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Transcript of 1 Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman,...
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 1
Chapter 5
Aggregate Supply and Demand
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 2
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 3
Chapter Organisation5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 Aggregate Demand Under Alternative Supply Assumptions
5.4 Supply-side Economics
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 4
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 5
The Aggregate Supply Curve
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 6
The classical AS curve Is vertical, indicating that the same amount of
goods will be supplied whatever the price level
AssumptionThe 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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 7
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 8
The Keynesian AS curve Is horizontal, indicating firms will supply
whatever amount of goods is demanded at the existing price
AssumptionThere is unemployment, so firms may obtain
as much labour as they want at the current wage
ImplicationAD determines the level of output, with prices
‘sticky’ in the short run
The Keynesian AS Curve
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 9
Vertical or Horizontal?
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 10
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?
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 11
Frictional unemploymentUnemployment due to individuals shifting
between jobs and looking for new jobs
Structural unemploymentUnemployment 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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 12
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 13
Chapter Organisation5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 Aggregate Demand Under Alternative Supply Assumptions
5.4 Supply-side Economics
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 14
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 15
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 16
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 17
Chapter Organisation5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 Aggregate Demand Under Alternative Supply Assumptions
5.4 Supply-side Economics
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 18
5.3 AD Under Alternative Supply Assumptions
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 19
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 20
The Classical Case
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 21
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 22
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 23
Chapter Organisation5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 The Aggregate Demand Under Alternative Supply Assumptions
5.4 Supply-side Economics
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 24
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 25
Supply-side Economics
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 26
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
Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 27
In the short runGDP has increased substantially (from E to E’)
This is primarily due to the AD effect
In the long runThe 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