Download AS/AD Model

Macro Theory:
The AS/AD Model
Part 1 – The Basics
Part 2 – The Keynesian View
Dr. D. Foster – ECO 285 – Macroeconomics
Part 1 – The Basics
Warning .. Warning .. Warning
• Aggregate Supply and Aggregate Demand are not
like market supply & demand !!!!!
• The “static” analysis only hints at dynamic
interpretation.
• Ceteris Paribus assumption problematic to the point
of being wholly inappropriate.
Keynesian model notes:
• Descriptive analysis.
• No numerical interpretation.
• Only AS/AD graphical representation.
The Aggregate Demand Schedule
P
P = Price Level;
CPI or GDP deflator
Q = real output;
Real GDP
A
P2
B
P1
AD = Agg. Demand;
From 4 sectors –
HH, Bus, G, Foreign
AD1
Q1
Q2
Q or R-GDP
Aggregate Demand
• The price level and real output demanded are
inversely related.
• A fall in the price level will increase quantity
demanded.
• Why? -- the Wealth Effect
•
•
•
•
All prices and wages change.
But, the fixed wealth is … well, still fixed!
So, with lower prices we feel wealthier. Woo Hoo!
And, so we want to buy more stuff.
Aggregate Demand
• What about:
 Interest effect
 Foreign trade effect
 Exchange rate effect
Can’t do “all else equal.”
e.g. Lower prices: Consumption, but
one price is wages!!! If they fall, then
we’d see a Consumption!!!
• AD can shift to the left or right.




Increase AD – shift to the right.
Decrease AD – shift to the left.
Whenever C, I, G, net X increase/decrease.
Why? Due to changes in optimism & pessimism, and
due to fiscal & monetary policies.
The Aggregate Demand Schedule
P
Increases in
C, I, G, net X
Decreases in
C, I, G, net X
AD3
AD2
AD1
Q or R-GDP
Long Run Equilibrium between
Aggregate Demand and Aggregate Supply
P
AS1
• There is an Aggregate Supply that
reflects fully employed resource use.
• Output level:
Q* or RGDP* or potential RGDP
• Shifts in AD can only change the
price level and not real output (nor
employment).
P1
Classical Model
of the Economy
AD1
Q or R-GDP
What affects the Aggregate Supply?
• Labor force participation.
• Labor productivity.
• Marginal tax rates on wages.
• Provision of government benefits that affect
household incentives w.r.t. supply labor.
• State of technology.
• Capital stock.
A change in these factors
can AS (shift right)
or AS (shift left)
Short Run Aggregate Supply – Wage Inflexibility
• Nominal wages are sluggish upwards:
 A rise in prices has delayed effect on wages.
• Nominal wages are inflexible downwards:
 A fall in prices will result in employment and
income.
• Workers have money illusion:
 Higher nominal wages are viewed as real wage.
 So, more workers available even though real wage
has not risen.

e.g. if prices rise 5% and wages rise 3%…
Short Run Aggregate Supply
• What about:
 Sticky prices
 Misperception
 Intertemporal substitution
Unnecessary complications
to explain the SR AS.
Inflexible wages is all we need.
What happens if there is a AD?
• The Short Run will adjust to the Long Run:
 An AD will P and Q, but only in the SR.
 Prices rise but wages lag. Firms employment and
output.
 Eventually, workers realize their real wages (W/P) are
falling, get comparable wage, AS.

