Short-Run AS/AD Model Essentials

Macro
Short-Run AS/AD Model Essentials
Up to this point, our discussions of unemployment, inflation, output, and
income have revolved around how we measure these indicators of economic
performance. Now we want to focus on understanding how real-world events
and government policy changes might change these measures of economic
performance. Our tool for understanding how these events and policy
changes affect inflation, unemployment, and output will be the aggregate
supply and demand model.
Aggregate – to add up, aggregation usually implies that the things being
added up are similar, but not exactly identical
Short-Run Aggregate Supply/Aggregate Demand Model
 Similar to our basic supply and demand model
 Output of all goods, measured by Real GDP, is on the horizontal axis
 Confusingly, we use Y on the horizontal axis as the symbol for Real
GDP
 The price level (PL), often measured by the GDP Deflator, is on the
vertical axis
PL SRAS
PE AD
Y YE
Aggregate Demand - the quantity of real domestic product that households,
firms, government agencies, and foreign buyers wish to purchase at each
price level, ceteris paribus
AD = C + I + G + (X-M)
Components of AD
 Consumption (C) – essentially all spending by households on final
goods and services, with the exception of new homes
 Investment (I) – spending by households on new homes, spending by
firms on new capital equipment, additions to inventories by firms
 Government Purchases (G) – purchases of goods and services by the
government, (this does not include transfer payments)
 Net Exports (X-M) – spending by foreign citizens on “our” final goods
and services minus spending by “our” citizens on foreign final goods
and services
Short-Run Aggregate Supply - the quantity of real domestic product firms
are willing to produce at each price level, ceteris paribus
Slope of the SRAS curve
 Generally speaking, SRAS has a positive slope
 Higher prices of final goods and services lead to higher profits for firms
if input costs are “sticky”
o Input costs are often assumed to be sticky due to the fact that
wages and prices of other inputs are often fixed by long-term
contracts
 Slope of SRAS is a bone of contention that is responsible for a number
of disagreements in modern macroeconomics
o Important because the steepness affects the outcome of policy
changes
o Classical thought argues that it is very steep, even vertical
o Keynesian argues that it is much flatter, even horizontal at times
o Keynesian section represents a revision of thought resulting from
the Great Depression
Shape of the AD curve
 Remember, AD = C + I+ G + (X-M)
 Generally speaking, we believe that AD has a negative slope for 3
reasons.
1) Wealth, or real balances, effect
2) Interest rate effect
3) Foreign purchases effect/net export effect
Wealth effect
 acts through consumer expenditures (C)
 as the price level falls, the quantity of goods and services that your
nominal wealth will purchase increases (purchasing power, or real
wealth, increases)
 this is true for wealth held in the form of bank deposits, etc.
 so, as P decreases, real wealth rises, we feel richer and spend
more…so consumption rises and AD increases
Net export, or foreign purchases, effect
 we buy foreign goods because they are cheaper than domestic goods
 same holds true for foreigners
 if “our” PL falls compared to the PL in other countries, “our” goods
become more attractive residents of other countries, so our exports rise
 simultaneously, “their” goods become less attractive to us, so “our”
imports fall
 as a result, (X-M) rises
 so, as our PL decreases compared to the PL in other countries, (X-M)
rises and therefore AD rises
Interest rate effect (see money market graph)
 the AD curve drawn assuming the supply of money is fixed
 as the price level falls, fewer dollars are needed to purchase goods and
services
 demand for dollars falls
o in the money market, this means the money demand curve shifts
back
 the result is that the price of dollars falls
 price of the dollar is known as the interest rate
 capital projects and home ownership become more affordable as
interest rates drop
 investment rises as the interest rate falls
 so, as PL falls, MD decreases, interest rates fall, investments rise, and
AD increases
i S
Money Market i 0 i 1 D0 D1
Q
Why is the Short-Run AS/AD model useful?
 The Short-Run AS/AD model can be used to predict how real world
events and economic policies might change output, unemployment, and
inflation by examining changes in PE and YE.
PL SRAS
PE1 AD1
PE0 AD0
Y
0
YE YE
1 Demand –Pull Inflation
Demand‐Pull Inflation  An outward shift of the AD curve, perhaps due to a tax cut, causes inflation, but also increases output and reduces unemployment. This is known as “demand‐pull” inflation. PL SRAS
SRAS
PE1 PE0 AD0
Cost‐Push Inflation  An inward shift of the AS curve, usually due to an adverse supply shock, causes inflation, along with reduced output and lower unemployment. This is known as “cost‐push” inflation or “stagflation”. Y 1
YE YE
0 Cost‐Push Inflation What factors would shift the AD curve?
 remember AD = C+I+G+(X-M)
 anything that affects the desire of HH, firms, the government, or foreign
citizens will shift the AD curve
Consumption determinants
1) Changes in real wealth - stock market gains
2) Expectations - regarding wealth, income, etc.
3) Indebtedness - flip side of wealth
4) Taxes - on wealth, income
Investment determinants
1) Interest rates
2) Expectations regarding the profitability of projects
3) Business taxes - esp. capital gains and ITC's
4) Technological change
5) Degree of excess capacity
Government spending determinants
1) Whatever the government decides to spend!
Net exports determinants
1) Foreign national income
2) Exchange rates
3) Tariffs and quotas
What factors shift the SRAS curve?
 Input prices and wages - not the general price level
 Productivity - new technology allows greater output at constant price
 Legal/institutional environment - largely tax structure, regulations also
important
The Short-run AS/AD Model Notes
 Remember that the “short-run” is a period of time for which resource
prices are fixed
 The intersection of SRAS and AD give us short-run equilibrium
Is everything great at SR equilibrium?
 Short-run equilibrium is not actually very informative
 SR equilibrium merely says that AS=AD,
 It doesn’t tell us whether our current level of output is high or low.
 We need a benchmark against which we can judge the performance of
the economy
Return to an idea from the PPF, Potential GDP
 Consider the concept of productive efficiency
o Requires us making full use of resources, including labor
o Essentially it entails production without waste
 Recall our discussion of costs of unemployment
 If we are on the frontier we are producing a level of output we call
potential GDP
Potential GDP
 The level out output possible when we fully use our resources
 To be at PGDP we have to be at full-employment
 Symbolize PGDP with YP
 Add this to the graph
PL SRAS PE AD Y YE YP Economy exhibiting a recessionary gap
Recessionary/Contractionary Gap
 Whenever YE < YP, you have a recessionary gap
 Current output is less than potential
 Since YP requires full employment, having a YE less than YP also means
you have high unemployment on your hands
PL SRAS PE AD Y YP YE Economy exhibiting an inflationary gap
Inflationary/Expansionary Gap
 Whenever YE > YP, you have an inflationary gap
 Current output is greater than potential
 Since YP requires full employment, having a YE greater than YP also
means you have abnormally low unemployment on your hands