Aggregate Demand and Supply |
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OPTIONAL:
In this chapter we will study a tool that we can use to better understand these news articles. |
Introduction
Macroeconomics vs. Microeconomics
We have defined economics as the study of how we choose to use limited resources to obtain the maximum satisfaction of unlimited human wants
Macroeconomics Issues
The issues discussed in macroeconomics are:
1. full employment
2. price stability
3. economic growth
We have already discussed the importance of these topics in reducing scarcity and receiving the maximum satisfaction possible from our limited resources.
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The Business Cycle
Over time the levels of unemployment (UE), inflation (IN) and economic growth (EG) in an economy tend to fluctuate. These fluctuations can be illustrated on a graph of the business cycle.
1. Economists have given terms to the four phases of the business cycle:a. #1 = peak
b. #2 = recession
c. #3 = trough
d. #4 = recovery
During each phase of the business cycle the macroeconomic issues (UE, IN, and EG) change in a particular way:
Peak:
During the peak of the business cycle economic activity (output) is at its highest, therefore unemployment is very low, but inflation is high.Recession:
During the recession economic output declines ( a recession is defined as six months of declining output), therefore unemployment is rising and inflation is declining.Trough
During the trough economic output is is at its lowest, therefore unemployment is at its highest and inflation at its lowest.Recovery:
During the recovery economic output increases, therefore unemployment is declining and inflation is rising.The primary causes of the changes in output reflected in the business cycle are changes in spending. This could be changes in consumer spending (C), government spending (G), business spending on new capital (I), or purchases by foreigners Xn).
Notice that even though economic activity historically has been cyclical there is a secular trend upward over time (see red arrow in the graph below). Notice the each successive peak is higher than the previous peak.
In the twentieth century there were 20 recessions in the United States.
The last recession of the 20th century ended in 1991 and the US, are enjoyed it longest recovery ever. . . until March 2001 when we experienced a short recession.
OPTIONAL: Table listing dates and length of business cycle recessions and recoveries - http://www.nber.org/cycles.html
A Model of the Macro Economy: Aggregate Demand (AD) and Aggregate Supply (AS)
We have already discussed the Supply and Demand model to determine individual prices and quantities. That was a microeconomic model. The key word is "individual" product or "individual" industry.In macroeconomics we study the whole, or "aggregate", economy. Our new AGGREGATE supply and AGGREGATE demand model looks similar to the supply and demand model, but they are NOT the same! We are now discussing the whole economy, so AD is the demand for all products in an economy and AS is the supply of all products.
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Aggregate Demand
Definition
Aggregate demand is the demand of all products in an economy - OR the relationship between the Price Level and the level of aggregate output (real GDP) demanded.
Be able to define:
- Aggregate Demand
- Real Domestic Output (RDO) which can be measured by real GDP
- real GDP
- Price Level
Graphically: down-sloping -- why?
Economists have three explanations of why the AD curve is downward sloping from left to right. They are:
- the wealth effect
- the interest-rate effect
- the foreign purchases effect
We want to understand why if the Price Level increases the amount of aggregate output (real GDP) demanded decreases. Why is the AD curve downward sloping from left to right?
Amount
of output demanded 
We always want to understand why the graphs that we use in economics have the shapes that they do? Are their shapes realistic?
The wealth effect:
When the average level of prices in the economy increases, why do consumers, governments, business and foreigners purchase less?One reason is the wealth effect. When the price level in the economy increases what happens to the real value, or the purchasing power, of financial assets (of money you have saved) and why do we then buy less?
Price Level
Well, when the
Price Levelbecause they now have less real wealth.
The interest-rate effect:
When the average level of prices in the economy increases, why do consumers, governments, business and foreigners purchase less?Another reason is the interest rate effect. When the price level in the economy increases what happens to the interest rates and why do we then buy less ?
Price Level
Well, when the
Price Levelbecause people will buy less of those things for which they have to borrow money.
The foreign purchases effect :
When the average level of prices in the economy increases, why do consumers, governments, business and foreigners purchase less?The third reason is the foreign purchases effect. When the price level in the US economy increases what happens to the relative prices of foreign products and why are fewer American products purchased ?
Price Level
Well, when the
US Price Levelbecause people will now buy more of the now relatively cheaper foreign products.
Changes in AD
Just like with supply and demand in the individual product market, there are determinants that will shift the AS and AD curves. These determinants are the REAL WORLD EVENTS that cause the graphs to shift. remember, that our goal is to better understand what causes the business cycles -- or what causes UE, IN, and EG to change.
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(shifts to the right) |
(shifts to the left) |
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In the following discussion the double arrow ()
means "causes". It is important that yo get the cause-effect
in the correct order. the direction of the arrow matters
Just like with demand in the individual product market, there are determinants of AD that, if they change, will shift the AD curve. They are:
- change in consumer spending (C)
C
AD
C
AD - change in Investment spending (I)
(Note: "Investment" does NOT mean buying stocks and bonds. Investment occurs when business buy capital. Remember that capital is NOT money. Capital is a manufactured resources. capital is something that is produced that is used to produce something else. So if I buy 100 shares of Stock in Microsoft, that is NOT and investment, but if a carpenter buys a hammer, or if Microsoft builds a new office building, THAT is an "investment".)
