model is the total amount of output supplied to the economy at a specific price level in the economy.The axis (price level & GDP) represent the important focal points of macroeconomics, namely inflation (price level), output (GDP) and unemployment (implied in GDP).Simply, this basic model contains all of the core ideas studied in macroeconomics – which makes it a very useful.
3 The Aggregate Demand – Aggregate Supply model is a simple but powerful model for understanding the macro economy.The model shows how changes in the economy effect that important statistics that economists track – GDP, unemployment & inflation.The two axis mark the main macroeconomic issues - The vertical axis measures inflation of inflation.The horizontal axis measures GDP as listed, but it also measures unemployment because when GDP is below its potential, it implies that there is unemployment. This means that when GDP goes up, unemployment goes down and vice-versa.
4 Review – Microeconomic Equilibrium Markets are a self-correcting responsive system that uses prices to signal individual economic agents so they can coordinate their actions.Market efficiency – No waste: the quantity produced equals the quantity consumed. Excesses or shortages will cause an adjustment in the equilibrium price.Market shifts – changes in determinants of supply or of demand can affect market equilibrium price.In short, the reason that economists like markets is because it is a way for individuals to act economic betterment in a way that benefits others (larger society) and is responsive to changes in the wider world in a way that cannot be done better through other types of economic institutions.
5 From Equilibrium to “General Equilibrium” Imagine the entire national economy (the macroeconomy) to be the summation of many individual markets – which is called “aggregation”. If all of those individual markets were in equilibrium, then the whole economy would also be in equilibrium – described as a “General Equilibrium”.This views the macroeconomy is being built on the economic choices of individuals and firms sums up to affect the macroeconomy – economists say that it is built on a “microeconomic foundation”. Through this conception of the economy it is understandable how a disturbance in one market could cause changes in other markets – which could change the equilibrium state for the macroeconomy.
6 Difficulty in “Aggregating “the Economy The hard part of making a model of the macroeconomy by summing up markets is that the “price” and “quantity” measures are not really compatible between markets – there is no one “price” in the economy and what use is a numerical “quantity” if you are mixing all types of goods together? For example how would you combine the market for cars with the market for frozen pizza?The process of aggregating means eliminating any of the differences between the goods traded in different markets by harmonizing prices into a “price level” (which means “inflation”) and turning the total quantity of goods in the economy into the total value of goods in the economy (which means GDP).
7 The Aggregate Demand Curve represents consumers, investors & government (and net exports in an open economy).The Aggregate Supply Curve represents the productive ability of the economy.This simple model can be used to see how changes in the productive ability of the economy or the changes in consumption, investment, government spending and taxation, or international trade can affect the whole economy – GDP, unemployment and inflation.The intersection of Aggregate Demand and Aggregate Supply represents the General Equilibrium of the macroeconomy.
8 Price Level and Aggregate Demand The Aggregate Demand Curve shows how changes in the price level will affect Real GDP.Movements along the Aggregate Demand Curve are the result of how changes in the price level cause:The Wealth Effect – effect ability of people to consume more with their existing wealth from assets – lower prices mean more purchasing power with same income.The Interest Rate Effect – effects willingness of people to borrow money and use that money for consumption and investment – lower prices mean lower interest rates result in more investment.The Foreign Substitution Effect – change in relative prices between economies affect people’s decisions to buy goods or from this economy or foreign economies. - lower prices mean foreigners have greater purchasing power, which means increased net exports.
9 Aggregate Supply – Short Run The Aggregate Supply (AS)side of the model is the total amount of output supplied to the economy at a specific price level in the economy. The Aggregate Demand curve shows that as the price level increases, the supply of total output increases.This is for three reasons:Profit Expectations – Higher prices mean higher profits, which will result in more output.Misperception Theory – Firms do not know reason for higher prices, assume increased demand and make more output.Intertemporal Substitution Theory – Workers are willing to work more to take advantage of “good times” and increase output. They will save extra income for “bad times”.
10 Aggregate Supply – Long Run Potential GDPThe long run Aggregate Supply curve is considered the full employment supply curve – the relationship between the price level and output if the economy is at full employment. The long run aggregate supply curve is the same as the frontier of the production possibilities curve Because it represents the full employment of all resources in the economy it is vertical – inelastic at all price levels.The difference between the long-run and short-run Aggregate Supply curves shows that the for short periods of time an economy can produce beyond its productive potential – but is not sustainable into the long-run.
