Macro Theory:Macro Theory:

Dr. D. Foster – ECO 285 – Spring 2014

The AS/AD ModelThe AS/AD Model

Warning .. Warning .. WarningWarning .. Warning .. Warning

• Aggregate Supply and Aggregate Demand are not Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!like market supply & demand !!!!!

• The “static” analysis only hints at dynamic The “static” analysis only hints at dynamic interpretation.interpretation.

• Ceteris Paribus assumption problematic to the point Ceteris Paribus assumption problematic to the point of being wholly inappropriate.of being wholly inappropriate.

Keynesian model notes:Keynesian model notes:•Descriptive analysis.Descriptive analysis.•Some numerical interpretation.Some numerical interpretation.•Only AS/AD graphical Only AS/AD graphical representation.representation.

The Aggregate Demand ScheduleThe Aggregate Demand Schedule

AD1

P

Q or R-GDP

BP1

Q2

AP2

Q1

P = Price Level;CPI or GDP deflator

Q = real output;Real GDP

AD = Agg. Demand;From 4 sectors – HH, Bus, G, Foreign

Aggregate DemandAggregate Demand

• The price level and real output demanded are The price level and real output demanded are inversely related.inversely related.

• A fall in the price level will increase quantity A fall in the price level will increase quantity demanded.demanded.

• Why? -- the Why? -- the Wealth EffectWealth Effect

• All prices and wages change.All prices and wages change.

• But, the fixed wealth is … well, still fixed!But, the fixed wealth is … well, still fixed!

• So, with lower prices we feel wealthier. Woo Hoo!So, with lower prices we feel wealthier. Woo Hoo!

• And, so we want to buy more stuff.And, so we want to buy more stuff.

Aggregate DemandAggregate Demand

• What about:What about:

Interest effectInterest effect Foreign trade effectForeign trade effect Exchange rate effectExchange rate effect

• AD can shift to the left or right.AD can shift to the left or right. Increase AD – shift to the right.Increase AD – shift to the right. Decrease AD – shift to the left.Decrease AD – shift to the left. Whenever C, I, G, net X increase/decrease.Whenever C, I, G, net X increase/decrease. Why? Due to changes in the money supply … later.Why? Due to changes in the money supply … later.

Can’t do “all else equal.”Can’t do “all else equal.”e.g. Lower price: e.g. Lower price: Exports Exports Imports Imports and seemingly and seemingly quantity demanded. quantity demanded. But, this But, this SS€€ and and DD€€ which will reduce which will reduce

our exports, increase imports.our exports, increase imports.

The Aggregate Demand ScheduleThe Aggregate Demand Schedule

AD2

AD1

P

Q or R-GDP

AD3

Increases inC, I, G, net

X

Decreases in

C, I, G, net X

Long Run Equilibrium betweenLong Run Equilibrium betweenAggregate Demand and Aggregate SupplyAggregate Demand and Aggregate Supply

•There is an Aggregate Supply that reflects fully employed resource use.

•Output level:Q* or RGDP* or potential RGDP

AD1

P

Q or R-GDP

AS1

P1

•Shifts in AD can only change the price level and not real output (nor employment).

Classical Model of the Economy

What affects the Aggregate Supply?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 InflexibilityShort Run Aggregate Supply – Wage Inflexibility

• Nominal wages are sluggishsluggish upwards:A rise in prices has delayed effect on wages.

• Nominal wages are inflexibleinflexible downwards:A fall in prices will result in employment and Q.

• Workers have money illusionmoney 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%…e.g. if prices rise 5% and wages rise 3%…

Short Run Aggregate SupplyShort Run Aggregate Supply

• The Short Run will adjust to the Long RunThe 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:What about:

Sticky pricesSticky prices MisperceptionMisperception Intertemporal substitutionIntertemporal substitution

Unnecessary complicationsUnnecessary complicationsto explain the SR AS.to explain the SR AS.

Inflexible wages is all we need.Inflexible wages is all we need.

What happens if there is a AD?

From SR to LR Aggregate SupplyFrom SR to LR Aggregate Supply

An increase An increase in AD triggers in AD triggers

events.events.

Prices rise,Prices rise,wages lag,wages lag,

output rises.output rises.

Eventually,Eventually,wages catch upwages catch up

and AS declines.and AS declines.

In LR, onlyIn LR, onlyprices rise.prices rise.AD

1

P

Q or R-GDP

ASLR

P1

AS1

AD2

P2

Q2Q*

P3

AS2

AS3

From SR to LR Aggregate SupplyFrom SR to LR Aggregate Supply From the new From the new equilibrium, equilibrium,

what happens what happens if AD falls?if AD falls?

Prices fall,Prices fall,wages lag,wages lag,

output falls.output falls.

Eventually,Eventually,wages catch upwages catch up

and AS rises.and AS rises.

In LR, onlyIn LR, onlyprices fall.prices fall.AD

3

P

Q or R-GDP

ASLR

P1

AS4

AD2

P2

Q3 Q*

P3

AS3

Macro Theory:Macro Theory:

Dr. D. Foster – ECO 285 – Spring 2014

The AS/AD ModelThe AS/AD Model