The document discusses the aggregate demand-aggregate supply (AD-AS) model. It defines the AD and AS curves and how they determine short-run output and inflation. It also discusses how AD, AS, and the long-run aggregate supply curve determine long-run output and inflation. The document outlines how to use the AD-AS model to analyze business cycles and the role of stabilization policy in addressing output gaps.
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Principles of
Money, Banking & Financial Markets
Tenth Edition
Fredrick.S.Mishkin
MODULE-6
Aggregate Demand & Supply Analysis
Aggregate Demand & Supply AnalysisIn this chapter we will study the aggregate demand and supply analysis that will enable us to study the effects of monetary policy on output and prices.Aggregate demand is the total amount of output demanded at different price level.Aggregate supply is the total amount of output that firms in the economy want to sell at different price level.The equilibrium level of output is determined where aggregate demand equals aggregate supply.
Aggregate Demand & Supply AnalysisAggregate Demand Curve: it shows the relationship between the quantity of aggregate output demanded and the inflation rate.Aggregate Demand consists of four components:
Consumption Expenditure (the total demand for consumer goods and services)
Planned Investment Spending (the total planned spending by business firms on new Machines, Factories and other capital goods, plus planned spending on new homes)
Aggregate Demand & Supply Analysis
3. Government Expenditure (purchases): spending by all levels of government (federal, state and local) on goods and services .
4. Net exports (the net foreign spending on domestic goods and services which equals exports – Imports.Using the symbols C for Consumption Expenditure, I for planned investment spending, G for government spending, and NX for net exports, we can write the expression of aggregate demand Yad = C+I+G+NX
Aggregate Demand & Supply AnalysisDeriving the aggregate demand curve: the first step to derive the aggregate demand curve is to recognize that when the inflation rises, the Central Bank will increase the real interest rate in order to control inflation.We need to examine the effects of higher real interest rates on aggregate demand components.When real interest rate increases the planned investment decreases which in turn causes decline in aggregate demand.
Aggregate Demand & Supply AnalysisThus a higher inflation rate leads to a lower level of aggregate output demanded and so the aggregate demand curve slopes down as shown in the fig:1 on next slide. r I Yad = inflation , r = rate of interest, I = planned investment and Yad = aggregate demand
Aggregate Demand & Supply Analysis
fig:1
Aggregate Demand & Supply AnalysisFactors that shift the aggregate demand curve:
There are seven basic factors which may cause a shift in the aggregate demand curve:
1. Autonomous monetary policy: when current inflation rises, the central bank will raise the real interest rate which causes investment to decrease and hence decrease in aggregate demand. Thus aggregate demand curve shifts to left as in the figure.
2. Government purchases (expenditure): an increase in GE increases aggregate demand and shifts the aggregate demand curve to right as shown in fig:2
Aggregate Demand & Supply Analysis
fig:2
Aggregate Demand & Supply Analy.
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The Roman Empire, a vast and enduring power, stands as one of history's most remarkable civilizations, leaving an indelible imprint on the world. It emerged from the Roman Republic, transitioning into an imperial powerhouse under the leadership of Augustus Caesar in 27 BCE. This transformation marked the beginning of an era defined by unprecedented territorial expansion, architectural marvels, and profound cultural influence.
The empire's roots lie in the city of Rome, founded, according to legend, by Romulus in 753 BCE. Over centuries, Rome evolved from a small settlement to a formidable republic, characterized by a complex political system with elected officials and checks on power. However, internal strife, class conflicts, and military ambitions paved the way for the end of the Republic. Julius Caesar’s dictatorship and subsequent assassination in 44 BCE created a power vacuum, leading to a civil war. Octavian, later Augustus, emerged victorious, heralding the Roman Empire’s birth.
Under Augustus, the empire experienced the Pax Romana, a 200-year period of relative peace and stability. Augustus reformed the military, established efficient administrative systems, and initiated grand construction projects. The empire's borders expanded, encompassing territories from Britain to Egypt and from Spain to the Euphrates. Roman legions, renowned for their discipline and engineering prowess, secured and maintained these vast territories, building roads, fortifications, and cities that facilitated control and integration.
The Roman Empire’s society was hierarchical, with a rigid class system. At the top were the patricians, wealthy elites who held significant political power. Below them were the plebeians, free citizens with limited political influence, and the vast numbers of slaves who formed the backbone of the economy. The family unit was central, governed by the paterfamilias, the male head who held absolute authority.
Culturally, the Romans were eclectic, absorbing and adapting elements from the civilizations they encountered, particularly the Greeks. Roman art, literature, and philosophy reflected this synthesis, creating a rich cultural tapestry. Latin, the Roman language, became the lingua franca of the Western world, influencing numerous modern languages.
Roman architecture and engineering achievements were monumental. They perfected the arch, vault, and dome, constructing enduring structures like the Colosseum, Pantheon, and aqueducts. These engineering marvels not only showcased Roman ingenuity but also served practical purposes, from public entertainment to water supply.
