THE AGGREGATE DEMAND/ SUPPLY

MODEL

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The U.S. Great Depression

• 1929-1939– Output fell by 30%– Unemployment as high as 25%– Prices declined 30% in the first four years

• Led to the development of modern macroeconomic theory

Video

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Before: Classical Economics• Focused on long-run issues--growth

• Self-regulating markets through the “invisible hand”– Prices would adjust during recessions– Economy would always return to its potential output in the long-run

• Depression caused by institutions that prevented prices from falling, specifically:– Labor unions – Government

• Advocated a laissez-faire (hands-off) economic policy

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After: Keynesian Economics• John Maynard Keynes in The General Theory of

Employment, Interest, and Money (1936)

• Problems of the Depression required a short-run, rather than long-run, focus.

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Keynesian Economics• Adjustments to equilibrium for a single market and the

aggregate economy are different.

• Short-run equilibrium income may differ from long-run potential income.

• Paradox of thrift– In long run, saving leads to investment and growth.– In short run, saving may lead to a decrease in spending,

output, and employment.

• Aggregate demand management by government may be necessary.

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Keynesian Economics and the AS/AD Model

• Aggregate Demand Curve (AD)– Relates changes in the price level to changes in aggregate expenditures =

C + I + G + (X-M)

• Short-Run Aggregate Supply Curve (SAS)– Relates changes in the price level to changes in aggregate supply.

• Long-Run Aggregate Supply Curve (LAS)– Shows potential output at any point in time

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The Aggregate Demand CurveP

rice

leve

l

Real output

AD

P1

Y1

Wealth, interest rate, and international effects

Multiplier effect

Ye

P0

Y0

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Shifts in the AD Curve

Change in total expenditures = 300

Price level

Real output

AD0

P0

Initial effect = 100 increase in expenditures

AD1

100

Multiplier effect = 200

200

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The Short-Run Aggregate Supply Curve

Real output

Pri

ce le

vel

SAS

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Shifts in the SAS Curve

Real output

Pri

ce le

vel

SAS0

SAS1

1. Higher input prices

3. Higher sales and excise taxes

2. Higher import prices

4. Reduced productivity

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Long-Run Aggregate Supply Curve

Real output

Pric

e Le

vel

LAS

• Increases in capital, resources, growth-compatible institutions, technology, and entrepreneur- ship increase potential output and shift LAS to the right.

• Vertical because potential output is unaffected by the price level.

• LAS curve shows potential output

Potential output

LAS1

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LAS Curve

Real output

Pric

e Le

vel

Low-level potential output

High-level potential output

C

SAS

B

A

LAS

Underutilizedresources

Overutilizedresources

• Potential output is assumed to be the middle of a range bounded by high and low levels of potential output.

• When LAS = SAS (point B), there is no pressure for prices to rise or fall.

• When resources are over-utilized (point C), factor prices may be bid up

When resources are under-utilized (point A), factor prices may be bid down

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Short-Run Equilibrium:Changes in AD

Real output

Pric

e le

vel

E

SAS

Y0

P0

AD0

AD1

Y1

P1

F

• Short-run equilibrium is where SAS = AD0 (point E).

• If AD increases to AD1,

equilibrium output increases to Y1 and the price level increases to P1.

Y0

EP0

AD0

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Short-Run Equilibrium:Changes in SAS

Real output

Pri

ce le

vel

Y0

P0E

AD

G

SAS1

SAS0

Y1

P1

• Short-run equilibrium is where SAS0 = AD (point E). Equilibrium output is Y0 and the price level is P0.

• If SAS increases to SAS1,

equilibrium output decreases to Y1 and the price level increases to P1

(point G).

P0E

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Long-Run Equilibrium

LAS

AD0

AD1

Real output

Price level

P0

YP

E

HP1• Long-run equilibrium is point E where AD0 = LAS. Equilibrium output is at potential output YP and the price level is Po.

• An increase in AD to AD1

increases the price level to P1 but output is un- changed at YP.

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Integrating Short-Run and Long-Run Frameworks

AD

SAS

YP Real output

LAS

P0

E

Pri

ce le

vel

• The economy is in long-run and short-run equilibrium at point E where AD=SAS=LAS and output is YP and the price level is P0.

• AD grows at the same rate as potential output, so that unemployment and inflation are very low.

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Recessionary Gap

Real output

Pric

e le

vel

YPY1

LAS

AD

SAS0

P0

A

Recessionary gap

• A recessionary gap is the amount by which equilibrium output is below potential output.

• At point A, some resources are unemployed and the recessionary gap is YP – Y1.

Y1

P0

ASAS0

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Inflationary Gap• An inflationary gap is the amount by which equilibrium output is above potential output.

• If the economy is at point C, resources are being used beyond their potential and the inflationary gap is Y2 – YP.

Pri

ce le

vel

Y2YPReal

output

LAS

SAS0AD

P0C

Inflationarygap

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Expansionary Fiscal Policy

Real output

Price level

P0

SAS

AD0

Y0

LAS

AAD1

BP1

YP

• Economy is at equilibrium at A, there is a recessionary gap Y0 – YP.

• AD increases to AD1 and output returns to potential output YP and prices increase slightly to P1.

• Appropriate fiscal policy is to increase government spending and/or decrease taxes.

A

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Contractionary Fiscal Policy

• Economy is at equilibrium at B, there is an inflationary gap Y2 – YP.

• AD0 decreases to AD2 and output returns to potential output YP and inflation is prevented.

• Appropriate fiscal policy is to decrease government spending and/or increase taxes.

Real output

Pri

ce le

vel

YP Y2

LAS

ASP2

AD0

B

AD2

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Macro Policy Problems

• Implementing fiscal policy– Slow legislative process– Slow and uncertain reaction by the economy

• Avoiding “over-correcting”