AD and AS together

AD and AS together Here we put Aggregate Supply in the short run and Aggregate Demand together and use the model to help use understand the actual performance of the macroeconomic system.

Equilibrium in SR P AD1 AS1 P1 RGDP RGDP1

Equilibrium On the previous slide we have the AD curve cross the AS. 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 there 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.

Rise in AD P AS P2 P1 AD2 AD1 RGDP RGDP1 RGDP2

Rise in AD Say the AD rises (remember why AD could shift to the right? – maybe G increases or I increase, or we have seen many other reasons) With the AD rising along the given AS curve the tendency is for the price level to rise. This higher price will 1) Encourage movement along the AS so more output is produced, but 2) Encourage movement along the new AD, but this a decline back to where the AS and new AD meet. The higher price level here is inflation and since demand growth caused it we would say there is demand pull inflation.

Rise in AD If RGDP1 a few slides back was the full employment level of output, then when AD shifts right and we end up at RGDP2, the difference RGDP2 minus RGDP1 would be called a positive, or inflationary, GDP gap. Note: from our discussion of the multiplier, the amount the AD curve shifted would be the full multiplier impact of a change in C, I, G or X. But, when the price level changes some of this multiplier amount is choked off.

Fall in AD P AD1 AS1 P1 AD2 P2 RGDP2 RGDP RGDP1

Fall in AD AD can fall for many reasons we have covered. Our model would suggest that not only would RGDP fall, but the price level would fall as well. RGDP would fall less than the shift in AD because the lower price level would reverse some of the decline in AD. There is one problem with this theory – it is not consistent with the real world in the US! When RGDP declines due to lower AD we have not gotten the price level decline. This would be deflation, but we have not had deflation in the US in several decades. We need to modify our theory a tad!

Modify theory of AS 1)The arrows under the supply curve are what we saw before – higher price level, higher RGDP. P 2) Above the supply curve, the up arrow shows the price can go up the supply. But if the RGDP falls from RGDP1 it will not happen along the AS. It will happen along the price P1 line AS1 P1 RGDP RGDP1

Ratchet Effect We use the phrase the “ratchet effect” to signify the price level can rise with higher RGDP amounts but the price level will not fall with lower RGDP levels. The “ratchet” is similar to how a socket wrench works. When you tighten a nut or bolt the socket moves in the direction of tightening with force, but you can move the socket in the opposite direction, the ratchet, and it has no impact on the bolt. The tool was invented so you don’t have to take the tool off and put it back on the nut to apply the force. We just use the analogy here – the price can go up, but not down. Next let’s look at why the price level is thought to be inflexible downward!

Price level inflexible downward The following are reinforcing reasons as to why the price level is felt to be inflexible downward in the US economy. 1) Fear of price wars, 2) Menu costs, 3) Wage contracts, 4) Efficiency wage theory, and 5) Minimum wage laws (You can read the book about the logic of each of these ideas.)

Fall in AD with the Ratchet Effect P AD1 AS1 P1 AD2 RGDP RGDP1 RGDP2

Fall in AD with the Ratchet Effect If RGDP1 a few slides back was the full employment level of output, then when AD shifts left and we end up at RGDP2, the difference RGDP2 minus RGDP1 would be called a negative, or recessionary, GDP gap. Note: from our discussion of the multiplier, the amount the AD curve shifted would be the full multiplier impact of a change in C, I, G or X. AND, since the price level does not decline the full multiplier amount takes place. Also note the decline in RGDP is called a recession and the resultant output decline would be associated with cyclical unemployment.

Decrease in AS P AS2 AD1 AS1 P1 RGDP RGDP1

Decrease in AS Back in the 1970’s, and again in the 2000’s, in the US we had the “oil supply shocks” which put pressure on production because oil, or its by-products, is used in many production processes. This shifted the AS to the left. With AS shifting left the price level rose and RGDP fell. The higher price level is inflation and in this case is called cost push inflation due to higher costs of production. The decline in RGDP would be called a recession. Note along the new AS the higher price has been “ratcheted up.”

AS increase with AD increase P AS1 AS2 P2 P1 AD2 AD1 RGDP RGDP1 RGDP2

AS increase with AD increase In the late 1990’s we had technological gains related to the computer and this lead to productivity gains and AS shifting right. (On its own this would give downward pressure on price, but again the ratchet effect would kick in.) AD also shifted to the right because expectations of households and businesses were high due to the economy having experienced an economic expansion for several years ( it would go on for 9 years or so). So the impact on the economy from both shifts was big gains in RGDP but only mild inflation.

AD and AS together