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AD-AS Model
Part III:
Putting it all together
Stick Wages
Nominal wages that are slow to fall even in
the face of high unemployment and slow to
rise even in the face of labor shortages.
 Nominal wages cannot be sticky forever.
The length of their stickyness is the
difference in the short and long run

3 Ranges of the Segmented AS Curve
AS
PL
(3)
1.
2.
3.
(2)
(1)
RGDP
Keynesian
Intermediate
Classical
Long Run Aggregate Supply
Prices are relative. If your
pay is cut by 50% but all
prices drop by 50% your
income has the same
value
LR Aggregate Supply
The upward slope of the
SRAS is due to sticky
wages / other prices,
BUT wages always
adjust / are
renegotiated in the LR
LR -- ALL inputs are
flexible & PL has NO
effect on quantity of
output supplied
LR Aggregate Supply
o
LRAS’s position on the
horizontal axis
represents the speed
limit or potential (noninflationary) level of
output (i.e. full
employment)
LR Aggregate Supply

Actual RGDP is
almost always above
or below FE (Full
Employment) [i.e. at a
SR equilibrium]

Potential output for
the U.S. has grown
steadily over time
LR Aggregate Supply
Shifts in LRAS due to:
1.  in labor force
2.  in physical capital
3.  in natural resources
4.  in human capital
5.  in technology
Same reasons the PPC
shifts
Moving from the SR to the LR
If the economy is almost
always on its SRAS, why is
LRAS relevant?
Over time, the SRAS will shift
to restore the LR
equilibrium
Actual output will eventually
reach potential output
Putting AS & AD Together

Movement along a curve occurs because the
other curve has shifted. To understand the
economy, you need both curves (and
LRAS).
PL
SRAS
AD1
AD0
RGDP
SR Macroeconomic Equilibrium
PL
SRAS
P*
AD
Y*
RGDP
The intersection of SRAS &
AD is equilibrium:
quantity of total output
supplied = Q demanded
by C + I + G + (X - M).
It shows PL & RGDP
Below equilibrium, PL will
rise because there is a
shortage.
Above equilibrium, PL will
fall because there is a
surplus.
Negative Supply Shock
Darth Vader attacks Dathomir.
Shifts in SRAS (Supply Shocks)
Negative Supply Shock
--Some  in production
costs (e.g. increasing
commodity prices,
increasing nominal
wages, decline in
productivity)
--Shifts SRAS to the left
-- PL  (inflation up)
-- RGDP  (unemployment
up)
1.
LRAS
SRAS1
PL
SRAS0
P1
P*
AD
Y1 FE
RGDP
Negative SRAS Shock: Phillips
Connection
Inflation
SRPC1
SRPC0
Unemployment
Result: stagflation (means
stagflation + inflation)
= worst of all possible
worlds
= right shift of SR Phillips
Curve (cost-push
inflation)
What should we try to fix
first?
Positive Supply Shock
Luke Skywalker comes and saves the
day
Shifts in SRAS (Supply Shocks)
2. Positive Supply Shock
--Some  in production costs (e.g.
decreasing input prices,
increase in productivity)
--Shifts SRAS to the right
-- PL  (inflation down)
-- RGDP  (unemployment down)
LRAS
SRAS0
PL
SRAS1
P*
P1
Result: best of all possible worlds
Full employment & disinflation
creates waves of national
optimism
AD
FE Y1
RGDP
Negative SRAS Shock: Phillips
Connection
2. Positive Supply
Shock
inflation
SRPC0
SRPC1
unemployment
The Short Run Phillips
Curve shifts LEFT
Improved menu of
tradeoffs
How can we keep this
going?
Shifts in AD: Demand Shocks
Negative Demand
Shock:
Recession caused by a
leftward shift in AD
(e.g. a  in wealth,
oversupply of stock
of capital,
contractionary fiscal
or monetary policy)
1.
This was actually a movie
This dude is literally tightening his belt.
Shifts in AD: SR Demand Shocks
When AD shifts left…
Result: Recession
PL  (disinflation or
deflation)
RGDP 
(unemployment  )
Ex. 2001 Recession &
Great Depression
PL
LRAS
SRAS
P*
P1
AD1
Y1
FE
AD0
RGDP
Negative AD Shock: Phillips
Connection
inflation
Left Shift in Aggregate
Demand corresponds
to…
Movement downward
along the Phillips Curve
SRPC
unemployment
Tradeoff between inflation
and unemployment
Shifts in AD:
SR Demand Shocks
2. Positive Demand
Shock
-- demand-pull boom
caused by a right
shift in AD
(e.g. an  in wealth,
undersupply of
stock of capital,
expansionary fiscal
or monetary policy
Shifts in AD: SR Demand Shocks
AD shifts right…
Result: Inflationary
Boom
PL  (demand-pull
inflation)
RGDP  (unemployment
)
Ex. Spending on WWII
& Great Society
PL
LRAS
SRAS
P1
P*
AD1
AD0
FE
Y1
RGDP
Positive AD Shock: Phillips Connection
Right shift in AD
corresponds to…
inflation
Movement upward
along the Phillips
Curve
SRPC
unemployment
Tradeoff between
unemployment and
inflation
In the LR the economy self-corrects





Negative D shock  PL &
RGDP
AD moves  SRAS b/c sticky
wages are not falling as fast as
product market prices
(businesses lay off workers or
shut down b/c of  profitability)
 unemployment  bargaining
power of workers; nominal
wages 
 in cost of production shifts
SRAS to the right until FE
equilibrium (LRAS
equilibrium) is restored
Net result: same FE level
(RGDP) at a lower PL
PL
LRAS
SRAS0
SRAS1
1
2
AD1
Recessionary Gap
AD0
RGDP
While this explanation makes waiting for the LR adjustment
look quite desirable, SR recessions can be very disruptive to
the population.
Positive Ag. Demand Shock





 PL & RGDP
AD moves  SRAS b/c sticky
wages are not rising as fast as
product market prices (firms
ratchet up production, hire more
workers, & add shifts b/c of 
profitability)
Tight labor market  bargaining
power of firms; nominal wages

 in cost of production shifts
SRAS to the left until FE
equilibrium (LRAS
equilibrium) is restored
Net result: same FE level
(RGDP) at a higher PL
PL
LRAS
SRAS1
SRAS0
AD0
Inflationary Gap
AD1
RGDP
From LR to SR
How long does it take to move from SR to LR?
*answer depends on whether you believe in
Adaptive or Rational Expectations
Adaptive Expectations
Rational Expectations
Adaptive Expectations


The economy moves
from the short run to
the long run slowly
because individuals
respond to events as /
after they happen
People are largely
reactive to events “on
the ground”
Rational Expectations



The economy moves from SR to LR
quite quickly b/c people have an intuitive
understanding of the economic forces at
work & react immediately to where the
economy is going.
They make decisions optimally, using all
available information.
e.g. if a union is negotiating a contract
during a period of current & past low
inflation and announced gov’t policy
indicates that the G will be trying to
trade a  PL for  unemployment, then
the union will put that future inflation
into the new contract, sabotaging G
efforts to move up the SRAS -- instead
go straight to same RGDP at a higher
PL.
Implications: LR or “Extended”
Phillips Curve
3 Generalizations
1.
Under normal circumstances
there is a SR tradeoff between
the rate of inflation & the rate
of unemployment
2.
Aggregate supply shocks can
cause both  rates of inflation
&  rates of unemployment
3.
There is no significant tradeoff
between inflation &
unemployment over long
periods of time
Inflation
LRPC
SRPC1
SRPC0
Unemployment