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- 1. Aggregate Demandand Aggregate SupplyGT01003 Macroeconomics
- 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. Learning Objectives4. Using the AD-AS model to study businesscycles5. Analyze how the economy adjusts toexpansionary and recessionary gapsRelate this to the idea of a self-correctingeconomyThe role of stabilization policy
- 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Using the AD-AS Model toStudy Business Cycles
- 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. 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. 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. 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. Can active use of stabilizationpolicy help to eliminate outputgap?
- 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. 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. 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. 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. 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. Conclusion

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