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MACRO Economics Unit 7: The Real Sector: ADAS & Classical Theory Economist: Someone who sees something in practice and wonders if it would work in theory. -- Senator Ernest “Fritz” Hollings Created: 2007-2013 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License MACRO Economics Why Theory Matters “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.” -- John Maynard Keynes Slide 2 MACRO Economics AD-AS Model illustrates & analyzes theory using shifts in 3 curves: AD – Aggregate Demand SRAS –Short-Run Aggregate Supply LRAS – Long Run Aggregate Supply MACRO Economics AD-AS Model is NOT same as micro supply-and-demand. Aggregates behave differently. Remember the fallacy of composition? MACRO Use AD-AS Model to show: Economics Level & changes in: real output (real GDP) price index How people respond to price level changes Capacity of the economy (PPF) Economic Conditions Inflation Recession & Unemployment Stagflation Deflation and depression MACRO Economics Understanding the AD-AS Model: Aggregate Demand-Aggregate Supply (actually it’s AD-SRAS-LRAS) MACRO Graphic Space is Real Output vs. Price Level Economics P Price Level (price index) Q Real Output (amount of real goods & services produced) MACRO Economics Economy at some starting point. P Price Level (price index) Price Index @start Start Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics Economy Grows shifts right P Price Level (price index) after real growth in GDP, but no inflation or deflation Price Index @start start (now) after Real GDP Real GDPaft @start er Q Real Output (amount of real goods & services produced) MACRO Economics Economy shrinks moves left (recession) P Price Level (price index) after decline in real GDP unemployment has increased because fewer resources are employed Price Index after Start Real GDPafter Real GDP @start @start Q Real Output (amount of real goods & services produced) MACRO Inflation shift upward Economics P Price Level (price index) Price Index after inflation after Inflation Price Index Start @start Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics Deflation shift downward P Price Level (price index) Price Index Start @start deflation Price Index after after deflation Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics Real Life: both prices & real GDP change “Stagflation” shift up & left “stagflation” P Price Level (price index) Price Index after inflation after Inflation Start Price Index @start Real GDPafter Real GDP Q @start Real Output (amount of real goods & services produced) MACRO Economics Inflationary Growth up & right P Price Level (price index) Price Index after after inflation Inflation Price Index Start @start Real GDP Real GDPafter Q @start Real Output (amount of real goods & services produced) MACRO Economics 2 Other Possibilities Prices decline & real GDP increase down and to the right Prices decline & real GDP decrease down and to left MACRO Economics Reactions to Changes in Prices Two relationships (curves) show how people react to inflation/deflation: Aggregate Demand (AD) Willingness to spend. Short-Run Aggregate Supply (SRAS). Willingness to sell. MACRO AD is downward sloping because of 3 effects: Economics Wealth & Fixed Incomes Interest Rate & Debt Payments International Trade MACRO AD curve shows changes in willingness to buy real Q in response to changes in price level. Economics P Price Level (price index) Price Index @start Start AD Real GDP Q (or Y) Real Output @start (amount of real goods & services produced) MACRO Economics AD: Inflation reduces ability to buy P Price Level (price index) Price Index Start @start Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics Deflation increases ability to buy. P Price Level (price index) Price Index Start @start Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics AD: buyer reactions to inflation / deflation P Price Level (price index) Price Index Start @start Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics Now: producers & sellers Inflation: all prices increase But, inflation is not highly visible. Single-product price changes are. Producers/sellers see price change of their product. perceive a real price increase when it is really inflation willing to produce & sell more goods Temporary reaction SRAS, or Short-Run Aggregate Supply. Eventually costs increase & qty returns to original MACRO Economics SRAS curve shows changes in desire to sell real Q in response to changes in price level. P Price Level (price index) Price Index @start Start Real GDP @start Q (or Y) Real Output (amount of real goods & services produced) MACRO Economics SRAS: Price change “fools” producer P Price Level (price index) Price Index Start @start Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics Deflation “fools” into reduced output. P Price Level (price index) Price Index Start @start Real GDP @start Q Real Output (amount of real goods & services produced) MACRO Economics SRAS