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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
0 Y
AE
AE
AD in the P-Y space
0 Y
AD
P
Effects of Change in P on AE
(b)
Fall in Price Level
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y)
AE = C0 + I + G + (X-IM)
Y0 Y2
(a)
Rise in Price Level
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y0 Y1
45
45
45
45
E0 E0
AE’ (P1) = C1 + I + G + (X-IM)E1
E2
AE’ = C1 + I + G + (X-IM)
AE(P0) = C0 + I + G + (X-IM)
P ↑
P↓
Derive AD from AE
(b)
Fall in Price Level
Pri
ce (
P)
GDP (Y)
Y0 Y1
(a)
Rise in Price Level
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y0 Y1
45
45
E0
E0
AE’ (P1)
E1
E1
AE(P0)
P ↑
P1
P0
AD
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
(b)
Fall in Price Level
Pri
ce (
P)
GDP (Y)
Y0 Y1
(a)
Rise in Price Level
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y0 Y1
45
45
E0
E0
AE’ (P1)
E1
E1
AE(P0)
P ↑
P1
P0
AD
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
(b)
Fall in Price Level
Pri
ce (
P)
GDP (Y)
Y0
(a)
Rise in Price Level
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y0 Y1
45
45
E0
E0
AE’ (I1)
E1
AE(I0)
I ↑
P0
AD
Y1
E1
AD’
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
AD
AS
AE
C
I
GX
technology
resource
labor
Demand-side equilibrium orKeynesian equilibrium
Aggregate Supply and Aggregate Supply and Supply-side Equilibrium Supply-side 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
Y*
AS
Y
P
0
AD
P*
Aggregate Supply and Aggregate Supply and Supply-side Equilibrium 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
Yp
AS
Y
P
0
P’
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
Shift of the Aggregate Supply Curve
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
S1
S1 (higher wages)
S0
S0 (lower wages)
100
6,000
Pri
ce
Lev
el
5,500 GDP (Y)
A B
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
Movement along the Aggregate Supply Curve
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
AS
(Change in price)
100
6,000
Pri
ce
5,000 GDP (Y)
A
B 80
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
(b)
Pri
ce (
P)
GDP (Y)
Y’0
(a)
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y*0
45
45
E0 E0
AE(P0)
P0
AD AS
Effects of autonomous changes on AD and AE: Initial change
(b)
Pri
ce (
P)
GDP (Y)
(a)
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y*0 Y*1
45
45
E0
E0
AE’ (I1)
E1
AE(I0)
I ↑
P0
AD
Y’1
E1
AD’
Y’0
AS
E2
shortage
Effects of autonomous changes on AD and AE: Final outcome
(b)
Pri
ce (
P)
GDP (Y)
(a)
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y*0 Y*1
45
45
E0
E0
AE’ (I1)
E1
AE(I0)
P ↑
P0
AD
Y’1
E1
AD’
Y’0
AS
E2
Y’2
AE(P2)
P2
Y*2
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
(b)
Pri
ce (
P)
GDP (Y)
(a)
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y*0 Y*1
45
45
E0
E0
AE’ (I1)
E1
AE(I0)
P0
AD
Y’1
E1
AD’
Y’0
AS
E2
Y’2
AE(P2)
Y*2
E2
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
(b)
Pri
ce (
P)
GDP (Y)
(a)
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y*0 Y*1
45
45
E0
E0
AE’ (I1)
E1
AE(I0)
P0
AD
Y’1
E1
AD’
Y’0
AS
E2
Y’2
AE(P2)
Y*2
E2
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
Y’
AS
Y
P
0
AD
P’
Yp
Recessionary gap
Supply-side Equilibrium and inflationary gap
Y’
AS
Y
P
0
AD
P’
Yp
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.
Market self-correcting mechanismMarket self-correcting 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
(b)
Pri
ce (
P)
GDP (Y)
E0 P0
AD
Y’p
E1
Y’0
AS
E2
Wage falls
AS’
P1
Market self-correcting mechanismMarket self-correcting mechanism
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
(b)
Pri
ce (
P)
GDP (Y)
(a)
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y*0 Y*p
45
45
E0
E0
AE’ (P1)
E1
AE(P0)
P↓
P0
AD
Y’p
E1
Y’0
AS
E2
Wage falls
AS’
P1
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
(b)
Pri
ce (
P)
GDP (Y)
E0 P0
AD
Y’p
E1
Y’0
AS
Wage up
AS’
P1
Close an inflationary gap by market self-correcting mechanism
(b)
Pri
ce (
P)
GDP (Y)
(a)
Ag
gre
gat
e E
xpen
dit
ure
(A
E)
GDP (Y) Y*0 Y*p
45
45
E0
E0 AE’ (P1)
E1
AE(P0)
P↑
P0
AD
Y’p
E1
Y’0
AS
Wage up
AS’
P1
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.
Close an inflationary gap by market self-correcting mechanism
(b)
Pri
ce (
P)
GDP (Y)
E0 P0
AD
Y’p
E1
Y’0
AS
Wage up
AS’
P1