Aggregate Demand (AD) Again. Aggregate Demand (AD) and Aggregate Expenditure (AE) The equations...

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Aggregate Demand (AD) Again

Aggregate Demand (AD) Aggregate Demand (AD) and and

Aggregate Expenditure (AE)Aggregate Expenditure (AE) The equations look alikeThe equations look alike AD = C + I + G + (X - IM)AD = C + I + G + (X - IM)

andand AE = C + I + G + (X - IM)AE = C + I + G + (X - IM)

Difference between AD and AEDifference between AD and AE AD, Aggregate Demand, refers to the AD, Aggregate Demand, refers to the

relationship of total spending and relationship of total spending and general price levelgeneral price level

AD is depicted in the P-Y space.AD is depicted in the P-Y space. AE, Aggregate Expenditure, refers to AE, Aggregate Expenditure, refers to

the relationship of total spending and the relationship of total spending and the GDP level. the GDP level.

AE is depicted in the AE-Y space.AE is depicted in the AE-Y space.

AE in the AE-Y space

AD in the P-Y space

Effects of Change in P on AE

Fall in Price Level

GDP (Y)

AE = C0 + I + G + (X-IM)

Rise in Price Level

GDP (Y) Y0 Y1

AE’ (P1) = C1 + I + G + (X-IM)E1

AE’ = C1 + I + G + (X-IM)

AE(P0) = C0 + I + G + (X-IM)

Derive AD from AE

Fall in Price Level

GDP (Y)

Rise in Price Level

GDP (Y) Y0 Y1

AE’ (P1)

AE(P0)

Derive AD from the AE diagramDerive AD from the AE diagram When price rises from P0 to P1, AE shifts When price rises from P0 to P1, AE shifts

downward correspondingly. downward correspondingly. Keynesian equilibrium GDP falls from Y0 to Keynesian equilibrium GDP falls from Y0 to

Y1Y1 In the P-Y diagram, we find the In the P-Y diagram, we find the

corresponding coordinates for the two corresponding coordinates for the two pairs of P and Y*. pairs of P and Y*.

We do that for all price levels, and we We do that for all price levels, and we have all corresponding pairs of P and Y*have all corresponding pairs of P and Y*

We get the aggregate demand AD curve..We get the aggregate demand AD curve..

Derive AD from the AE diagramDerive AD from the AE diagram

AD implies all the demand-side AD implies all the demand-side equilibriumsequilibriums

Effect of changes in P on AE Effect of changes in P on AE and AEand AE

Change in P produces a shift in AE Change in P produces a shift in AE But change in P produces a But change in P produces a

movement in ADmovement in AD

Derive AD from AE

Fall in Price Level

GDP (Y)

Rise in Price Level

GDP (Y) Y0 Y1

AE’ (P1)

AE(P0)

Effect of autonomous changes Effect of autonomous changes on AE and ADon AE and AD

Autonomous change in C, I, and X-IM, and Autonomous change in C, I, and X-IM, and change in Gchange in G

will shift AE curve and will shift AE curve and Will shift AD as wellWill shift AD as well The horizontal shift in AD is equivalent to The horizontal shift in AD is equivalent to

the horizontal change in the AE-Y diagram.the horizontal change in the AE-Y diagram.

Effects of autonomous changes on AD and AE

Fall in Price Level

GDP (Y)

Rise in Price Level

GDP (Y) Y0 Y1

AE’ (I1)

AE(I0)

Aggregate Supply and Aggregate Supply and Supply-side Equilibrium Supply-side Equilibrium

The AD-AS diagram revisitedThe AD-AS diagram revisited Bring the aggregate supply (AS) to Bring the aggregate supply (AS) to

the diagramthe diagram

From demand-side equilibrium to econ-wide equilibrium

Supply-side Equilibrium

technology

resource

Demand-side equilibrium orKeynesian equilibrium

Supply-side equilibriumSupply-side equilibrium Also called Economy-wide equilibriumAlso called Economy-wide equilibrium The supply-side equilibrium is a more The supply-side equilibrium is a more

comprehensive concept. It takes account comprehensive concept. It takes account of AD and AS together. of AD and AS together.