11 General Equilibrium - Theory The macro economy is in “general equilibrium” when the Aggregate Expenditures equilibrium is at the point where Real GDP is equal to Potential GDP. Potential GDP can also be thought of as the “full employment level of output”.Potential GDP represents the “Long Run” Aggregate Supply of the economy.This point of “General Equilibrium” is point “E”.
12 Recessionary Gap – Full Employment – Inflationary Gap Aggregate Expenditure & Aggregate Demand-Aggregate SupplyRecessionary Gap – Full Employment – Inflationary Gap
13 Insights from Aggregate Supply-Aggregate Demand Model The economy is a self-correcting system that will return to General Equilibrium. When the economy is in disequilibrium the result will be higher unemployment or inflation. Individuals across the economy will respond to this situation by adjusting their behavior across markets in the macroeconomy – the “aggregate” response of these individuals will bring the economy back into General Equilibrium where aggregate expenditures will equal real GDP.Price level is the way the economy “self-corrects” for coordination problems. When the economy is in disequilibrium, individuals will respond to it by raising prices (inflation) or lowering prices (for employment this is wages).The debate about whether the government should actively guide this “self-correcting” process hinges on how quickly this process happens – is it an “efficient” process?
14 Macro Movement – Equilibrium & Growth There are two long-term trends in the macroeconomy:# 1 – Equilibrium - The economy is always changing. The AD-AS model is based on the idea that the economy will tend toward general equilibrium. However, this is a constant process of adjustment – it is best to think of general equilibrium as a “gravitational center” for the economy.# 2 – The process of economic growth will move both the AD curve and the AS curve shift to the right. If they shift in a coordinated manner then GDP growth happens without inflation. If the shifts are uncoordinated, then the result can be inflationary or deflationary.
15 Output Gap – A Coordination Failure Economic reality is that Real GDP fluctuates on either side of Potential GDP - called an “output gap”. General equilibrium requires that the Aggregate Demand choices and the Aggregate Supply decisions match - doing this across an whole economy is a difficult process.When this matching process of does not work there is a “coordination failure” resulting in either inflation or unemployment (recession).The primary cause for a macroeconomic coordination failure are “shocks” that cause either the Aggregate Demand or Aggregate Supply curve to shift in a way that people did not expect.
16 Economic Time – Measure of Economic Adjustment Economics is the study of the relationships of cause and effect in economic activity. Basically economists look at how an event causes changes throughout the economy and how the economy adjusts to those changes.Typically, economists look at how unexpected changes (called “shocks”) will affect the economy and then how the economy adjusts and how long this process takes.Economists use the term “short-run” to describe the period of time during which the economy is adjusting and the term “long-run” to describe the period after which the economy has fully adjusted to the “shocks”.Economists are interested in what can be a “shock” to the economy and what things keep the economy from adjusting to the shock, which is called a “friction”.Some of the most important debates between economists are about “shocks” and “frictions”.
17 Disrupting General Equilibrium - Macroeconomic Shocks Macroeconomic shocks are sudden unexpected changes in the economy that can result in an “coordination failure”. A shock can be a “supply side” shock that moves the location of the Aggregate Supply curve or a “demand side” shock that moves the location of the Aggregate Demand curve.Most recessions are the result of six types of macroeconomic shocks. These are:Demand Side Shocks - Monetary policy (caused by changes in interest rates), uncertainty (people holding back on investment or spending) and financial crisis, and fiscal policy (caused by an increase in taxes or cut in government spending).Supply Side Shocks - Oil or energy price changes or technological improvements (which changes productivity across the economy).Some recessions are a combination of these shocks in which the shocks happen simultaneously or one shock triggers another shock.
18 Demand Side ShockA demand side shock will cause the Aggregate Demand curve to sift either inward or outward – this can result in inflation or a recession. These are examples of demand side shocks in the economy.Financial crisis – this can cause the Aggregate Demand curve to shift inward because of a decline in consumption and investment, which will cause unemployment.Fiscal policy – increase in government spending or reduction in taxes will cause the Aggregate Demand Curve to shift outward because of an increase in consumption and investment, which will cause inflation. A decrease in fiscal policy will have the opposite effect.
