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Chapter 5 Aggregate Supply and Demand Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 1 Aggregate Supply and Aggregate Demand The aggregate supply–aggregate demand (AS–AD) model is the basic tool for studying output fluctuations and the determination of price levels The model describes the relationship between overall prices (GDP deflator) and output (real GDP) Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 2 Chapter Organisation 5.1 The Aggregate Supply Curve 5.2 The Aggregate Demand Curve 5.3 Aggregate Demand Under Alternative Supply Assumptions 5.4 Supply-side Economics Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 3 5.1 The Aggregate Supply Curve The AS curve describes, for each given price level, the quantity of output firms are willing to supply The AS curve is upward sloping since firms are willing to supply more at higher prices In the short run the AS curve is horizontal (the Keynesian AS curve) In the long run the AS curve is vertical (the classical AS curve) Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 4 The Aggregate Supply Curve Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 5 The Classical AS Curve The classical AS curve Is vertical, indicating that the same amount of goods will be supplied whatever the price level Assumption The labour market is in equilibrium at full employment and all factors of production are fully utilised Implication Increases in AD do not increase output but merely raises prices Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 6 The Classical AS Curve The level of output corresponding to full employment is called potential GDP Potential GDP grows over time as the economy accumulates resources and new technologies This shifts the AS curve to the right over time Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 7 The Keynesian AS Curve The Keynesian AS curve Is horizontal, indicating firms will supply whatever amount of goods is demanded at the existing price Assumption There is unemployment, so firms may obtain as much labour as they want at the current wage Implication AD determines the level of output, with prices ‘sticky’ in the short run Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 8 Vertical or Horizontal? Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 9 Vertical or Horizontal? At levels of output below potential, the AS is quite flat, as there is little tendency for prices of goods and factors to fall At levels of output above potential, the AS curve is steep and prices tend to rise continuously Hence, the effect of changes in AD on output and prices depends on the level of actual output relative to potential output Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 10 Types of Unemployment Frictional unemployment Unemployment due to individuals shifting between jobs and looking for new jobs Structural unemployment Unemployment due to a mismatch between the skills of the labour force and the skills demanded by firms Unemployment is a consequence of technological improvements Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 11 Types of Unemployment The natural rate of unemployment (NRU) The frictional and structural unemployment associated with the full employment level of output Current estimates of the NRU in Australia are about 6.5% Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 12 Chapter Organisation 5.1 The Aggregate Supply Curve 5.2 The Aggregate Demand Curve 5.3 Aggregate Demand Under Alternative Supply Assumptions 5.4 Supply-side Economics Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 13 5.2 The Aggregate Demand Curve The AD curve Shows the combinations of the price and output level at which the goods and money markets are in equilibrium Is downward sloping because for a given level of nominal money, higher prices reduce the value of the real money supply, which reduces the demand for output Increases in autonomous AD shifts the AD curve to the right Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 14 The Aggregate Demand Curve The AD relationship between price and output Is dependent upon the real money supply Real money supply is nominal money supply () deflated by the price level (P) That is: /P When P falls, the real money supply rises, interest rates fall and investment rises, causing AD to increase Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 15 The Aggregate Demand Curve The quantity theory of money provides a simple analysis of the AD curve MV=PY Where M is the nominal money supply and V is the velocity of money If we assume that V and M are constant then an increase in output Y must be offset by a decrease in prices P Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 16 Chapter Organisation 5.1 The Aggregate Supply Curve 5.2 The Aggregate Demand Curve 5.3 Aggregate Demand Under Alternative Supply Assumptions 5.4 Supply-side Economics Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 17 5.3 AD Under Alternative Supply Assumptions Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 18 The Keynesian Case Initial equilibrium is at E where AD and AS intersect (goods and money market equilibrium) Assume an increase in AD, which shifts AD to AD’ The new equilibrium point is E’ where output has increased Firms are willing to supply any amount of output at that level of price Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 19 The Classical Case Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 20 The Classical Case Assume an increase in AD At the initial level of prices, spending has increased and the economy would tend to move towards point E’ However, firms cannot obtain more labour as the economy is at full employment Wages are bid up which increases the costs of production The increase in costs is passed on as higher prices Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 21 The Classical Case The increase in prices reduces real money stock and decreases spending The economy moves up along AD’ until spending has decreased to the level consistent with full employment output at E” Increases in AD only lead to higher prices, not increases in output Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 22 Chapter Organisation 5.1 The Aggregate Supply Curve 5.2 The Aggregate Demand Curve 5.3 The Aggregate Demand Under Alternative Supply Assumptions 5.4 Supply-side Economics Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 23 5.4 Supply-side Economics Shifting the AS to the right is preferred as it increases potential GDP There is debate about how best to achieve this increase in AS Supply-side economics (advocated by George Bush Senior) argue Cutting taxes will significantly increase AS This increase will be so large that total tax revenue will rise Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 24 Supply-side Economics Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 25 Supply-side Economics The initial tax cut shifts AD to the right The AS also shifts to the right over time because lower tax rates increase the incentive to work However, the AD curve shifts by more than the AS curve, since consumer spending increases by more than the increase in potential GDP Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 26 Supply-side Economics In the short run GDP has increased substantially (from E to E’) This is primarily due to the AD effect In the long run The economy moves to E” GDP has only increased by a small amount, total tax collection falls, the government’s budget deficit rises, and prices are permanently higher Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 27