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  1. 1. Aggregate Demandand Aggregate SupplyGT01003 Macroeconomics
  2. 2. Learning Objectives1. Define the aggregate demand and aggregatesupply curves2. Show how aggregate supply and demanddetermine short-run output and inflation Show how aggregate demand, aggregate supply, andthe long-run aggregate supply curve determine long-run output and inflation
  3. 3. Learning Objectives4. Using the AD-AS model to study businesscycles5. Analyze how the economy adjusts toexpansionary and recessionary gapsRelate this to the idea of a self-correctingeconomyThe role of stabilization policy
  4. 4. Introduction The aggregate demand - aggregate supply(AD-AS) model has two distinct advantagesover the basic Keynesian model:i. It applies to both the short run and the longrunii. It shows both inflation and output Effective for analyzing macroeconomic policies
  5. 5. The Aggregate Demand Curve Aggregate demand (AD) curve shows therelationship between short-run equilibrium output,Y, and the rate of inflation, Holds all other factors constant AD has a negative slope↑ → ↓ PAE → ↓ Y Along the AD curve, short-run Yequals planned spendingOutput (Y)ADInflation()
  6. 6. Shifts in Aggregate DemandCurve At a given inflation rate, aggregate demand shiftswhen Demand Shocks Stabilization Policy Demand shocks are changesother than those causedby changes in output orthe real interest rate Consumer wealth Business confidence Foreign demand forUS goods Output (Y)ADADInflation()
  7. 7. Shifts in Aggregate DemandCurveStabilization Policy: A rightward shift of the AD curve: Increase government spending (expansionary fiscalpolicy) Cut taxes (expansionary fiscal policy) Increase the money supply (expansionary monetarypolicy) A leftward shift of the AD curve: Decrease government spending (contractionary fiscalpolicy) Raise taxes (contractionary fiscal policy)
  8. 8. Aggregate Supply Aggregate supply curve (AS) shows therelationship between the rate of inflation and theshort-run equilibrium level of output Holds all other factors constant Aggregate supply curve has a positive slope When output is below potential, actual inflation isabove expected inflation When output is above potential, actual inflation isbelow expected inflation
  9. 9. The Aggregate Supply Curve If the economy is operating at potential output,then= e =1 at A If Y > Y*and 2 > e at B If Y < Y*and 3 < e at C The AS curve slope upInflation()Output (Y)AggregateSupply (AS)2Y1BY23CY*1A
  10. 10. Shifts in the AS Curve What causes the AS curve to shift? Changes in available resources & technology Changes in the expected inflation Inflation shocksInflation()Output (Y)AS1Y*12AS2 If actual inflationexceeds expectations,expected inflationincreases AS curve shifts tothe left At each level of output,inflation is higher
  11. 11. Shifts in the AS Curve An inflation shock is a sudden change in thenormal behavior of inflation A shock is not related to an output gap A sudden rise in the price of oil increases prices of Gasoline, diesel fuel, jet fuel, heating oil Goods made with oil (synthetic rubber, plastics,etc.) Transportation of most goods OPEC reduced supplies in 1973; price of oilquadrupled Food shortages occurred at the same time Sharp increase in inflation in 1974
  12. 12. Shifts in the AS Curve An adverse inflation shock shifts the aggregatesupply curve to the left Increases inflation at each output level Oil price increases in 1973 A favorable inflation shock shifts the aggregatesupply curve to the right Lower inflation at each output level Oil price decrease in 1986
  13. 13. Long-Run Equilibrium In the long run, Actual output equals potential output Actual inflation equals expected inflation Long-run equilibriumoccurs at the intersection of Aggregate demand Aggregate supply and Long-run aggregatesupplyInflation()Output (Y)AggregateDemand (AD)AggregateSupply (AS)Y*Long-Run AggregateSupply (LRAS)
  14. 14. Short-Run Equilibrium Short-run equilibrium occurs when there iseither an expansionary gap or a recessionarygap Intersection of AD and AS curves at a level ofoutput different from Y* Point A in the graph Short-run equilibrium istemporaryInflation()Output (Y)ADAS1LRASY* Y11AY*LRAS
  15. 15. Using the AD-AS Model toStudy Business Cycles
  16. 16. Five Steps for Using the AD-ASModel to Study Business Cycles Example Event: Great Recession 2007-2009 Step 1: Draw a diagram to show the long runequilibriumInflation()Output (Y)AggregateDemand (AD)AggregateSupply (AS)Y*Long-Run AggregateSupply (LRAS)
  17. 17. Five Steps for Using the AD-ASModel to Study Business Cycles Step 2: Ask whether the event affects the ADcurve, AS curve or both. The Great Recession caused worldwide financialpanic and the sharp decrease in house prices. Worldwide financial panic and the decrease inhouse prices were negative demand shocks
  18. 18. Five Steps for Using the AD-ASModel to Study Business CyclesInflation()Output (Y)ASY*LRASAAD11AD2Y12 B Step 3: Shift thecurve(s) in theappropriate direction(s). Step 4: Find the newshort-run equilibrium The new short-runequilibrium is at B
  19. 19. Five Steps for Using the AD-ASModel to Study Business Cycles Step 5: Compare the new short-runequilibrium to the original long-run equilibrium. We find that the actual output Y1 < thepotential output Y* and the 2 is below theexpected 1 Thus, there is a recessionary gap.
  20. 20. Can active use of stabilizationpolicy help to eliminate outputgap?
  21. 21. Self-Correcting Economy In the long-run the economy tends to be self-correcting Missing from Keynesian model Concentrates on the short-run; no priceadjustments Given time, output gaps disappear without anychanges in monetary or fiscal policy Whether stabilization policies are neededdepends on the speed of the self-correction process the nature of the shock that created the output
  22. 22. The Role of Stabilization PolicySpeed of Self-Correction Process: The greater the gap, the longer the adjustmentperiod A slow self-correcting mechanism (Large outputgap) Fiscal and monetary policy can help stabilize theeconomy A fast self-correcting mechanism (Small outputgap) Fiscal and monetary policy are not effective and
  23. 23. The Role of Stabilization PolicyThe Nature of the Shocks: Active fiscal policy and monetary policy arehelpful when a recession is caused bynegative demand shocks Active fiscal policy and monetary policy can becostly when a recession is caused by negativeprice shocks
  24. 24. The Role of Stabilization PolicyNegative DemandShocks: AD shifts to AD2 Output falls to Y1 An expansionary fiscalpolicy or monetarypolicy shifts the ADcurve back toward AD1 The inflation returnsback to the initial level 1Inflation()Output (Y)ASY*LRASAAD11AD2Y12 B
  25. 25. The Role of Stabilization PolicyNegative Price Shocks: A negative price shockshifts the AS curve to AS2. Output falls to Y1 andinflation rises to 2 An Expansionary fiscalpolicy or monetary policyshifts the AD to AD2 Inflation rises to 3Inflation()Output (Y)AD1AS1Y*LRAS1Y12AS2AD23
  26. 26. Conclusion