Modeling Demand and Supply Shocks using Aggregate Demand (AD) and Aggregate Supply (AS)

Outline

•“Short-run” versus the long run.

•AD and AS Together: “Short-run” equilibrium

•Demand shocks in the short-run

•The long-run AS curve

•Adjustment to “long run” equilibrium

•Supply shocks in the short-run

•Long-run effects of supply shocks

Professors Hall and Liebermancall the Keynesian model a “short-run” model. Why?

Because it is possible for the economy to be in equilibrium, but at the same time real GDP

can be above or below potential or full employment GDP

450

AE

Real GDP($Trillions)

Y1 YFE Y20

AE1

AE2

AE3

E

H

K

•Point K is a short-run equilibrium since Y1 < YFE

•Point H is a short-run equilibrium since Y2 > YFE

•Point E is a long-run equilibrium since equilibrium GDP corresponds to YFE

Long-run equilibrium occurs when the economy is in equilibrium at full employment

Full employment GDP

Short run equilibrium is a combination of price level and GDP consistent with both AS and AD curves

PriceLevel

Real GDP($Trillions)

0

AD

AS

E

B

F

6 10 14

100

140

Why is point E a short-run equilibrium?

•At point B, the price level is 140 and AS = $14 trillion. But equilibrium GDP is equal to $6 trillion when the price level is 140—we know this from the AD curve.

•At point E, the price level is consistent with an output level of $10 along both AS and AD curves

PriceLevel

Real GDP($Trillions)

0

AD1

AS

Effect of a Demand Shock

AD2

10 12 13.5

E

H J

100

130

Increase in government spending

Issue: Why did the economy move from point E to point H—instead of E to J?

G GDPMultiplier Effect

AD curve shifts rightward

Unit cost P

Money Demand

Interest rate

a and IP GDP

Movement along new AD curve

Movement along AS curve

Net result: GDP increases, but by less due to the effect of an increase in the price level

PriceLevel

Real GDP($Trillions)

0

AD2

AS

Effect of a decrease in the money supply

AD1

1086.5

EK

S

100

M GDP

AD curve shifts Leftward

Unit cost P

Money Demand

Interest rate

a and

IP GDP

Movement along new AD curve

Movement along AS curve

Net result: GDP decreases, but by less due to the effect of an decrease in the price level

Interest

rate

a and IP

PriceLevel

Real GDP($Trillions)

0

Long run AS curve: A vertical line indicating all possible output and price level combinations the economy could end up in the long run

Long run AS curve

YFE

Some economists (including Hall &

Lieberman) believe the economy is “self-

correcting”—that is, forces are present that

push the economy to long-run (or full-employment)

equilibrium.

(How does it work?)

PriceLevel

Real GDP($Trillions)

0

AD1

AS1

Long Run AS Curve

YFE Y3 Y2

AD2

AS2

P1

P3

P2

P4

E

HJ

KLet AD shift from AD1 to AD2

Positive demand shock P and Y

Change in short-run equilibrium

Y > YFEWage

RateUnit Cost

PY until Y =YFE

Long-run adjustment process

The following factors could shift the (short-run) aggregate supply schedule up to the left:

•An increase in the price of a basic commodity—e.g., petroleum, natural gas, wheat, soybeans.

•An increase in average money wages and benefits not restricted to just one industry or sector of the economy.

•An increase in the average markup over unit cost not restricted to just one industry or sector of the economy.

PriceLevel

Real GDP($Trillions)

0

AD2

AS1

Effect of an increase in petroleum prices

AD1

1086.5

E

S

100

AS2

130

Date Price ($)Jan. 1972 1.79Dec. 1973 4.68Jan. 1974 10.84

April 1979 14.55June 1979 18.00

Nov 1979 24.00

Aug. 1980 30.00Oct. 1981 34.00

Price of One Barrel of 340 crude oil

Source: The Petroleum Economist

I’d call that a shock,wouldn’t you? The story

of Joseph (see Old Testament)suggests buffer stocks

as the remedy forsupply-shock

inflation

Productivity () means the average output of a worker

per year, or alternatively: = GDP/N

where N is total employment and Y is real GDP.

depends onthe efficiency with

which labor is employedin the production of

goods & services

Let denote average annual compensation of employees (including benefits). Thus unit labor cost (UCL) is defined as:

ULC = /

Notice that compensationcan rise with no effect on ULC,

so long as productivitykeeps pace

Productivity & Costs, Nonfarm Sector

-2

-1

0

1

2

3

4

5

6

year/quarter

perc

ent c

hang

e Productivity

Hourly Compensation

Unit Labor Cost

Productivity 4.1 2.7 0.6 5 5

Hourly Compensation 4.6 4.2 4.8 4.7 4

Unit Labor Cost 0.5 1.4 4.2 -0.3 -1

98.4 99.1 99.2 99.3 99.4

Source: www.dismal.com% change, annual rate