8/10/2019 ad-as-130507224848-phpapp02.pptx

1/26

Aggregate Demandand Aggregate Supply

GT01003 Macroeconomics

8/10/2019 ad-as-130507224848-phpapp02.pptx

2/26

Learning Objectives

1. Define the aggregate demand and aggregatesupply curves

2. Show how aggregate supply and demanddetermine short-run output and inflation

Show how aggregate demand, aggregate supply, andthe long-run aggregate supply curve determine long-run output and inflation

8/10/2019 ad-as-130507224848-phpapp02.pptx

3/26

Learning Objectives

4. Using the AD-AS model to study business

cycles

5. Analyze how the economy adjusts to

expansionary and recessionary gaps

Relate this to the idea of a self-correcting

economyThe role of stabilization policy

8/10/2019 ad-as-130507224848-phpapp02.pptx

4/26

Introduction

The aggregate demand - aggregate supply

(AD-AS) modelhas two distinct advantages

over the basic Keynesian model:

i. It applies to both the short run and the longrun

ii. It shows both inflation and output

Effective for analyzing macroeconomic policies

8/10/2019 ad-as-130507224848-phpapp02.pptx

5/26

The Aggregate Demand Curve

Aggregate demand (AD) curve shows therelationship between short-run equilibrium output,Y, and the rate of inflation,

Holds all other factors constant

AD has a negative slope

PAE Y

Along the AD curve, short-run Y

equals planned spending

Output (Y)

ADInfla

tion

()

8/10/2019 ad-as-130507224848-phpapp02.pptx

6/26

Shifts in Aggregate Demand

Curve

At a given inflation rate, aggregate demand shiftswhen

Demand Shocks

Stabilization Policy Demand shocksare changes

other than those causedby changes in output orthe real interest rate

Consumer wealth

Business confidence

Foreign demand forUS goods

Output (Y)

AD

AD'

Inflation

()

8/10/2019 ad-as-130507224848-phpapp02.pptx

7/26

Shifts in Aggregate Demand

Curve

Stabilization Policy:

A rightward shift of the AD curve:

Increase government spending (expansionary fiscalpolicy)

Cut taxes (expansionary fiscal policy)

Increase the money supply (expansionary monetarypolicy)

A leftward shift of the AD curve:

Decrease government spending (contractionary fiscalpolicy)

Raise taxes (contractionary fiscal policy)

8/10/2019 ad-as-130507224848-phpapp02.pptx

8/26

Aggregate Supply

Aggregate supply curve (AS) shows therelationship between the rate of inflation and theshort-run equilibrium level of output

Holds all other factors constant

Aggregate supply curve has a positive slope

When output is below potential, actual inflation isabove expected inflation

When output is above potential, actual inflation isbelow expected inflation

8/10/2019 ad-as-130507224848-phpapp02.pptx

9/26

The Aggregate Supply Curve

If the economy is operating at potential output,then

=e = 1 at A

If Y > Y*and 2 >

eat B

If Y < Y*and 3

< eat C

The AS curve slope up Inflation

()

Output (Y)

Aggregate

Supply (AS)

2

Y1

B

Y2

3C

Y*

1

A

8/10/2019 ad-as-130507224848-phpapp02.pptx

10/26

Shifts in the AS Curve

What causes the AS curve to shift? Changes in available resources & technology

Changes in the expected inflation

Inflation shocks

Infla

tion

()

Output (Y)

AS1

Y*

1

2

AS2 If actual inflation

exceeds expectations,

expected inflation

increases

AS curve shifts to

the left

At each level of output,inflation is hi her

8/10/2019 ad-as-130507224848-phpapp02.pptx

11/26

Shifts in the AS Curve

An inflation shockis a sudden change in thenormal behavior of inflation

A shock is not related to an output gap

A sudden rise in the price of oil increases prices of

Gasoline, diesel fuel, jet fuel, heating oilGoods made with oil (synthetic rubber, plastics,

etc.)

