Title: Aggregate Supply and Aggregate Demand
1Aggregate Supply and Aggregate
Demand
11
CHAPTER
2Thread
- By now the IS/LM model is familiar to you as a
- theoretical perspective on the economy
- and a guide to interpreting economic policy
- We have made one key assumption that the overall
price level is constant - This condition is now dropped
- We will have three shock absorbers real
interest rates r, real output (Y) and the price
level P
3Objectives you should be able to
- Derive and AD curve, and describe what factors
affect its shape and cause it to shift - Derive the AS curve, also describe the factors
affects its shape and shifts it - Use the AD/AS model to interpret the economy and
suggest policies in light of shocks - Describe how expectations play a role in the
economy
4Aggregate Demand
- The aggregate demand (AD) curve shows the
combinations of price levels and income levels at
which the goods and money market are both in
equilibrium. - The aggregate demand curve shows an inverse
relationship between the price level and income
levels because of the - Interest rate effect
- International effect
5The Interest Rate Effectcash balance approach
-- ignore
The price level increases
Real money balances decrease
People sell bonds to increase money balances
Bond prices fall and interest rates increase
Investment decreases, which decreases total
expenditures
6Interest Rate Effecttransactions approach
r
r
LM1
LM2
M1/P1
M1/P2
r2
r1
Md(Y1)
Y1
Y
7The International Effect
The price level increases
The real exchange rate rises
Exports become more expensive and decrease
Imports become cheaper and increase
Net exports decrease, which decreases total
expenditures
8Interest Rate and International Effects
LM1 (PP1)
LM0 (PP0)
Real Interest Rate ()
B
C
A
IS0 (PP0)
IS1 (PP1)
Aggregate Output
Y2
Y1
Y0
9From IS/LM to AD
LM2 (PP2)
LM1 (PP1)
LM0 (PP0)
Real Interest Rate ()
B
C
A
IS0 (PP0)
IS1 (PP1)
IS2 (PP2)
Real Output, Income
Y2
Y1
Y0
C
P2
B
Price Level
P1
Aggregate Demand
A
P0
Real Output, Income
Y2
Y1
Y0
10The Slope of AD
- The AD Curve is flatter if
- The interest rate effect is larger
- The international effect is larger
- The marginal propensity to consume and the
multiplier are larger
11Shifts in the AD Monetary Policy
LM0 (P0)
LM1 (P0)
A
Real Interest Rate ()
1. Expansionary monetary policy shifts the LM
curve to the right.
B
IS
Real Output, Income
Y0
Y1
2. Equilibrium income rises at every price
level. The AD curve shifts to the right, too.
Price Level
B
Aggregate Demand
P0
A
Real Output, Income
Y1
Y0
12Shifts in the AD Fiscal Policy
LM0 (P0)
B
1. Expansionary fiscal policy shifts the IS
curve to the right.
Real Interest Rate ()
A
IS1(P0)
IS0(P0)
Real Output, Income
Y0
Y1
2. Equilibrium income rises at every price
level. The AD curve shifts to the right, too.
Price Level
B
Aggregate Demand
P0
A
Real Output, Income
Y1
Y0
13Group Exercise
- Select news article connected with fiscal policy
maybe the war
14Aggregate Supply in the Short Run
- The aggregate supply (AS) curve shows how the
price level responds to changes in aggregate
output. - AS is positively sloped because
- as firms produce more they demand more inputs
- the market supply of factors of production is
positively sloped - firms costs increase
- firms respond by raising prices resulting in an
upward sloping AS
15Factors that Shift the AS Curve
- Factors that reduce the costs of production,
independent of demand, shift the AS to the right - Increases in productivity tech. change
- Factors that increase the costs of production,
independent of demand, will shift AS to the left - Workers negotiate for higher wages because they
expect increases in inflation - Adverse supply shocks - natural disasters or oil
supply disruptions, that increase costs of
important inputs
16The AS Curve - Its Slope and Shifts
AS1
1. The AS curve shifts up when input costs
rise independently of demand.
2. Demand for inputs rises, increasing
their prices. As input prices rise, so do
product prices.
Aggregate Supply
AS0
Price Level
Price Level
AS2
P1
P0
2. The AS curve shifts down when worker
productivity rises.
1. As real output rises.
Real output, Income
Real output, Income
Y1
Y0
17Short Run Equilibrium AD Increases
1. The economy is in equilibrium at A and
expansionary monetary policy increases AD to AD1.
Aggregate Supply
Price Level
B
2. If prices are constant, income increases to
Y2.
P1
A
P0
AD1
3. With flexible prices, output increases only
to Y1.