The temporary profit motive has been eliminated.
From SR to LR Aggregate Supply
P
ASLR
AS3
An increase
in AD triggers
events.
AS2
AS1
Prices rise,
wages lag,
output rises.
P3
Eventually,
wages catch up
and AS declines.
P2
P1
AD2
AD1
Q*
Q2
Q or R-GDP
In LR, only
prices rise.
AS/AD Model – Hints at 4 types of changes
P
ASLR
AS1
• Inflation with growth due
to rising AD.
• Depression with deflation
due to falling AD.
• Growth with deflation due
to rising AS.
• Depression with inflation
due to falling AS.
(stagflation)
P1
AD1
Q*
Q or R-GDP
Macro Theory:
The AS/AD Model II Keynesian Version
Dr. D. Foster – ECO 285 – Macroeconomics
Part 2 – The Keynesian View
P
AS/AD Model –
Long Run & Short Run
ASLR
AS1
AD shows demand from 4
sectors of economy.
AS in LR shows full
employment of resources.
AS in SR shows effect of
inflexible wages.
P1
Keynesian argument
AD1
Q*
Q or R-GDP
The Keynesian Perspective
• The short run is more important to us.
• We live our lives through the SR not the LR
and the LR may take too long!
• We need a theory of the SR to smooth out the
business cycle.
• Equilibrium occurs when
planned spending equals
realized spending.
In fact, Keynes didn’t really
have a business cycle
theory (“animal spirits”).
He had a theory of how to
deal with a business cycle.
Equilibrium in the Keynesian Model
• When planned spending = realized spending
• Assumes planned C, G, net X = realized C, G, net X
• But, planned I may not equal realized I
If AD>AS then Ip>Ir and inventories fall unexpectedly.

And business will I which production and income/employment.
If AD<AS then Ip<Ir and inventories build up unexpectedly.

And business will I which production and income/employment.
Recall from our discussion of GDP = the change in business inventories,
although very small in absolute terms, is a closely watched variable
because it tells us what will happen to business investment …
Details of the Keynesian Model
• Changes in spending have a multiplier effect
on income.
 C=$100 will Y=$100; some of this is spent, so
C=$80 which Y=$80; some of this is spent, so
C=$64 which Y=$64 …
 True for  in C, I, G, net X
• This only applies when there is no inflation.
 All income changes are “real.”
• In a recession, additional resources can be
employed without raising wages/prices.
Keynesian theory in AS/AD Model
Introduce a flat AS.
P
ASLR
Introduce
disequilibrium at Q1
with AD2.
AS1
Equilibrium process
moves us to Q2.
AD2
But, we still have a
depression.
AD3
If we can further
increase spending to
AD3 we can boost
employment and
output.
AD1
Q1 Q 2 Q 3
Q*
Q or R-GDP
Continue until we
reach Q*.
Fiscal Policies
• Government spending & taxes.
•  G has a direct effect on AD (just as  C, I, net X)
• Since G is discretionary, it can be controlled, unlike others.
• Taxes have a more complicated effect.
To keep things simple, assume “lump sum taxes.”
T will affect both consumption and saving.
e.g., if taxes are raised by $400 then maybe consumption
will fall by $320, and saving will fall by $80 to compensate.
Since changes in income are driven by multiplier effects on spending,
the effects are not offsetting!!!! [T = lesser C   Y]
Odd Keynesian balanced budget multiplier = 1, where ∆G = ∆T = ∆Y
Fiscal Policies
• Transfer payments can be included here.
Recall that they are not included as G in GDP.
But, we can consider these as “negative taxes.”
That is, total government spending = G + TP,
while total government revenue = T + TP.
So an TP can be thought of as an equivalent T
An TP will C and S, so overall Y just like a T
• Some fiscal policies may be “automatic stabilizers.”
With unemployment, transfer payments rise automatically.
e.g., Unemployment insurance, food stamps, welfare.
This would tend to boost AD without explicit Congressional
approval.
Also, taxes serve this purpose. As the economy slides into
recession, incomes fall and so do tax payments.
Taxes, Spending, Debt & Deficits
• A change in taxes should affect AD & AS
Is the effect on AS larger?
• The Laffer Curve and tax collection.
Of course the purpose isn’t
to maximize tax revenues!
• If G is financed by borrowing, how will we react?
Ricardian equivalence - do we plan on a future tax burden?
The “crowding out” issue.
• Should budget be set to balance at full employment?
Keynes – No! Balance over the business cycle.
Buchanan – Politicians will never do that!
“Structural deficit” – what remains at full employment.
2014:Q4
102.5%
2014:Q4
$18.1 t
2014
2.78%
2014
$485 b
2014:Q4
$3.9 t.
CBO; By 2038 %GDP:
Fed’l spending 26%
Fed’l revenue 19.5%
Interest on debt 5%
2014:Q4
$420.5 b.
Macro Theory:
The AS/AD Model
Part 1 – The Basics
Part 2 – The Keynesian View
Dr. D. Foster – ECO 285 – Macroeconomics