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THE AGGREGATE DEMAND/ SUPPLY MODEL

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THE AGGREGATE DEMAND/ SUPPLY MODEL

- 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

- 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

- 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.

- 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.

- Aggregate Demand Curve (AD)
- Relates changes in the price level to changes in aggregate expenditures =
C + I + G + (X-M)

- Relates changes in the price level to changes in aggregate expenditures =
- 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

Multiplier effect

Price

level

Wealth, interest rate, and international effects

P0

P1

AD

Y0

Y1

Ye

Real output

200

100

AD1

Initial effect = 100 increase in expenditures

Price level

Multiplier effect = 200

Change in total expenditures = 300

P0

AD0

Real output

SAS

Price level

Real output

1. Higher input prices

SAS1

2.Higher import prices

3. Higher sales and excise

taxes

Price level

4. Reduced productivity

SAS0

Real output

LAS1

LAS

- LAS curve shows potential output

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

Price Level

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

Potential

output

Real output

LAS

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

C

- 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

B

A

SAS

Price Level

Underutilized

resources

Overutilized

resources

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

Real

output

Low-level potential output

High-level potential output

P1

F

P0

E

AD1

AD0

Y1

Y0

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

Price level

- If AD increases to AD1,
- equilibrium output
- increases to Y1 and the
- price level increases to P1.

SAS

P0

E

AD0

Y0

Real output

SAS1

G

P1

E

P0

Y1

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

Price level

SAS0

- If SAS increases to SAS1,
- equilibrium output
- decreases to Y1 and the
- price level increases to P1
- (point G).

E

P0

AD

Y0

Real output

H

P1

AD1

LAS

Price level

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

E

P0

- An increase in AD to AD1
- increases the price level
- to P1 but output is un-
- changed at YP.

AD0

YP

Real output

- 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.

LAS

SAS

E

Price level

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

P0

AD

YP

Real output

SAS0

A

P0

Y1

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

LAS

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

SAS0

A

P0

Price level

AD

Recessionary

gap

Y1

YP

Real output

- An inflationary gap is the amount by which equilibrium output is above potential output.

LAS

Price level

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

C

SAS0

P0

AD

Inflationary

gap

YP

Real

output

Y2

B

P1

AD1

YP

Price level

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

LAS

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

SAS

P0

A

A

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

AD0

Y0

Real output

AD2

LAS

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

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

B

AS

P2

Price level

AD0

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

YP

Y2

Real output

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

- Avoiding “over-correcting”