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”


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)


LRAS

SRAS and LRAS

P

Y

SRAS

PE

YN

In the long run, PE = P

and Y = YN.

Y = YN + a(P – PE)


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


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


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.


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.


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


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


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


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


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


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


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


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’


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


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


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


LRAS

Revisiting SRAS

P

Y

SRAS

PE

YN

In the long run, PE = P

and Y = YN.

Y = YN + a(P – PE)


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


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


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


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”


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!

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Lecture 14: AD-ASwbrooks/Lecture14.pdf · AGGREGATE DEMAND AND AGGREGATE SUPPLY 1 The AD-AS Model...

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