AD0
Real output, Income
Y2
Y1
Y0
18Short Run Equilibrium AS Decreases
1. The economy is in equilibrium at A and a
significant portion of capital is damaged by an
earthquake.
AS1
AS0
Price Level
B
2. This increases production costs and shifts AS
to AS1.
P1
A
P0
3. The economy moves to B with higher prices and
lower output.
AD
Real output, Income
Y0
Y1
19Long Run Equilibrium AD Increases
Potential Output
Price Level
C
P2
A
P0
AD1
AD0
Real output, Income
Y0
20Long Run Equilibrium AS Decreases
AS1
AS0
Price Level
C
P2
B
P1
P0
AD
Y0
Real output, Income
Y1
21Alternative Adjustment to Long-Run Equilibrium
AS0
AS1
Price Level
P0
P1
A
B
P2
AD
Real output, Income
Y0
Y1
22Alternative Adjustment to Long Run Equilibrium
Potential Output
Price Level
AS0
C
P0
P1
A
AD1
AD0
Y0
Y1
Real output, Income
23Why Output Deviates From Potential and the AS is
Positively Sloped
- Worker Misperception Model
- Workers supply more labor when nominal wages
increase even if real wages have not - Imperfect Information Model
- Firms respond to nominal price increases of their
product by producing more even if its relative
price is the same - Sticky Wage and Price Model
- Firms have contractual relations with customers
and do not raise prices, even if demand
increases.
24Aggregate Demand Management
- Offsetting Aggregate Demand Shocks
- Offset negative shocks that push output below
potential with expansionary monetary and fiscal
policy - Offset positive shocks that push output above
potential with contractionary monetary and fiscal
policy - Offsetting Aggregate Supply Shocks
- Adverse AS shocks cause stagflation- simultaneous
inflation and decreases in output - Stagflation creates a policy dilemma, requiring a
choice between more inflation or increasing output
25Adjustment After an Adverse Supply Shock
Potential Output
AS1
Price Level
AS0
P2
C
P1
B
P0
A
AD1
AD0
Y0
Y1
Real output, Income
26Reasonable Expectations
- Most people form reasonable expectations -
expectations based on relevant information. - People form expectations with a combination of
extrapolations from the past and predictions of
the future, based on theory. - People will not make the same mistakes over and
over again in forming their expectations.
27Rational Expectations
- Rational expectations are expectations based on
the predictions of an economic model. - The economic model distinguishes rational
expectations from reasonable expectations. - People figure out economic models an base their
expectations on them.
28Policy and Expectations
- The more stable the economy and the more
consistently policy impacts the economy, the more
reasonable expectations become rational
expectations. - The distinction between rational and reasonable
expectations is important in determining policy
effects - Rational expectations AD policy affects only
the price level, not real output - Reasonable expectations AD policy may work
because the model changes
29An Unconventional View of Expectations and AD/AS
- Aggregate demand policy matters in both the short
run and the long run. - There are many levels of potential output which
can be equilibrium, depending on aggregate
demand. - High aggregate demand can cause technological
change which can increase potential output.
30Inflation in the AS/AD Model
Potential Output
AS1
Price Level
AS0
P1
B
P2
C
AD1
A
P0
AD2
AD0
Real output, Income
Y0
Y1
31The U.S. Economy at the End of the 1990s
Potential Output
Potential Output
Price Level
Price Level
AS
AS
B
B
P1
P1
P0
P0
A
A
AD1
AD1
AD0
AD0
Y0
Y1
Y1
Y0
Real output, Income
Real output, Income
The Conventional View
The Unconventional View
32Short-Run Models and Theories
IS/LM
Summary A short-run model of real output. Real
output is determined by the level of expenditures
(aggregate demand). The two components are the
IS curve (goods market equilibrium) and the LM
curve (money market equilibrium).
Key Policy Implications Government can smooth
business cycles by using monetary and fiscal
policy.
Key Predictions Fiscal policy and monetary policy
can directly affect real output. Expansionary
fiscal policy leads to higher interest rates and
higher real output. Expansionary monetary policy
leads to lower interest rates and higher real
output. Crowding out can limit the effectiveness
of monetary policy. A liquidity trap cam limit
the effectiveness of monetary policy.
Key Assumptions The price level is
fixed. Equilibrium in the goods market is
determined by aggregate expenditures. Equilibrium
in the money market is determined by the demand
and supply of money.
33Short-Run Models and Theories
IS/LM/BP (Large Country)
Summary A short-run model of real output that
includes the international sector. The
upward-sloping BP curve shows where the balance
of payments is zero.
Key Assumptions The price level is fixed. Forces
constantly push the economy toward IS/LM
equilibrium and balance of payments equilibrium.
