Aggregate Supply and Aggregate Demand
-Assessing Change in the Economy
Module Convenor: Luke Buchanan-Hodgman
Contact: [email protected] Office: Keynes D2.12 Contact Hours: Thursday 10-11
Learning Objectives
1.
LO1: Use the AS-AD model to assess the concept of ’shocks’
and induced changes to the equilibrium level of prices and real
GDP
2.
LO2: Identify varying output gaps by shifting AS and AD in
the model
Shocks v. Induced Changes
A important distinction within the AS-AD model is the differing ways in which changes in the model come about;
I ’Shocks’
Shocks areexogenous, initial events which have an immediate impact on either AD, SRAS and/or LRAS. An example would be a sudden collapse of stock prices.
I ’Induced Changes’ (’second-round effects’.)
Identifying the Output Gap: AD Shifting
I At AD0 = SRAS0 there is a
negative (recessionary) output gap asY1<Y∗;
I Negative output gaps imply that the economy is running at below its potential (Y∗);
Identifying the Output Gap: AD Shifting
I If AD0→AD1, the output gap
closes and Y1converges to
(Y∗);
I The shift of AD also leads to a higher price level as we move
alongthe SRAS curve;
I At AD1 = SRAS0 = LRAS0,
the economy as operating at its potential and is at itslong-run
Identifying the Output Gap: AD shifting
I AD1 →AD2, a positive
(inflationary) output gap opens up;
I AD2 = SRAS0>LRAS0
implying thatY2>Y∗;
Identifying the Output Gap: SRAS shifting
I At AD0 = SRAS0 there is a
negative (recessionary) output gap asY1<Y∗;
I Negative output gaps imply that the economy is running at below its potential (Y∗);
Identifying the Output Gap: SRAS shifting
I If SRAS0→SRAS1, the
output gap closes and Y1
converges to (Y∗);;
I The shift of SRAS also leads to a lower price level as we move
alongthe AD curve;
I At AD0 = SRAS1 = LRAS0,
the economy as operating at its potential and is at itslong-run
Identifying the Output Gap: SRAS shifting
What happens next?
I SRAS1→SRAS2, a positive
(deflationary) output gap opens up;
I AD0 = SRAS2>LRAS0
implying thatY2>Y∗;
Expressing Growth: LRAS shifting
I Remember, LRAS0 tells us an
Expressing Growth: LRAS shifting
I A shift from LRAS0to LRAS1
represents a permanent increase in productivity;
I Any increase in LRAS can be interpreted as economic growth;
Closing the Output Gap
Two aims of government are to obtain a stable rate of economic
growth and maintain low unemployment. Clearly, persistent output
gaps violate these aims. Output gaps can close for a number of
reasons;
1.
Policy induced shifts in demand (∆
G
);
2.
Natural changes in private sector demand;
3.
Adjustments in factor prices;
Closing a Positive Output Gap: Government (
↓
∆G
)
I At AD0 = SRAS0, there is an
positive (inflationary) output gap;
I Government can close the output gap by decreasing government spending (contractionary fiscal policy)
I A shift from AD0 to AD1is
Closing a Positive Output Gap: Market Mechanism:
Private Sector Demand (
↓ {
C
,
I
,
(X
−
M
)
}
)
I At AD0 = SRAS0, there is an
positive (inflationary) output gap;
I Any increase in LRAS can be interpreted as economic growth;
Closing a Positive Output Gap: Market Mechanism: Factor
Price Adjustment
I A shift from LRAS0to LRAS1
represents a permanent increase in productivity;
I Any increase in LRAS can be interpreted as economic growth;
Closing a Negative Output Gap: Government (
↑
∆G
)
I A shift from LRAS0to LRAS1
represents a permanent increase in productivity;
I Any increase in LRAS can be interpreted as economic growth;
Closing a Negative Output Gap: Market Mechanism:
Private Sector Demand (
↑ {
C
,
I
,
(X
−
M
)
}
)
I A shift from LRAS0to LRAS1
represents a permanent increase in productivity;
I Any increase in LRAS can be interpreted as economic growth;
Closing a Negative Output Gap: Market Mechanism:
Factor Price Adjustment
I A shift from LRAS0to LRAS1
represents a permanent increase in productivity;
I Any increase in LRAS can be interpreted as economic growth;
First-Round Effect:
↓
∆ ir (+demand-side shock)
What happens?
I A decrease in interest rates
reducesthe cost borrowing;
I Consumption (C) and investment (I) increase;
I This causes AD to shift from AD0 to AD1;
I We move the initial equilibrium E0to the new equilibrium E1
with pair{P0,Y∗} to pair
Second-Round Effect: SRAS adjusts
What happens next?
I Employment is higher thanY∗, putting upward pressure on wages (and other factor
prices);
I Increasing wages (and other
factor prices) shifts the SRAS
curve from SRAS0to SRAS1;
I We move the initial equilibrium E1to the new equilibrium E2
with pair{P1,Y1} to pair
The Phillips Curve
Summary
1.
LO1: Use the AS-AD model to assess the concept of ’shocks’
and induced changes to the equilibrium level of prices and real
GDP
X
2.
LO2: Identify varying output gaps by shifting AS and AD in
the model
X
