Transcript Lecture 20

Long Run
Aggregate Demand & Supply
Lecture 20
Dr. Jennifer P. Wissink
©2015 Jennifer P. Wissink, all rights reserved.
November 3, 2015
The Aggregate Demand Curve: A Warning
 The
AD curve is not a market demand curve like
in Econ 1110. It’s a more complex concept.
– It’s an equilibrium locus, really.
 Remember:
A higher price level causes the
demand for money to rise, which causes the
interest rate to rise.
– Then, the higher interest rate causes aggregate
output to fall.
– At all points along the AD curve, both the goods
market and the money market are in equilibrium.
Shifts in Aggregate Demand via
Monetary Policy

An increase in Ms at a
given price level shifts the
aggregate demand curve
to the right.

A decrease in Ms at a
given price level shifts the
aggregate demand curve
to the left.
Shifts in Aggregate Demand via
Fiscal Policy

An increase in G or
a decrease in net T
at a given price level
shifts the aggregate
demand curve to the
right.

A decrease in G or
an increase in net T
at a given price level
shifts the aggregate
demand curve to the
left.
Tracking an
increase in the
money supply
The Aggregate Supply Curve

The Aggregate Supply (AS) Curve is a graph
that shows the relationship between the
aggregate quantity of output supplied by all
firms in an economy (Y) and the overall price
level (PL).
The Aggregate Supply Curve: Warning

The aggregate supply curve is not a market supply curve
or the sum of all the individual supply curves in the
economy like in Econ 1110. Instead…
– It refers to all firms in all kinds of markets – even pricesetting firms (which do not even have individual supply
curves).
– When we draw a firm’s supply curve, we assume that
input prices are constant. In macroeconomics, an
increase in the overall price level means that at least
some input prices will be rising as well.
– Rather than an aggregate supply curve, you might want
to think of it as a...
... “price/output response” curve — a curve that traces
out the price and output decisions of all the markets and
firms in the economy under a given set of
circumstances.
Aggregate Supply in the Short Run: SR-AS





In the short run, the
aggregate supply curve
(the price/output response
curve) has a positive
slope.
At low levels of aggregate
output, the curve is fairly
flat.
Then there is an
“intermediate” range.
As the economy
approaches capacity, the
curve becomes nearly
vertical.
At capacity, the curve is
vertical.
Shifts in MACRO SR-AS
A
cost shock, or supply shock, is a change in
the economic environment that shifts the SR-AS
curve.
PL
SR-AS0
PL
SR-AS0
Bad Shock
SR-ASN
SR-ASN
Good Shock
Y
Y
Factors That Shift the SR-AS Curve
GOOD SHOCKS Shift SR-AS Right
BAD SHOCKS Shift SR-AS Left
Increases in Aggregate Supply
Decreases in Aggregate Supply
Lower costs
lower input prices
lower wage rates
Higher costs
higher input prices
higher wage rates
Economic growth
more capital
more labor
techno change
Stagnation
capital deterioration
Public policy
supply-side policies
tax cuts
deregulation
Public policy
waste and
inefficiency
over-regulation
Good weather
Bad weather, natural
disasters,
destruction from
wars
The Equilibrium Price Level

The equilibrium price
level is the PL where
AD = SR-AS.

PL0 and Y0 correspond to
equilibrium in the goods
market and the money
market and a set of
price/output decisions on
the part of all the firms in
the economy.
Significant Macro Debate

PL
What does the SR-AS
really look like?


Y
Where does AD
intersect SR-AS?
How quickly does
SR-AS shift in
response to a
change in the
economic situation?
i>clicker question
If you were POTUS and you wanted expansionary fiscal
policy to work really well (i.e., have the greatest multiplier
impact), where would you hope AD currently intersects
SR-AS?
PL
A.
B.
C.
D.
SR-AS
In the horizontal part.
In the intermediate part.
In the vertical part.
Doesn’t matter.
Y
Monetary &/or Fiscal Policy When SR-AS is
Rather Flat

Expansionary Policy
– Monetary OR Fiscal
– Suppose we are on the
“flatter” part of SR-AS.
– AD shifts out (to the right).
– Policy works well when the
economy is on the flatter
portion of the SR-AS curve,
causing little change in PL
relative to the output
increase.
– Note: assuming no shift in
SR-AS for now.
Monetary &/or Fiscal Policy When SR-AS is
Rather Steep

Expansionary Policy
– Monetary OR Fiscal
– Suppose we start out on the
“steeper” part of SR-AS.
– AD shifts out.
– When the economy is
operating near capacity, an
increase in AD will result in an
increase in the price level, PL,
with little increase in output.
– Note: still assuming no shift in
SR-AS.
SR-AS Shifts: The Response of Input Prices to
Changes in the Overall Price Level

If price-level increases were assumed to be fully
anticipated, then wage rates and other input prices would
be expected to increase at exactly the same rate as the
overall price level  a SR-AS that would shift as soon as
the AD shifted and the PL changed.

But many argue that this is simply not the observed case.

So... there must be a lag between changes in input prices
and changes in output prices, otherwise the
SR-AS (the SR price/output response) curve would be
vertical.

So... we operate with the idea that enough input prices
tend to lag changes in output prices to make it so we talk
about SR-AS & LR-AS.
SR-AS versus LR-AS

We distinguish between the
– short run AS curve (SR-AS)
– long run AS curve (LR-AS)

SR-AS is positively sloped and…
– tends to start out rather flat/horizontal at low levels of Y
– then has a section that’s positively sloped
– then tends to get very steep/vertical as we approach Y-capacity (which is
different than Ypotential/YFE )
– will shift with cost/supply shocks (see chart again, the one with the pics)

LR-AS is vertical.
–
–
–
–
This is because eventually all prices adjust, including input prices.
Typically we assume the LR-AS is vertical at Ypotential/YFE.
Ypotential/YFE is the level of income/output where there is no inflation.
If Y>YFE then you’ll get rising price/wage levels and a shift in the SR-AS
back to LR-AS, but now at a higher price level.
– If Y<YFE then you’ll get falling price/wage levels and a shift in the SR-AS
back to LR-AS, but now at a lower price level.
AD, LR-AS and SR-AS Curves in a
No-Inflation Equilibrium

Recall: Some/enough
input costs lag behind
price-level changes in the
short run, resulting in an
upward-sloping SR-AS
curve.

In the long run, costs and
the price level move in
tandem, so once costs
finally “catch up” and
adjust, the LR-AS curve
is vertical at what we will
call YPotential or YFE = Y0