Transportation of most goods

OPEC reduced supplies in 1973; price of oilquadrupled

Food shortages occurred at the same time

Sharp increase in inflation in 1974

8/10/2019 ad-as-130507224848-phpapp02.pptx

12/26

Shifts in the AS Curve

An adverse inflation shock shifts the aggregate

supply curve to the left

Increases inflation at each output level

Oil price increases in 1973

A favorable inflation shock shifts the aggregate

supply curve to the right

Lower inflation at each output levelOil price decrease in 1986

8/10/2019 ad-as-130507224848-phpapp02.pptx

13/26

Long-Run Equilibrium

In the long run,

Actual output equals potential output

Actual inflation equals expected inflation

Long-run equilibriumoccurs at the intersection of

Aggregate demand

Aggregate supply and Long-run aggregate

supply

In

flation

()

Output (Y)

Aggregate

Demand (AD)

Aggregate

Supply (AS)

Y*

Long-Run AggregateSupply (LRAS)

8/10/2019 ad-as-130507224848-phpapp02.pptx

14/26

Short-Run Equilibrium

Short-run equilibrium occurs when there is

either an expansionary gapor a recessionary

gap

Intersection of AD and AS curves at a level ofoutput different from Y*

Point A in the graph

Short-run equilibrium is

temporary Infla

tion

()

Output (Y)

AD

AS1

LRAS

Y* Y1

1

A

Y*

LRAS

8/10/2019 ad-as-130507224848-phpapp02.pptx

15/26

Using the AD-AS Model to

Study Business Cycles

8/10/2019 ad-as-130507224848-phpapp02.pptx

16/26

Five Steps for Using the AD-AS

Model to Study Business Cycles

Example Event: Great Recession 2007-2009

Step 1:Draw a diagram to show the long run

equilibrium

Inflation(

)

Output (Y)

Aggregate

Demand (AD)

Aggregate

Supply (AS)

Y*

Long-Run Aggregate

Supply (LRAS)

8/10/2019 ad-as-130507224848-phpapp02.pptx

17/26

8/10/2019 ad-as-130507224848-phpapp02.pptx

18/26

Five Steps for Using the AD-AS

Model to Study Business Cycles

In

flation

()

Output (Y)

AS

Y*

LRAS

A

AD1

1

AD2

Y1

2 B

Step 3:Shift the

curve(s) in the

appropriate direction(s).

Step 4:Find the new

short-run equilibrium

The new short-runequilibrium is at B

8/10/2019 ad-as-130507224848-phpapp02.pptx

19/26

Five Steps for Using the AD-AS

Model to Study Business Cycles

Step 5:Compare the new short-run

equilibrium to the original long-run equilibrium.

We find that the actual output Y1< the

potential output Y* and the 2is below theexpected 1

Thus, there is a recessionary gap.

8/10/2019 ad-as-130507224848-phpapp02.pptx

20/26

Can active use of stabilization

policy help to eliminate output

gap?

8/10/2019 ad-as-130507224848-phpapp02.pptx

21/26

Self-Correcting Economy

In the long-run the economy tends to be self-

correcting

Missing from Keynesian model

Concentrates on the short-run; no priceadjustments

Given time, output gaps disappear without any

changes in monetary or fiscal policy

Whether stabilization policies are needed

depends on

the speed of the self-correction process

the nature of the shock that created the output

8/10/2019 ad-as-130507224848-phpapp02.pptx

22/26

The Role of Stabilization Policy

Speed of Self-Correction Process:

The greater the gap, the longer the adjustment

period

A slow self-correcting mechanism (Large output

gap)

Fiscal and monetary policy can help stabilize theeconomy

A fast self-correcting mechanism (Small output

gap)

Fiscal and monetary policy are not effectiveand

8/10/2019 ad-as-130507224848-phpapp02.pptx

23/26

The Role of Stabilization Policy

The Nature of the Shocks:

Active fiscal policy and monetary policy are

helpful when a recession is caused bynegative demand shocks

Active fiscal policy and monetary policy can be

costly when a recession is caused by negativeprice shocks

8/10/2019 ad-as-130507224848-phpapp02.pptx

24/26

The Role of Stabilization Policy

Negative Demand

Shocks:

AD shifts to AD2

Output falls to Y1

An expansionary fiscal

policy or monetary

policy shifts the ADcurve back toward AD1

The inflation returns

back to the initial level 1

In

flation

()

Output (Y)

AS

Y*

LRAS

A

AD1

1

AD2

Y1

2 B

8/10/2019 ad-as-130507224848-phpapp02.pptx

25/26

The Role of Stabilization Policy

Negative Price Shocks:

A negative price shock

shifts the AS curve to AS2.

Output falls to Y1 andinflation rises to 2

An Expansionary fiscal

policy or monetary policyshifts the AD to AD2

Inflation rises to 3

Inflation

()

Output (Y)

AD1

AS1

Y*

LRAS

1

Y1

2

AS2

AD2

3

8/10/2019 ad-as-130507224848-phpapp02.pptx

26/26

Conclusion