Download AD and AS together - Wayne State College

AD and AS together
Here we put Aggregate Supply and
Demand together and use the model
to help use understand the actual
performance of the macroeconomic
system.
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I would like to use another analogy here – this one from the
world of medicine.
Have you every had a sinus infection? No fun! Can you live
with a sinus infection and have the infection go away without
any hands on intervention from a doctor?
The answer is yes, but why would you want to in modern
America? Please think about this! Sometimes we may want a
hands off approach.
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A point about the method
When we talked about Aggregate Supply we made it a point
to distinguish between the short run and the long run. We are
always in a short run and are moving toward a long run.
In AD/AS graphs we use from here out focus your attention
on the AD - SRAS intersection and if this happens at a place
other than where LRAS, then an automatic adjustment will
happen in the economy as we talked about during our
discussion about SRAS. The adjust will include a shift of
the SRAS curve.
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Equilibrium
P
LRAS
AD1
SRAS1
P1
RGDP1
RGDP
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Equilibrium
On the previous slide we have the AD curve cross the SRAS
exactly where the SRAS crosses the LRAS. This is our usual
starting point. Note the price level is determined at this
intersection and the level of RGDP is determined at this point.
The economy would stay at this point and then we observe
price level P1 and RGDP level RGDP1 in the economy if
every thing else stayed the same.
The real world, though, is one of change and things will not
stay the same. Let’s see how our model works here.
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Rise in AD
P
LRAS
AD1
SRAS1
P2
P1
AD2
RGDP1
RGDP2
RGDP
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Rise in AD
Say that AD rises. Since at P1 the AS is at RGDP1 and the
AD is more, the national economy shortage will pull the price
level up and firms will follow along the SRAS by adjusting
input usage. The short term impact is to have the price level
rise and the level of RGDP rise.
The increase in the price level is called inflation. We have a
demand theory of inflation. If demand rises the level of
prices will rise. This is a demand pull theory of inflation.
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Rise in AD
The distance RGDP2 - RGDP1 is called an expansionary or
positive GDP gap. It is the gap by which the economy has
expanded above the natural pace of the economy.
The expansionary gap will naturally go away in the long run if
nothing else changes. The way this will happen is the input
prices will eventually rise because resources are being worked
hard. With higher input prices the SRAS shifts to SRAS2 and
the economy is back at the natural level of output, although at
a higher price level. We see this on the next slide.
Again, the time frame of the adjustment may lead policy
makers to take action before the long run natural mechanism
can take place.
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In the long
run an
increase in
AD only
changes the
price level
(to P3).
Rise in AD
P
LRAS SRAS2
P3
AD1
SRAS1
P2
P1
AD2
RGDP1
RGDP2
RGDP
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Fall in SRAS
P
LRAS
SRAS2
AD1
SRAS1
P1
RGDP1
RGDP
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Fall in SRAS
On the previous slide say we have a oil prices spike up high or some
other widely used input has an increase in price. This input price
rise can cause SRAS to shift left. We would then have inflation with
reduced output. The reduced output would be recognized as a
recession with more unemployment and the higher price would be
inflation.
If nothing is done from a policy perspective the recession and
unemployment would eventually lead to lower input prices as inputs
simply seek employment. Eventually the SRAS would shift back to
SRAS1. But, if this takes a long time the unemployment may cause
policy makers to want to increase AD without waiting for SRAS to
shift out. This would cure the unemployment, but would mean even
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more inflation. (see this on the next slide)
Fall in SRAS
P
LRAS
SRAS2
AD1
SRAS1
P1
RGDP1
RGDP
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Fall in AD
P
LRAS
AD1
SRAS1
P1
AD2
P2
RGDP2
RGDP1
RGDP
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Fall in AD
Imagine AD falls (we have mentioned before why this might
happen). Since at P1 the AS is at RGDP1 and the AD is less,
the national economy surplus will pull the price level down
and firms will follow along the SRAS by adjusting input usage.
The short term impact is to have the price level fall and the
level of RGDP fall.
If the RGDP fall is for two consecutive calendar quarters or
more, the decline in RGDP is called a recession. If the
recession is considered severe the recession is called a
depression. The decline in the price level is called deflation.
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Fall in AD
Now, as the AD falls the RGDP level falls and when we
produce less the unemployment rate could rise. Although this
is not explicit in the graph, be aware of this.
The fall in RGDP in the example is RGDP2 – RGDP1.
The distance RGDP1 – RGDP2 is called a contractionary or
negative GDP gap. It is the gap by which in the economy the
level of RGDP is has contracted short of the long run pace of
the economy.
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Fall in AD
P
LRAS
AD1
SRAS1
SRAS2
P1
AD2
P2
RGDP2
RGDP1
RGDP
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Fall in AD
If the fall in AD is persistent, the resources will be under used
(unemployment) and eventually wages and other input prices
will fall. SRAS1 will shift out to SRAS2 and the economy
will be back in line with LRAS, although at a lower price
level.
Conclusion: A fall in AD may cause a recession in the short
term, but in the long term will only cause the price level to
decline. Note the economy can pull out of a recession on its
own, but it may take a great deal of time. Perhaps we as a
nation will not want to wait and we will have put into play
expansionary monetary and/or fiscal policy.
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