19 Supply Side ShockA supply side shock will cause the Aggregate Supply curve to sift either inward or outward – this can result in stagflation or low-inflation growth. These are examples of supply side shocks in the economy.Oil Crisis – this can cause the Aggregate Supply curve to shift inward because of a decline in consumption and investment, which will cause unemployment & inflation. A drop in oil prices will have the opposite effect.Technology change – A sudden improvement in technology will push out the Aggregate Supply curve, which will result in increased economic growth and drop in inflation (this was seen in the tech boom of the 1990’s). If technology does not grow (or its rate of growth slows significantly) then the result will be higher unemployment and inflation.
20 Recessionary Gap – Return to Equilibrium An recessionary gap is when Aggregate Expenditures equilibrium GDP is less than Potential GDP.Reasons :Consumers or investors hold back on spending.Government spending is too low.Foreign demand is low (exports are less than imports).Current price level is too high.The economy adjusts to an recessionary gap through a decrease in the price level as producers in markets across the economy cut costs and unemployed workers accept lower wages for work. This decrease in the price level (deflation) will cause the Aggregate Expenditures curve to shift downward and the economy will return to general equilibrium at the level of Potential GDP.
21 Macro Process - Steps in Closing Recessionary Gap When an economy is suffering a recessionary gap because of insufficient aggregate demand:The level of wages and prices will go down as workers and business compete to gain employment and business.Lower price levels will shift the Aggregate Supply curve to the right until AD-AS equilibrium GDP is at Potential GDP.Result is Real GDP at the level of potential GDP with a lower price level.
22 Inflationary Gap – Return to Equilibrium An inflationary gap is when Aggregate Expenditures equilibrium GDP is greater than Potential GDP.Reasons :Consumers or investors spend too much.Government spending is too high.Foreign demand is high (exports are greater than imports).Current price level is too low.The economy adjusts to an inflationary gap through a increase in the price level as producers in markets across the economy raise their prices. This increased price level (inflation) will cause the Aggregate Expenditures curve to shift downward and the economy will return to general equilibrium at the level of Potential GDP.
23 Macro Process - Closing Inflationary Gap When an economy is suffering an inflationary gap because of too much aggregate demand:The level of wages and prices will go up as workers and business demand higher compensation.Higher price levels will shift the Aggregate Supply curve to the left until AD-AS equilibrium GDP is at Potential GDP.Result is Real GDP at the level of potential GDP with a higher price level.
24 Price Level to Real GDP growth in the United States The Historical Data shows two clear phases:Stagflation (stagnant economic growth and increasing inflation) during the 1970’s – Ended by the Federal Reserve in“Great Moderation” (low inflation and steady economic growth) beginning in 1982 to 2007.
25 Economic Growth & Inflation – Price Stickiness The historical statistical evidence shows that the economy tends to higher GDP and higher price level over time. Only during periods of great economic dislocation does the GDP shrink and at no point does the price level go down.The reason for the upward progression in prices is due to difficultly of lowering prices and wages – even during difficult recessions, business are more willing to live with unsold inventory than lower prices and workers are more tolerant of unemployment than they are willing to cut their wages. Economists use the term price and wage “rigidity” or “stickiness” to describe this process. The slow adjustment of wages to a shock represents a “friction” in the process of returning to general equilibrium.This means that process described by economic theory does not happen or happens slowly. This means that the economy my not be efficient in recovering from a negative shock.
26 Recent Evidence of Wage Stickiness The 2008 economic downturn marked the worst recession since the Great Depression – unemployment went up to 10% and it has taken years to come down to 5.8%.The chart to the right shows how most workers have seen either no pay raise or only a small pay raise during this time. This supports the idea of “wage stickiness” – workers resist pay cuts.The reality of wage stickiness, which effects efficiency in the labor market, means that the macroeconomy does not efficiently return to general equilibrium after a macroeconomic shock. This opens the possibility for activist monetary policy (fiscal or monetary policy) to help the economy return to general equilibrium.