Download Aggregate Demand

Macro Theory:
The AS/AD Model
Dr. D. Foster – ECO 285 – Spring 2014
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.
• Some 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 price: Exports Imports
and seemingly  quantity demanded.
But, this S€ and D€ which will
reduce our exports, increase imports.
• 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 the money supply … later.
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 Q.
• 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.
From SR to LR Aggregate Supply
P
ASLR
From the new
equilibrium,
what happens
if AD falls?
AS3
AS4
Prices fall,
wages lag,
output falls.
P3
Eventually,
wages catch up
and AS rises.
P2
P1
AD2
AD3
Q3 Q*
Q or R-GDP
In LR, only
prices fall.
Macro Theory:
The AS/AD Model
Dr. D. Foster – ECO 285 – Spring 2014