In the previous Demand-side equilibrium, In the previous Demand-side equilibrium, it only looks at the demand side it only looks at the demand side equilibrium. Or it implicitly assumes AS is equilibrium. Or it implicitly assumes AS is horizontal. horizontal.

Supply-side Equilibrium

Determines the supply-side Determines the supply-side equilibrium priceequilibrium price

And supply-side equilibrium quantity And supply-side equilibrium quantity

Aggregate Supply (AS) and Aggregate Supply (AS) and the AS curvethe AS curve

AS shows the quantity of goods and AS shows the quantity of goods and services that all firms are willing to services that all firms are willing to supply at each price level, holding all supply at each price level, holding all other determinants of quantity other determinants of quantity supplied constant.supplied constant.

Slope of the ASSlope of the AS

Upward slopingUpward sloping– When the price is up, production is more When the price is up, production is more

profitable, hence firms increase supply. profitable, hence firms increase supply. It gets steeper at higher GDP levelIt gets steeper at higher GDP level

– Productions increases and finally strains Productions increases and finally strains the existing capacity. Firms have to pay the existing capacity. Firms have to pay higher rate to get additional unit of labor higher rate to get additional unit of labor (such as pay workers the overtime rate) (such as pay workers the overtime rate) or other inputs.or other inputs.

Aggregate Supply

Shifters of the AS Shifters of the AS

Price of inputsPrice of inputs– Labor cost (wage rate)Labor cost (wage rate)– Price of other inputsPrice of other inputs

TechnologyTechnology Size of suppliersSize of suppliers Capital stockCapital stock Resource endowmentResource endowment

Shift of the Aggregate Supply Curve

S1 (higher wages)

S0 (lower wages)

5,500 GDP (Y)

Movement along the AS curve Movement along the AS curve

Change the price of output PChange the price of output P

Movement along the Aggregate Supply Curve

(Change in price)

5,000 GDP (Y)

From AE-Y diagram to From AE-Y diagram to the AD-AS diagramthe AD-AS diagram

How the demand-side and supply-How the demand-side and supply-side equilibrium are relatedside equilibrium are related

What happens to the supply-side What happens to the supply-side equilibrium if G changes?equilibrium if G changes?

What happens to the supply-side What happens to the supply-side equilibrium if other autonomous equilibrium if other autonomous changes?changes?

What happens to the supply-side What happens to the supply-side equilibrium if P changes?equilibrium if P changes?

Demand and supply sides equilibrium

GDP (Y)

GDP (Y) Y*0

AE(P0)

Effects of autonomous changes on AD and AE: Initial change

GDP (Y)

GDP (Y) Y*0 Y*1

AE’ (I1)

AE(I0)

shortage

Effects of autonomous changes on AD and AE: Final outcome

GDP (Y)

GDP (Y) Y*0 Y*1

AE’ (I1)

AE(I0)

AE(P2)

Dampening the multiplier effectDampening the multiplier effect

As can be seen, the rise in the price As can be seen, the rise in the price will dampen the original increase in will dampen the original increase in the equilibrium GDPthe equilibrium GDP

Represented by the green arrow in Represented by the green arrow in the diagramthe diagram

This is another reason that the This is another reason that the oversimplified multiplier is oversimplified multiplier is oversimplified oversimplified

Changes in P and Y Changes in P and Y depend on the slope of ASdepend on the slope of AS

If AS is flat, the dampening effect by If AS is flat, the dampening effect by price is smallprice is small

If the AS is completely horizontal, If the AS is completely horizontal, there is no dampening effect.there is no dampening effect.

That is what is assumed in the That is what is assumed in the Keynesian modelKeynesian model

Changes in G is very powerfulChanges in G is very powerful

AS horizontal

GDP (Y)

GDP (Y) Y*0 Y*1

AE’ (I1)

AE(I0)

AE(P2)

Changes in P and Y Changes in P and Y depend on the slope of ASdepend on the slope of AS

If AS is steep, the dampening effect If AS is steep, the dampening effect by price is greatby price is great

If the AS is vertical, there is 100% If the AS is vertical, there is 100% dampening effect.dampening effect.

