Transcript Chapter 5 PPT

Chapter 5
Aggregate Supply and
Demand
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
1
Aggregate Supply and Aggregate
Demand

The aggregate supply–aggregate demand
(AS–AD) model is the basic tool for studying
output fluctuations and the determination
of price levels

The model describes the relationship
between overall prices (GDP deflator) and
output (real GDP)
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
2
Chapter Organisation
5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 Aggregate Demand Under Alternative
Supply Assumptions
5.4 Supply-side Economics
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
3
5.1 The Aggregate Supply
Curve

The AS curve describes, for each given
price level, the quantity of output firms are
willing to supply

The AS curve is upward sloping since firms
are willing to supply more at higher prices

In the short run the AS curve is horizontal
(the Keynesian AS curve)

In the long run the AS curve is vertical (the
classical AS curve)
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
4
The Aggregate Supply Curve
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
5
The Classical AS Curve

The classical AS curve
 Is vertical, indicating that the same amount of
goods will be supplied whatever the price level

Assumption
 The labour market is in equilibrium at full
employment and all factors of production are
fully utilised

Implication
 Increases in AD do not increase output but
merely raises prices
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
6
The Classical AS Curve

The level of output corresponding to full
employment is called potential GDP

Potential GDP grows over time as the
economy accumulates resources and new
technologies

This shifts the AS curve to the right over
time
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
7
The Keynesian AS Curve

The Keynesian AS curve
 Is horizontal, indicating firms will supply
whatever amount of goods is demanded at the
existing price

Assumption
 There is unemployment, so firms may obtain as
much labour as they want at the current wage

Implication
 AD determines the level of output, with prices
‘sticky’ in the short run
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
8
Vertical or Horizontal?
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
9
Vertical or Horizontal?

At levels of output below potential, the AS
is quite flat, as there is little tendency for
prices of goods and factors to fall

At levels of output above potential, the AS
curve is steep and prices tend to rise
continuously

Hence, the effect of changes in AD on
output and prices depends on the level of
actual output relative to potential output
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
10
Types of Unemployment

Frictional unemployment
 Unemployment due to individuals shifting
between jobs and looking for new jobs

Structural unemployment
 Unemployment due to a mismatch between the
skills of the labour force and the skills
demanded by firms
 Unemployment is a consequence of
technological improvements
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
11
Types of Unemployment

The natural rate of unemployment (NRU)
 The frictional and structural unemployment
associated with the full employment level of
output
 Current estimates of the NRU in Australia are
about 6.5%
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
12
Chapter Organisation
5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 Aggregate Demand Under Alternative
Supply Assumptions
5.4 Supply-side Economics
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
13
5.2 The Aggregate Demand
Curve

The AD curve
 Shows the combinations of the price and output
level at which the goods and money markets
are in equilibrium
 Is downward sloping because for a given level
of nominal money, higher prices reduce the
value of the real money supply, which reduces
the demand for output
 Increases in autonomous AD shifts the AD curve
to the right
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
14
The Aggregate Demand Curve

The AD relationship between price and
output
 Is dependent upon the real money supply
 Real money supply is nominal money supply
() deflated by the price level (P)
 That is: /P
 When P falls, the real money supply rises,
interest rates fall and investment rises, causing
AD to increase
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
15
The Aggregate Demand Curve

The quantity theory of money provides a
simple analysis of the AD curve
MV=PY
Where M is the nominal money supply and
V is the velocity of money

If we assume that V and M are constant
then an increase in output Y must be offset
by a decrease in prices P
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
16
Chapter Organisation
5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 Aggregate Demand Under
Alternative Supply Assumptions
5.4 Supply-side Economics
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
17
5.3 AD Under Alternative
Supply Assumptions
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
18
The Keynesian Case
 Initial equilibrium is at E where AD and AS
intersect (goods and money market equilibrium)
 Assume an increase in AD, which shifts AD to
AD’
 The new equilibrium point is E’ where output
has increased
 Firms are willing to supply any amount of output
at that level of price
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
19
The Classical Case
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
20
The Classical Case
 Assume an increase in AD
 At the initial level of prices, spending has
increased and the economy would tend to move
towards point E’
 However, firms cannot obtain more labour as
the economy is at full employment
 Wages are bid up which increases the costs of
production
 The increase in costs is passed on as higher
prices
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
21
The Classical Case
 The increase in prices reduces real money stock
and decreases spending
 The economy moves up along AD’ until
spending has decreased to the level consistent
with full employment output at E”
 Increases in AD only lead to higher prices, not
increases in output
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
22
Chapter Organisation
5.1 The Aggregate Supply Curve
5.2 The Aggregate Demand Curve
5.3 The Aggregate Demand Under
Alternative Supply Assumptions
5.4 Supply-side Economics
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
23
5.4 Supply-side Economics

Shifting the AS to the right is preferred as it
increases potential GDP

There is debate about how best to achieve
this increase in AS

Supply-side economics (advocated by
George Bush Senior) argue
 Cutting taxes will significantly increase AS
 This increase will be so large that total tax
revenue will rise
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
24
Supply-side Economics
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
25
Supply-side Economics

The initial tax cut shifts AD to the right

The AS also shifts to the right over time
because lower tax rates increase the
incentive to work

However, the AD curve shifts by more than
the AS curve, since consumer spending
increases by more than the increase in
potential GDP
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
26
Supply-side Economics

In the short run
 GDP has increased substantially (from E to E’)
 This is primarily due to the AD effect

In the long run
 The economy moves to E”
 GDP has only increased by a small amount, total
tax collection falls, the government’s budget
deficit rises, and prices are permanently higher
Copyright  2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch,
Bodman, Crosby, Fischer and Startz
27