Lecture 14: AD-ASwbrooks/Lecture14.pdf · AGGREGATE DEMAND AND AGGREGATE SUPPLY 1 The AD-AS Model...
Transcript of Lecture 14: AD-ASwbrooks/Lecture14.pdf · AGGREGATE DEMAND AND AGGREGATE SUPPLY 1 The AD-AS Model...
Lecture 14: AD-AS
26 March 2020
Prof. Wyatt Brooks
AGGREGATE DEMAND AND AGGREGATE SUPPLY 1
The AD-AS Model
The “Aggregate Demand – Aggregate Supply” model
Deceptively simple model, widely used in thinking about macroeconomic issues
Not as simple as “adding up demand curves”
Long run vs. short run is important
Can use it to describe policy debates
2
The Model of Aggregate Demand and Aggregate Supply
P
Y
AD
SRAS
P1
Y1
The price level
Real GDP, the quantity of output
The model determines the eq’m price level
and eq’m output (real GDP).
“Aggregate Demand”
“Short-Run Aggregate
Supply”
AGGREGATE DEMAND AND AGGREGATE SUPPLY 3
Review from Last Lecture
P
Y
SRAS
YN
When P > PE
Y > YN
When P < PE
Y < YN
PEthe expected
price level
Y = YN + a(P – PE)
AGGREGATE DEMAND AND AGGREGATE SUPPLY 4
LRAS
SRAS and LRAS
P
Y
SRAS
PE
YN
In the long run, PE = P
and Y = YN.
Y = YN + a(P – PE)
AGGREGATE DEMAND AND AGGREGATE SUPPLY 5
The Aggregate-Demand (AD) Curve
The AD curveshows the quantity of all g&s demanded in the economy at any given price level.
P
Y
AD
P1
Y1
P2
Y2
AGGREGATE DEMAND AND AGGREGATE SUPPLY 6
Why the AD Curve Slopes Downward
Y = C + I + G + NX
Assume G fixed by govt policy.
To understand the slope of AD, must determine how a change in Paffects Y.
P
Y
AD
P1
Y1
P2
Y2 Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY 7
The Wealth Effect (P and C )Suppose P rises. The dollars people hold buy fewer g&s,
so real wealth is lower. People feel poorer. Result: C falls.
AGGREGATE DEMAND AND AGGREGATE SUPPLY 8
The Wealth Effect (P and I )Suppose P rises. Nominal interest rate = Real interest rate +
inflation Higher prices means more inflation If real rates are constant, then nominal increases Higher interest rates discourage real investment Imagine someone trying to borrow to build a
factory or start a new businessResult: I falls.
AGGREGATE DEMAND AND AGGREGATE SUPPLY 9
The Slope of the AD Curve: SummaryAn increase in Preduces the quantity of goods & services demanded, which generates the downward sloping AD curve.
P
Y
AD
P1
Y1
P2
Y2
AGGREGATE DEMAND AND AGGREGATE SUPPLY 10
The Long-Run Equilibrium
In the long-run equilibrium,
PE = P, Y = YN ,
and unemployment is at its natural rate.
P
YAD
SRAS
PE
LRAS
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY 11
Using AD-AS to Model Changes What happens if something changes in the
economy? The AD-AS model allows us to consider
changes to: Demand: a shift of the AD curve Supply: a change in YN
Price expectations: a shift in the SRAS curve Moreover, the changes in AD or in YN may be
permanent or temporary
AGGREGATE DEMAND AND AGGREGATE SUPPLY 12
Why the AD Curve Might Shift Changes in C Stock market boom/crash Preferences re: consumption/saving tradeoff Tax hikes/cuts Interest rates, monetary policy
Changes in I Firms buy new computers, equipment, factories Expectations, optimism/pessimism Interest rates, monetary policy Investment Tax Credit or other tax incentives
AGGREGATE DEMAND AND AGGREGATE SUPPLY 13
Why the AD Curve Might Shift Changes in G Federal spending, e.g., defense State & local spending, e.g., roads, schools
Changes in NX Booms/recessions in countries that buy our
exports. Appreciation/depreciation resulting from
international speculation in foreign exchange market
General idea: AD shifts whenever people demandmore goods and services at any given price level
AGGREGATE DEMAND AND AGGREGATE SUPPLY 14
Why the AD Curve Might ShiftAny event that changes C, I, G, or NX– except a change in P –will shift the AD curve.
Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right.
P
YAD1
AD2
Y2
P1
Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY 15
The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate.
YN is also called potential output
or full-employment output.
P
Y
LRAS
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY 16
Why the LRAS Curve Might Shift
Any event that changes any of the determinants of YNwill shift LRAS.
Example: Immigration increases L, causing YN to rise.
P
Y
LRAS1
YN
LRAS2
YN’
AGGREGATE DEMAND AND AGGREGATE SUPPLY 17
Why the LRAS Curve Might Shift Changes in L or natural rate of unemployment Immigration Baby-boomers retire
Changes in K (physical capital) or H (human capital) Investment in factories, equipment More people get college degrees
AGGREGATE DEMAND AND AGGREGATE SUPPLY 18
Why the LRAS Curve Might Shift Changes in natural resources Reduction in supply of imported oil Changing weather patterns that affect
agricultural production
Changes in technology Productivity improvements from technological
progress
AGGREGATE DEMAND AND AGGREGATE SUPPLY 19
LRAS1980
Using AD & AS to Depict LR Growth and Inflation
Over the long run, tech. progress shifts LRAS to the right
P
Y
AD1990
LRAS1990
AD1980
Y1990
and growth in the money supply shifts AD to the right.
Y1980
AD2000
LRAS2000
Y2000
P1980Result: ongoing inflation and growth in output.
P1990
P2000
AGGREGATE DEMAND AND AGGREGATE SUPPLY 20
LRAS
Revisiting SRAS
P
Y
SRAS
PE
YN
In the long run, PE = P
and Y = YN.
Y = YN + a(P – PE)
AGGREGATE DEMAND AND AGGREGATE SUPPLY 21
Shift in SRAS If YN changes then both SRAS and LRAS shift If YN increases then they both shift to the right If YN decreases then they both shift to the left
If price expectations PE change, then only SRAS (not LRAS) changes If PE increases then SRAS shifts to the left If PE decreases then SRAS shifts to the right
The difference between the short run and the long run is that PE are equal to P in the long run
AGGREGATE DEMAND AND AGGREGATE SUPPLY 22
Example: Permanent Increase in ADSuppose that something happens that permanentlyincreases AD
P
Y
AD1
SRAS
LRAS
AD2
Y1
In the short run, prices and GDP both increase.
P2
Y2
In the long run, since P > PE then PE increase, shifting SRAS to the left
P1
P3
SRAS2
AGGREGATE DEMAND AND AGGREGATE SUPPLY 23
Why the Slope of SRAS Matters
If AS is vertical, fluctuations in ADdo not cause fluctuations in output or employment.
P
Y
AD1
SRAS
LRAS
ADhi
ADlo
Y1
If AS slopes up, then shifts in ADdo affect output and employment.
Plo
Ylo
Phi
Yhi
Phi
Plo
AGGREGATE DEMAND AND AGGREGATE SUPPLY 24
RBC vs. New KeynesianTwo leading schools of thought in macroeconomics are “New Keynesian” and “Real Business Cycle”
Heart of the disagreement: How important are nominal rigidities?
If not, then SRAS is very steep and only changes in YN matter for changes in GDP
Hence the name “Real Business Cycle”
AGGREGATE DEMAND AND AGGREGATE SUPPLY 25
Next Class In the next class we will use the AD-AS
model to see the trade-offs governments face in combating recessions
Make sure to keep up with your assignments
Stay well!