2. Learning Objectives
1. Define the aggregate demand and aggregate
supply curves
2. Show how aggregate supply and demand
determine short-run output and inflation
Show how aggregate demand, aggregate supply, and
the long-run aggregate supply curve determine long-
run output and inflation
3. Learning Objectives
4. Using the AD-AS model to study business
cycles
5. Analyze how the economy adjusts to
expansionary and recessionary gaps
Relate this to the idea of a self-correcting
economy
The role of stabilization policy
4. Introduction
The aggregate demand - aggregate supply
(AD-AS) model has two distinct advantages
over the basic Keynesian model:
i. It applies to both the short run and the long
run
ii. It shows both inflation and output
Effective for analyzing macroeconomic policies
5. The Aggregate Demand Curve
Aggregate demand (AD) curve shows the
relationship 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 Y
equals planned spending
Output (Y)
AD
Inflation()
6. Shifts in Aggregate Demand
Curve
At a given inflation rate, aggregate demand shifts
when
Demand Shocks
Stabilization Policy
Demand shocks are changes
other than those caused
by changes in output or
the real interest rate
Consumer wealth
Business confidence
Foreign demand for
US goods Output (Y)
AD
AD'
Inflation()
7. Shifts in Aggregate Demand
Curve
Stabilization Policy:
A rightward shift of the AD curve:
Increase government spending (expansionary fiscal
policy)
Cut taxes (expansionary fiscal policy)
Increase the money supply (expansionary monetary
policy)
A leftward shift of the AD curve:
Decrease government spending (contractionary fiscal
policy)
Raise taxes (contractionary fiscal policy)
8. Aggregate Supply
Aggregate supply curve (AS) shows the
relationship between the rate of inflation and the
short-run equilibrium level of output
Holds all other factors constant
Aggregate supply curve has a positive slope
When output is below potential, actual inflation is
above expected inflation
When output is above potential, actual inflation is
below 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 up
Inflation()
Output (Y)
Aggregate
Supply (AS)
2
Y1
B
Y2
3
C
Y*
1
A
10. Shifts in the AS Curve
What causes the AS curve to shift?
Changes in available resources & technology
Changes in the expected inflation
Inflation shocks
Inflation()
Output (Y)
AS1
Y*
1
2
AS2 If actual inflation
exceeds expectations,
expected inflation
increases
AS curve shifts to
the left
At each level of output,
inflation is higher
11. Shifts in the AS Curve
An inflation shock is a sudden change in the
normal 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 oil
quadrupled
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 aggregate
supply curve to the left
Increases inflation at each output level
Oil price increases in 1973
A favorable inflation shock shifts the aggregate
supply 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 equilibrium
occurs at the intersection of
Aggregate demand
Aggregate supply and
Long-run aggregate
supply
Inflation()
Output (Y)
Aggregate
Demand (AD)
Aggregate
Supply (AS)
Y*
Long-Run Aggregate
Supply (LRAS)
14. Short-Run Equilibrium
Short-run equilibrium occurs when there is
either an expansionary gap or a recessionary
gap
Intersection of AD and AS curves at a level of
output different from Y*
Point A in the graph
Short-run equilibrium is
temporary
Inflation()
Output (Y)
AD
AS1
LRAS
Y* Y1
1
A
Y*
LRAS
16. Five Steps for Using the AD-AS
Model to Study Business Cycles
Example Event: Great Recession 2007-2009
Step 1: Draw a diagram to show the long run
equilibrium
Inflation()
Output (Y)
Aggregate
Demand (AD)
Aggregate
Supply (AS)
Y*
Long-Run Aggregate
Supply (LRAS)
17. Five Steps for Using the AD-AS
Model to Study Business Cycles
Step 2: Ask whether the event affects the AD
curve, AS curve or both.
The Great Recession caused worldwide financial
panic and the sharp decrease in house prices.
Worldwide financial panic and the decrease in
house prices were negative demand shocks
18. Five Steps for Using the AD-AS
Model to Study Business Cycles
Inflation()
Output (Y)
AS
Y*
LRAS
A
AD1
1
AD2
Y1
2 B
Step 3: Shift the
curve(s) in the
appropriate direction(s).
Step 4: Find the new
short-run equilibrium
The new short-run
equilibrium is at B
19. Five Steps for Using the AD-AS
Model to Study Business Cycles
Step 5: Compare the new short-run
equilibrium to the original long-run equilibrium.
We find that the actual output Y1 < the
potential output Y* and the 2 is below the
expected 1
Thus, there is a recessionary gap.
20. Can active use of stabilization
policy help to eliminate output
gap?
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 price
adjustments
Given time, output gaps disappear without any
changes in monetary or fiscal policy
Whether stabilization policies are needed
depends on
the speed of the self-correction process
the nature of the shock that created the output
22. The Role of Stabilization Policy
Speed of Self-Correction Process:
The greater the gap, the longer the adjustment
period
A slow self-correcting mechanism (Large output
gap)
Fiscal and monetary policy can help stabilize the
economy
A fast self-correcting mechanism (Small output
gap)
Fiscal and monetary policy are not effective and
23. The Role of Stabilization Policy
The Nature of the Shocks:
Active fiscal policy and monetary policy are
helpful when a recession is caused by
negative demand shocks
Active fiscal policy and monetary policy can be
costly when a recession is caused by negative
price shocks
24. The Role of Stabilization Policy
Negative Demand
Shocks:
AD shifts to AD2
Output falls to Y1
An expansionary fiscal
policy or monetary
policy shifts the AD
curve back toward AD1
The inflation returns
back to the initial level 1
Inflation()
Output (Y)
AS
Y*
LRAS
A
AD1
1
AD2
Y1
2 B
25. The Role of Stabilization Policy
Negative Price Shocks:
A negative price shock
shifts the AS curve to AS2.
Output falls to Y1 and
inflation rises to 2
An Expansionary fiscal
policy or monetary policy
shifts the AD to AD2
Inflation rises to 3
Inflation()
Output (Y)
AD1
AS1
Y*
LRAS
1
Y1
2
AS2
AD2
3
