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As/Ad Model

Macroeconomics – Chapter 10: The Aggregate Demand/Aggregate Supply Model * Keynesian Economics – Economists who focused on the short run * John Maynard Keynes – their leading advocate the originator of macroeconomics as a separate discipline from micro * Classical Economists – economists who focused on long-run issues such as growth * Aggregate Demand Management – government’s attempt to control the aggregate level of spending in the economy * Equilibrium Income – the level of income toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production * Potential Income – the level of income that the economy is technically capable of producing without generating accelerating inflation * Paradox of Thrift – and increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession * Multiplier Model – the model that was meant to capture Keynesian economics * This model emphasized aggregate output fluctuations * Explored why those output fluctuations generally would not lead to wild fluctuations in output – depressions * Instead lead to smaller fluctuations – recessions * The AS/AD Model – aggregate supply/aggregate demand Is a pedagogical model – designed to give a framework to organize thinking about macro economy * Does not focus on problems that occur because of interactions between individuals * Consists of 3 curves * Short-run aggregate supply (SAS) curve * Aggregate demand (AD) curve * Long-run aggregate supply (LAS) curve – highest sustainable level of output * The price level of all goods is on the vertical axis and the aggregate output is on the horizontal axis * It is a historical model – starts at one point in time and says what will likely happen when changes affect the economy * Aggregate expenditures (demand) – the sum of consumption, investment, government spending, and net exports – p.234 * Discuss the historical development of macroeconomics * The depression began in the 1930s and lasted 10 years * During he depression output fell by 30% and unemployment rose to 25% * This was the beginning of macro’s focus on the demand side of economics * Keynes started asking what short run forces were causing the Depression and what society could do to counteract them * This created the framework that focuses on short-run issues such as business cycles and how to stabilize output fluctuations * By the 1950s, Keynesian economics had been accepted by most economists and taught almost everywhere in the US * In the 1970s inflation became a serious issue which meant that the multiplier model was not very helpful * It assumed that the price level is fixed * The standard model taught in macro then shifted to the Aggregate Supply/Aggregate Demand (AS/AD) model * Explain the shape to the aggregate demand curve and what factors shift the curve * Aggregate demand (AD) curve – a curve that shows how a change in price level will change aggregate expenditures on all goods and services * It is downward-sloping The reasons for the downward slope are due to the: * Interest rate effect – the effect that a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates – p.234 * International effect – as the price level falls (assuming the exchange rate does not change), net exports will rise – p.

234 * Money wealth effect (real balance effect) – a fall in the price level will make the holders of money richer, so they buy more – p.

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234 * The multiplier effect strengthens each of these effects * Multiplier effect – the amplification of initial changes in expenditures – p. 235 * Shifts in the AD curve – means that at every price level, total expenditures have changed – p. 236 * Shift factors of aggregate demand: Foreign Income – recessions and expansions occurring in other countries cause demand for US goods decreases or increases respectively * Exchange Rate Fluctuations – when a country’s currency loses value, relative to foreign currencies, demand for foreign goods decreases and demand for domestic goods increases; exports also increase * Distribution of income – * Expectations – expectations of future output and future prices * Government Policies – spending policy, tax policy, etc – p. 238 * When consumption expenditures increase, the AD curve shifts to the right, when consumption expenditures decrease, the AD curve shifts to the left * Explain the shape of the short-run aggregate supply curve and what factors shift the curve – p. 39 * Short-run Aggregate Supply (SAS) curve – a curve that specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant * The curve is upward-sloping which means that other things constant, an increase in output is accompanied by an rise in price level * When aggregate demand increases, the price level rises * Two reasons that the SAS curve slopes upward, other things constant: * Upward-sloping curves in auction markets * Firms’ tendency to increase their markup when demand increases * The shape of the SAS curve reflects two different types of markets * The auction market – markets represented by the supply/demand model * Posted-price markets – prices are set by the producers and change infrequently * Often called Quantity-adjusting Markets – markets in which firms respond to changes in demand primarily by changing production instead of changing their prices * Shifts in the SAS curve: – p. 239 Changes in input prices, such as wages or supply costs * If input prices rise, the SAS curve shifts up, if input prices fall, the SAS curve shifts down * Change in the productivity factors of production * An increase in productivity shifts the curve down * A reduction of input costs per unit of output shifts the curve down * Changes in import prices of final goods * Import prices are a shift factor because they are a component of an economy’s price level * When import prices rise the SAS curve shifts up * Changes in excise and sales tax * Higher sales tax shifts the curve up * How much will the curve shift: The percentage change in wages and other factor prices minus changes in productivity * If productivity rises by 3% and wages rise by 7%, we can expect that the price level will rise by 4% for a given level of output * Explain the shape of the long-run aggregate supply (LAS)curve – p.

241 * Long-run aggregate supply (LAS)curve – a curve that shows the long run relationship between output and the price level * The position of the LAS curve is determined by potential output * Just where to position the curve is somewhat in debate * The range is bounded by a high level of output and a low level of output and the LAS curve can be thought of as being the mid-point of that range * The shape of the LAS curve * The LAS curve is vertical At potential output all resources are being fully utilized * A rise in the price level mean that the price of goods and factors of production, including wages, will rise * Show the effects of shifts of the aggregate demand and aggregate supply curves on the price level and output in both the short run and long run – p. 243 * Short run equilibrium is where the SAS curve and the AD curve intersect * If the AD curve shifts to the right * Price level will rise * Output will increase * If the SAS curve shifts up * Price level will rise * Output will decrease * Long run equilibrium is where the LAS and AD curves intersect * AD curve can only determine price level, it has no effect on output * If the AD increases, price levels rise Explain how dynamic feedback effects can destabilize the economy – p. 246 * * Discuss the limitations of the macro policy model – p. 250 * Fiscal policy – changing government spending and tax policy is a slow process * Changes cannot be completed in a timely fashion * Potential output cannot be measured accurately * Many other interrelationships that the model does not take into account * Rate of unemployment fluctuates and is difficult to predict * Falling asset prices and falling price level on expectations of aggregate demand * When there are pressures for price levels to fall there are also pressures for asset prices to fall

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