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3/15/16
W10: AS-AD Model
•  Short run vs. long run
•  Aggregate supply
•  Aggregate demand
•  Short run and long run macroeconomic equilibria
•  Business cycle in the AS-AD model
•  Inflation cycles
Reading:
•  CH10 pg.242-254
•  CH12 pg.296, 301-09, until “The quantity theory of money”
HW: TBA
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Short Run vs. Long Run
We distinguish two time frames associated with different
states of the labor market:
§  Short-run – nominal wages do not change
§  Long-run – nominal wages change
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Aggregate Supply
The quantity of real GDP supplied is the total quantity that
firms plan to produce during a given period
Short-run aggregate supply is the relationship between
the quantity of real GDP supplied and the price level when
the nominal wages, the prices of other resources, and
potential GDP remain constant
Long-run aggregate supply is the relationship between
the quantity of real GDP supplied and the price level when
real GDP equals potential GDP
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Short Run and Long Run Aggregate Supply
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Short Run and Long Run Aggregate Supply
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Increase in Potential GDP
Potential GDP increases for three reasons:
§  An increase in the full-employment quantity of labor
§  An increase in the quantity of capital (physical or human)
§  An advance in technology
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Increase in Potential GDP
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Aggregate Demand
The quantity of real GDP demanded:
Y=C+I+G+X–M
Aggregate demand is the relationship between the quantity
of real GDP demanded and the price level
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Aggregate Demand Curve
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Why Is AD Curve Downward Sloping?
A rise in the price level, all else held constant, decreases
real wages
ê
People decrease spending
ê
The quantity of real GDP demanded decreases
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Changes in Aggregate Demand
Aggregate demand curve shifts because of:
§  Expectations about future incomes and inflation
§  Fiscal policy and monetary policy
§  The world economy
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Changes in Aggregate Demand
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Short-Run Macroeconomic Equilibrium
Short-run macroeconomic equilibrium occurs when the
quantity of real GDP demanded equals the quantity of real
GDP supplied at the point of intersection of the AD curve
and the SAS curve
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Short-Run Macroeconomic Equilibrium
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Long-Run Macroeconomic Equilibrium
Long-run macroeconomic equilibrium occurs when real
GDP equals potential GDP – when the economy is on its
LAS curve
Long-run equilibrium occurs at the intersection of the AD
and LAS curves
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Long-Run Macroeconomic Equilibrium
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Long-Run Macroeconomic Equilibrium
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What Is Business Cycle?
Expan
n
Ex
pan
sio
on
tion
trac
ti
trac
Con
Con
Peak
sion
Peak
Trough
Trough
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US Business Cycle Expansions and
Contractions
•  Contractions (recessions) start at the peak of a
business cycle and end at the trough
•  Expansions start at the trough of a business cycle and
end at the peak
•  Cycle:
1.  Trough from previous trough
2.  Peak from previous peak
or
http://www.nber.org/cycles.html
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Mainstream Business Cycle Theory
•  Potential GDP grows at a steady pace
•  Aggregate demand grows at a fluctuating rate
•  Real GDP fluctuates around potential GDP
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The Business Cycle
Potential GDP increases to $16 trillion and the LAS curve
shifts rightward.
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The Business Cycle
During an expansion, aggregate demand increases and
usually by more than potential GDP.
The AD curve shifts to AD1.
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The Business Cycle
The SAS shifts to SAS1.
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The Business Cycle
But if aggregate demand increases more slowly than
potential GDP, the AD curve shifts to AD2.
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The Business Cycle
But if aggregate demand increases more quickly than
potential GDP, the AD curve shifts to AD3.
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Inflation Cycles
•  In the long run, inflation occurs if the quantity of money
grows faster than potential GDP
•  In the short run, many factors can start an inflation, and real
GDP and the price level interact
•  To study these interactions, we distinguish between two
sources of inflation:
§ 
§ 
Demand-pull inflation
Cost-push inflation
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Demand-Pull Inflation
An inflation that starts because aggregate demand increases
Examples:
•  a cut in the interest rate
•  an increase in the quantity of money
•  an increase in government expenditure
•  a tax cut
•  an increase in investment stimulated by an increase in
expected future profits
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Demand-Pull Inflation
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Demand-Pull Inflation
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Demand-Pull Inflation
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Cost-Push Inflation
An inflation that starts with an increase in costs
Two main sources of increased costs:
1. An increase in the money wage rate
2. An increase in the money price of raw materials, such as oil
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Cost-Push Inflation
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Cost-Push Inflation
•  The initial increase in costs creates a one-time rise in
the price level, not inflation
•  To create inflation, aggregate demand must increase
•  That is, the Fed must increase the quantity of money
persistently
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Cost-Push Inflation
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Cost-Push Inflation
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