curve P Price Level (price index) Price Index @start Start Real GDP @start Q (or Y) Real Output (amount of real goods & services produced) MACRO Economics Short-Run Equilibrium: Purchases = Sales where AD intersects SRAS. P Price Level (price index) Price Index @start SR-AS start AD Real GDP Q (or Y) @start Real Output In a short-run equilibrium, the economy is always where SRAS=AD because the quantity of Real GDP we buy must equal the amount we sell. MACRO Economics AD and SRAS curves only show Real GDP vs Price Level changes. Other changes shift the curves. MACRO AD curves shift (move) when changes such as… Economics Expectations about future More optimism shifts AD right More pessimism shifts AD left. Growth in other countries boosts exports. Government decisions change T or G MACRO AD shift: more optimism or more G or lower T or more X Economics P Price Level (price index) Price Index Start @start AD after Real GDP @start AD before Q Real Output (amount of real goods & services produced) MACRO Economics Next: Shifts in SRAS curve Factors that shift SRAS: Changes in expectations about future economic conditions. Technology improves. Cost increases: Firms realize that resource prices have risen but they cannot pass the increase on to customers. MACRO Input cost increases shift SRAS left/up – but there is a lag. Economics SRAS: short-run reaction only “fooled” by price change Once inflation is perceived, then SRAS curve shifts upward/left. MACRO Economics Sellers react to inflation SR-AS after P Price Level (price index) Price Index after inflation Price Index @start SR-AS Final reaction start Real GDP @start Initial reaction start MACRO Economics Improved technology can shift SRAS also. P Price Level (price index) SR-AS start SR-AS Price Index @start start Real GDP @start after MACRO External input cost increases also shift SRAS - example: oil. Economics P Price Level (price index) SR-AS after SR-AS Price Index @start start Real GDP @start start MACRO Economics Both AD & SRAS are short-run reactions to price changes – ignoring physical capacity. MACRO Economics LRAS is missing piece representing capacity and resources. MACRO Production Possibilities determined by available resources / technology, not prices Economics P Price Level (price index) LRAS: long-run aggregate supply (“capacity of economy” or “sustainable production rate” when all resources are employed) Q Real Output (amount of real goods & services produced) MACRO Economics Economy left of LRAS unemployment exists P Price Level (price index) LRAS: long-run aggregate supply any point in this region indicates the economy is not using all resources --- unemployment exists Q Real Output (amount of real goods & services produced) MACRO Economics Unemployment. P Price Level (price index) LRAS: long-run aggregate supply Amount of unemployment Q Real Output (amount of real goods & services produced) MACRO What if we sell more than we can produce (SRAS > LRAS)? reduce inventories Economics P Price Level (price index) LRAS: long-run aggregate supply attempting to produce more than capacity, only possible for short run, actually draws down inventory Q Real Output (amount of real goods & services produced) MACRO Long run growth is a shift in LRAS. Economics P Price Level (price index) LRAS1 LRAS2 Q Real Output (amount of real goods & services produced) MACRO Putting them altogether. Economics We’re now ready to put all three curves together. Short-run equilibrium is where SRAS = AD, but… Where is that relative to LRAS? Three possibilities……. MACRO Long-Run Full-Employment Equilibrium -- the goal Economics LRAS P Price Level (price index) SR-AS Price Index start @start AD Real GDP @start MACRO Economics Recessionary Gap (also known as “contractionary gap”) LRAS P Price Level (price index) SR-AS Gap represents amount of unemployment Price Index start @start AD Real GDP Real GDP @start if we had full employment MACRO Inflationary Gap (also known as Expansionary Gap) Economics P Price Level (price index) Price Index LRAS SR-AS start @start AD Real GDP @start MACRO Economics LRAS: Beneficial Supply Shocks Abundant harvests Discovery of natural resources Technology breakthroughs Population growth & immigration MACRO Shocks cause a gaps. Economics “Supply shocks” New technology More people/resources Destruction of people/resources War Natural Disaster MACRO Economics LRAS: Adverse Supply Shocks Examples Drought Natural Disasters Suddenly reduced supply of any critical resource Government instability Terrorist attacks War Any permanent reduction of economy’s ability to produce real goods and services MACRO Economics Aggregate Demand Shocks Changes in: confidence/optimism perceived wealth foreign economic events fiscal policy (G or T) monetary policy (interest rates) MACRO Economics Short-Run Aggregate Supply Shocks Changes in: external input cost short-run supply restrictions uncertainty re: profits? MACRO Economics That’s it. Our AD-AS model is now complete.