Chapter 11: The Aggregate Demand-Aggregate ...
Chapter 11: The Aggregate Demand-Aggregate Supply Model Key Terms Aggregate Demand-Aggregate Supply Model (AD-AS): a model of real output and overall price level determination Aggregate Demand Curve: a relationship between overall spending in the economy and the aggregate price level Real-Balances Effect: the hypothesis that overall wealth in the economy will be inversely related to the overall price level, and therefore, that aggregate demand and the price level will be inversely related Foreign Trade Effect: the hypothesis that net exports will be inversely related to the overall price level, and therefore, that aggregate demand and the price level will be inversely related Short-Run Aggregate Supply Curve (SRAS) Curve: a relationship between real output and the overall price level in the short run; a horizontal version of the curve indicates that firms in the short run meet demand, on average, at existing prices Long-Run Aggregate Supply (LRAS) Curve: a relationship between potential output and the overall price level; a vertical curve indicating that potential output is independent of the inflation rate Stagflation: the combination of a recessionary gap and a rising price level Phillips Curve: a term that typically refers to a statistical relationship between the inflation rate and the unemployment rate Exceptions-Augmented Phillips Curve Model: distinguishes between a short-run and a long-run Phillips curve and argues that the short-run version shifts when exceptions about the inflation rate change Long-Run Phillips Curve: a relationship between the inflation rate and the unemployment rate in the long run; the vertical curve is drawn at the natural rate of unemployment Short-Run Phillips Curve (SRPC): a relationship between actual unemployment and the inflation rate given inflationary expectations Adaptive Expectations of Inflation: a method of forming expectations about the inflation rate that involves looking to past experience, especially recent past experience The Three Components of the AD-AS Model - Three central components 1. Long-Run Aggregate Supply Curve - Related to the concept of potential output (Ch. 7) 2. Short-Run Aggregate Supply Curve - Related to key assumption underpinning (Ch. 8 & 10) 3. Aggregate Demand Curve - Related to developed from PAE curve (Ch. 8 & 10) Aggregate Demand: - Shows the amount of PAE (and output) at various price levels - The two price levels (P and P’ underpinning the two PAE curves in panel - Figure 11.1
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Shifts in the Aggregate Demand curve… a. Rightward shift can be caused by; increases in autonomous expenditure, expansionary monetary and expansionary fiscal policy b. Leftward shift can be caused by; decreases in autonomous expenditure, contractionary monetary and contractionary fiscal policy Short-Run Aggregate Supply: - Drawn as a horizontal line - Connection with the Keynesian cross model that in the short-run firms supply the output their consumers demand at the prices they have posted - Will shift in the short-run whenever firm costs (input prices) change a. Fall = downward b. Rise = upwards Long-Run Aggregate Supply: - A vertical line - The economy’s potential output (Y*) during a given period is independent of the price level - Potential output depends on the amounts of capital, labour, other inputs and other factors that determine the productivity of inputs (e.g. education levels, and technological knowledge) - Increases in capital = shift right - Decreases in capital = shift left Short-Run and Long-Run Equilibrium in the AD-AS Model - In the short-run actual output = intersection of SRAS and AD curves - If they intersect to the left of the LRAS output falls below potential output and there is a recessionary gap; prices will fall - If they intersect on the right it exceeds potential output and there is an expansionary gap; pressure for prices to rise - AD-AS model can be used to speed up the return to long-run equilibrium - Expansionary macroeconomic policy can be used to eliminate recessionary gap and vice versa - Can be used to explain stagflation, upward price shock causes SRAS to shift up the new short-run equilibrium will not have a higher price and a lower level of real output Alternate Version of AD-AS Model - SRAS curve is upward sloping and not horizontal, if overall wages adjusted more slowly than the rate of overall price-level adjustment - If the SRAS curve is upward sloping and the economy is operating at potential output then the AD curve shifts right (produces a short-run equilibrium at a higher price and higher level of output) and in the long run SRAS curve shifts left making prices even higher - Opposite for initial downward shift of SRAS curve The Expectations-Augmented Phillips Curve Model as a Supplement to the AD-AS - Phillips curve model is used to supplement the AD-AS curve because the ADAS does not deal directly with the rate of inflation
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The short-run Phillips curve is drawn horizontally and shows a tradeoff between the inflation rate and the actual unemployment rate The long-run Phillips curve is drawn vertically at the natural rate of unemployment
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Shifts in the Aggregate Demand curve… a. Rightward shift can be caused by; increases in autonomous expenditure, expansionary monetary and expansionary fiscal policy b. Leftward shift can be caused by; decreases in autonomous expenditure, contractionary monetary and contractionary fiscal policy Short-Run Aggregate Supply: - Drawn as a horizontal line - Connection with the Keynesian cross model that in the short-run firms supply the output their consumers demand at the prices they have posted - Will shift in the short-run whenever firm costs (input prices) change a. Fall = downward b. Rise = upwards Long-Run Aggregate Supply: - A vertical line - The economy’s potential output (Y*) during a given period is independent of the price level - Potential output depends on the amounts of capital, labour, other inputs and other factors that determine the productivity of inputs (e.g. education levels, and technological knowledge) - Increases in capital = shift right - Decreases in capital = shift left Short-Run and Long-Run Equilibrium in the AD-AS Model - In the short-run actual output = intersection of SRAS and AD curves - If they intersect to the left of the LRAS output falls below potential output and there is a recessionary gap; prices will fall - If they intersect on the right it exceeds potential output and there is an expansionary gap; pressure for prices to rise - AD-AS model can be used to speed up the return to long-run equilibrium - Expansionary macroeconomic policy can be used to eliminate recessionary gap and vice versa - Can be used to explain stagflation, upward price shock causes SRAS to shift up the new short-run equilibrium will not have a higher price and a lower level of real output Alternate Version of AD-AS Model - SRAS curve is upward sloping and not horizontal, if overall wages adjusted more slowly than the rate of overall price-level adjustment - If the SRAS curve is upward sloping and the economy is operating at potential output then the AD curve shifts right (produces a short-run equilibrium at a higher price and higher level of output) and in the long run SRAS curve shifts left making prices even higher - Opposite for initial downward shift of SRAS curve The Expectations-Augmented Phillips Curve Model as a Supplement to the AD-AS - Phillips curve model is used to supplement the AD-AS curve because the ADAS does not deal directly with the rate of inflation
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The short-run Phillips curve is drawn horizontally and shows a tradeoff between the inflation rate and the actual unemployment rate The long-run Phillips curve is drawn vertically at the natural rate of unemployment
