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Macro Theory:

Macro Theory:. Dr. D. Foster – ECO 285 – Spring 2014. The AS/AD Model. Warning .. Warning .. Warning. Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! The “static” analysis only hints at dynamic interpretation.

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Macro Theory:

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  1. Macro Theory: Dr. D. Foster – ECO 285 – Spring 2014 The AS/AD Model

  2. 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.

  3. The Aggregate Demand Schedule P P = Price Level; CPI or GDP deflator Q = real output;Real GDP AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign A P2 B P1 AD1 Q or R-GDP Q1 Q2

  4. 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.

  5. 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.

  6. AD2 The Aggregate Demand Schedule P Increases in C, I, G, net X AD3 Decreases in C, I, G, net X AD1 Q or R-GDP

  7. Long Run Equilibrium betweenAggregate Demand and Aggregate Supply • There is an Aggregate Supply that reflects fully employed resource use. • Output level:Q* or RGDP* or potential RGDP P AS1 • Shifts in AD can only change the price level and not real output (nor employment). Classical Model of the Economy P1 AD1 Q or R-GDP

  8. 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)

  9. 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%…

  10. Short Run Aggregate Supply • 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. • What about: • Sticky prices • Misperception • Intertemporal substitution Unnecessary complicationsto explain the SR AS.Inflexible wages is all we need. What happens if there is a AD?

  11. From SR to LR Aggregate Supply An increase in AD triggers events. AS3 P ASLR AS2 AS1 Prices rise, wages lag, output rises. Eventually, wages catch up and AS declines. In LR, onlyprices rise. P3 P2 P1 AD2 AD1 Q or R-GDP Q2 Q*

  12. From SR to LR Aggregate Supply From the new equilibrium, what happens if AD falls? AS3 P ASLR AS4 Prices fall, wages lag, output falls. Eventually, wages catch up and AS rises. In LR, onlyprices fall. P3 P2 P1 AD2 AD3 Q or R-GDP Q3 Q*

  13. Macro Theory: Dr. D. Foster – ECO 285 – Spring 2014 The AS/AD Model

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