Changes in G or autonomous Changes in G or autonomous changes would cause only inflation changes would cause only inflation but no effect on GDP.but no effect on GDP.

AS vertical

GDP (Y)

GDP (Y) Y*0 Y*1

AE’ (I1)

AE(I0)

AE(P2)

Recessionary gap and Recessionary gap and Inflationary gap againInflationary gap again

The supply-side equilibrium GDP Y’ The supply-side equilibrium GDP Y’ can be greater or smaller than the can be greater or smaller than the potential GDP level.potential GDP level.

If Y’ < YIf Y’ < Yp p : Recessionary gap: Recessionary gap

If Y’ > YIf Y’ > Yp p : Inflationary gap, an : Inflationary gap, an overheating economyoverheating economy

Supply-side Equilibrium and Recessionary gap

Recessionary gap

Supply-side Equilibrium and inflationary gap

Inflationary gap

Market self-correcting mechanismMarket self-correcting mechanism

Classical economics argues that the Classical economics argues that the market mechanism would bring the market mechanism would bring the economy back to the potential GDP, economy back to the potential GDP, the full employment GDP level, the full employment GDP level, through the price adjustment. This is through the price adjustment. This is called market self-correcting called market self-correcting mechanism.mechanism.

If a recessionary gap, there will be If a recessionary gap, there will be high unemployment rate, an excess high unemployment rate, an excess supply of labor, wage rate falls supply of labor, wage rate falls

Cost of production falls, and AS shifts Cost of production falls, and AS shifts downward. downward.

Returns to the full employment level.Returns to the full employment level. GDP increases and prices fallGDP increases and prices fall

Close a recessionary gap by market self-correcting mechanism

GDP (Y)

Wage falls

As price falls, through the wealth As price falls, through the wealth effect, AE shifts upeffect, AE shifts up

GDP increases by a multiplier effectGDP increases by a multiplier effect

Close a recessionary gap by market self-correcting mechanism

GDP (Y)

GDP (Y) Y*0 Y*p

AE’ (P1)

AE(P0)

Wage falls

Why does the market fail in closing Why does the market fail in closing the recessionary gapthe recessionary gap

Wage is rigid to go downwardWage is rigid to go downward Price is also rigid to go downwardPrice is also rigid to go downward Households may still hold Households may still hold

consumption even if goods price falls consumption even if goods price falls (in this case the AD is vertical).(in this case the AD is vertical).

Hence the market self-correcting Hence the market self-correcting mechanism does not workmechanism does not work

Why does the market fail in closing Why does the market fail in closing the recessionary gapthe recessionary gap

The adjustment time takes long time.The adjustment time takes long time. It may take so long that “all of us would It may take so long that “all of us would

die during the adjustment process.”die during the adjustment process.” Keynes: “The long run is a misleading Keynes: “The long run is a misleading

guide to current affairs. In the long run we guide to current affairs. In the long run we are all dead. are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.””

Close an inflationary gapClose an inflationary gap

If an inflationary gap, there is If an inflationary gap, there is shortage in the labor market, i.e. shortage in the labor market, i.e. excess demand for labor, wage rate excess demand for labor, wage rate will be pushed upwill be pushed up

AS thus shifts up. AS thus shifts up. Close the inflationary gap.Close the inflationary gap. Returns to the full employment levelReturns to the full employment level

Close an inflationary gap by market self-correcting mechanism

GDP (Y)

Wage up

GDP (Y)

GDP (Y) Y*0 Y*p

E0 AE’ (P1)

AE(P0)

Wage up

Close an inflationary gapClose an inflationary gap

The market self correcting The market self correcting mechanism is more effective in mechanism is more effective in closing inflationary gap because the closing inflationary gap because the wage rate and price are flexible to go wage rate and price are flexible to go upward.upward.

Yet it is a painful process too. During Yet it is a painful process too. During the adjustment process, GDP falls the adjustment process, GDP falls but prices go up. but prices go up.

Stagflation. Stagflation.

GDP (Y)

Wage up

Aggregate Demand (AD) Again. Aggregate Demand (AD) and Aggregate Expenditure (AE) The equations...

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