Key Policy Implications If exchange rates are
flexible, government need not worry about
maintaining balance of payments equilibrium. It
can focus on domestic goals. Government can
adjust exchange rates, import controls, export
drives, and capital controls to achieve domestic
goals.
Key Predictions If a country has flexible
exchange rates, the exchange rate adjusts to
domestic IS/LM equilibrium. A country with fixed
exchange rates may have difficulty achieving its
domestic goals.
34Short-Run Models and Theories
Mundell-Fleming model
Summary An IS/LM/BP model for a small open
economy. The BP curve is horizontal at the world
interest rate.
Key Predictions If exchange rates are fixed,
expansionary fiscal policy must be accompanied by
expansionary monetary policy. If exchange rates
are fixed, expansionary monetary policy must be
accompanied by expansionary fiscal policy. If
exchange rates are flexible, expansionary fiscal
policy can affect the economy only if monetary
policy is also expansionary.
Key Policy Implications Government must accept
the world interest rate. To increase output an
economy should run expansionary fiscal policy and
monetary policies.
Key Assumptions The price level is
fixed. Capital will flow in an out of a country
to keep domestic interest rates at the world
interest rate.
35Short-Run Models and Theories
AS/AD Model
Summary A model that integrates the long run and
the short run. The AD curve is downward sloping.
The AS model determines how changes in aggregate
expenditures are split between changes in output
and the price level.
Key Predictions Increases in aggregate demand
lead to increases in real output. Adverse
aggregate supply shocks lead to lower output and
higher prices. Changes in aggregate demand that
are perfectly anticipated have a smaller impact
on real output and a larger impact in the price
level compared to when the changes are
anticipated.
Key Policy Implications When the economy is below
potential output, it should run expansionary
monetary or fiscal policy to increase real
output. When the economy is above potential
output, it should run contractionary monetary or
fiscal policy to reduce real output and avoid
inflation. When the economy is at potential
output, policy should be neutral.
Key Assumptions Prices are flexible. A fall in
the price level leads to higher aggregate demand
because of the international and interest rate
effects. The more people expect a change in
aggregate demand, the less that change will
affect real output.
36Determinants of the Slope of AD
- The AD Curve is Flat if
- Investment is responsive to changes in the
interest rate - The multiplier is large
- The LM curve is highly responsive to changes in
income - The international effect is large
37A Flat IS Curve Means a Flat AD Curve
LM0
LM1
r0
Real Interest Rate ()
r1
IS
Real Output, Income
Y0
Y1
Price Level
Aggregate Demand
P0
P1
Real Output, Income
Y1
Y0
38Income-Sensitive LM Means a Flat AD
LM0 (P0)
LM1 (P0)
Real Interest Rate ()
r0
IS
r1
Real Output, Income
Y0
Y1
Price Level
P0
Aggregate Demand
P1
Real Output, Income
Y1
Y0
39Large International Effect Means Flat AD
LM0
LM1
Real Interest Rate ()
IS1
IS0
Real Output, Income
Y0
Y1
Price Level
P0
Aggregate Demand
P1
Real Output, Income
Y1
Y0
40An Alternative AD/AS Model
- Criticisms of the AD/AS Model
- The curves are confusing because they are not
micro supply and demand curves - The model does not adequately explain how the
economy reaches equilibrium - The alternative AD/AS model develops the AS and
AD curves with inflation and real output on the
axes.
41The Alternative AD Curve
Slope of the Alternative AD Curve
More inflation
Higher real interest rates
Lower quantity of aggregate expenditures
Downward sloping AD curve
Shifts in the AD Curve
Fiscal policy
Changes in the Feds policy rule
42The Alternative AD/AS Model
Potential Output
Inflation
Short-run AS is horizontal because of inflation
inertia caused by slowly moving expectations of
inflation.
A
?0
AS
AD
Real output, Income
Y0
43Adjustment to Long-Run Equilibrium
Potential Output
Potential Output
Inflation
Inflation
A
AS0
?0
D
B
AS1
AS1
?1
?1
C
?0
AS0
AD
AD
Y1
Y0
Y0
Y1
Real output, Income
Real output, Income
44Expansionary Monetary Policy
Potential Output
Inflation
C
AS1
?1
A
B
?0
AS0
AD1
AD0
Real output, Income
Y0
Y1
45Contractionary Fiscal Policy
Potential Output
Inflation
A
B
?0
AS0
C
?1
AS1
AD0
AD1
Real output, Income
Y0
Y1
46An Adverse Supply Shock
Potential Output
Inflation
B
AS1
?1
A
?0
AS0
AD
Real output, Income
Y0
Y1