I
AD
I
AD - change in Government purchases (G)
G
AD
G
AD - change in Net Exports (Xn)
Xn
AD
Xn
AD - change in Money Supply (S)
MS
Interest Rates
I
AD
MS
Interest Rates
I
AD - change in Taxes (T)
T
C
AD
T
C
AD - change in Saving (S)
S
C
AD
S
C
AD
Summary of the determinants of AD:
AD
C
C
I
I
G
G
Xn
Xn
MS
MS
T
T
S
S
But what causes these things to change? Well, economists have identified some determinants of the main components of spending: C, I, G, and Xn.
Determinants of C, I, G, and Xn:
C = consumer spending (and saving)
- consumer wealth
Wealth
Wealth
- consumer expectations
Expected future Income
Expected future Income
- consumer indebtedness
Consumer Debt
Consumer Debt
- taxes
T
TI = investment spending
- interest rates (money supply)
MS
MS
- profit expectations on investment projects
profit expectations
profit expectations
- business taxes
Business Taxes
Business Taxes
- technology
technology
- degree of excess capacity
excess (unused) plant capacity
excess (unused) plant capacity
G = government purchases
Xn = net export spending
- net income abroad
Income in Foreign Countries
Income in Foreign Countries
- exchange rates
value of the US dollar
value of the US dollar
Aggregate Supply (AS)
Definition
Aggregate Supply is the supply of all products in an economy - OR the relationship between the Price Level and the level of aggregate output (real GDP) supplied.
Graphically
Graphically, we would expect the AS curve to be upward sloping. If businesses can get a higher price for their products (higher price level) then they will want to produce MORE. So the AS curve should be upward sloping.But, remember that the price level is the average level of ALL prices in the economy, therefore, if the price level increases, the price of resources will also increase. Higher resource prices will encourage businesses to produce LESS. So maybe the AS curve should be downward sloping????
Some economists graph the AS curve like in the graph below to handle this problem:
Shape
We can identify three different parts, or ranges, to the AS curve:1. Keynesian (horizontal) range
2. classical (vertical) range
3. intermediate (up-sloping) range
In the Keynesian or horizontal range the level of output in the economy is low. Very little is being produced so there are a lot of resources NOT being used. Businesses are therefore able to produce more output without having to pay more for the additional resources. Since many resources are unemployed, businesses will not have to pay a higher price to employ them. Therefore, they can produce more without having to raise the price (note how the price level is constant (does not increase) in the Keynesian range of the AS curve.
In the Classical or vertical range of the AS curve there are no more resources available. ALL are being used. So all businesses together cannot produce any more since there are no more resources to use. But, if some businesses try to produce more by enticing resources away from other businesses with higher resource prices (higher wages for example) they will have to raise their prices to cover the higher costs - BUT the amount produced in the whole economy will stay the same since no additional resources are being available. So, the AS curve is vertical indicating no additional output even at higher price levels.
In the intermediate range the AS curve begins to rise slowly as a few resources begin to run out and at higher levels of output the AS curve becomes steeper as the economy runs out of even more resources, until it is vertical when all resources are being used and it is not possible to produce any more output.
Aggregate Supply and Full Employment
If we want to use the AS-AD model to better understand the macroeconomic issues of UE, IN. and EG, then we need to be able to locate the "full employment level of output" - the amount of GDP that can be produced if all resources are being used.You would think that this would occur where the AS curve is vertical, but what do we really mean by "full employment"? Does this mean all resources, including labor, working everyday day for as many hour as is physically possible? Or does it mean "full employment" under "normal" conditions where people work maybe 40 hours a week? They retire at age 65 and don't begin to work until age 18 or 22? If this is our definition of "full employment", then it would be possible to produce more than the full employment level of output by having people work 50, 60, 70, 80, or even more hours a week. People could never retire and just keep working until they die, etc. If this happened then MORE would be produced. But this isn't really what we mean when we say "full employment". Therefore, it is possible to produce more than the "normal" full employment level of output.
The graph below shows how we can illustrate this level of output under normal conditions of full employment.
Note that at levels of output beyond the full employment level (beyond RDO-FE) the price level increases dramatically resulting in high inflation, therefore some people define the full employment level of output as the amount of output that can be produced and still maintain low inflation.
Increase and decrease in AS
Increase in AS
(shifts to the right)Decrease in AS
(shifts to the left)
Determinants of AS
Just like with supply in the individual product market, there are determinants of AS that, if they change, will shift the AS curve. They are:a. change in input prices
price of resources
price of resources1) labor
2) land (OPEC)
[OPTIONAL: http://news.bbc.co.uk/hi/english/business/the_economy/newsid_300000/300492.stm]
3) capital
4) entrepreneurial abilityb. changes in the productivity of resource
productivity
productivityBe sure to know the difference between:1) Productivity
- output per unit of resource
2) production
- the quantity produced
3) productive efficiency
- producing at a minimum cost (5 Es)c. legal-institutional environment
business taxes and gov't red tape
business taxes and gov't red tape1) business taxes and subsidies
2) government regulation (red-tape)
Summary of the Determinants of AS
price of resources price of resources productivity productivity business taxes and gov't red tape
business taxes and gov't red tape
AS
AS
AS
AS
AS
AS
AS
AS
Macroeconomic Equilibrium
Equilibrium
You can use the AS-AD graph to find the equilibrium price level and the equilibrium level of output. We can then figure out what happens to US, IN and EG. The equilibrium level of output ant he equilibrium price level will occur where the two lines cross.
In this economy the level of real domestic output (real GDP) will move toward RDO1 and the price level will move toward PL1.
Changes in AD and the Macroeconomic Issues
The reason we have developed the AS-AD model is to better understand UE, IN, and EG.
Employment
If the equilibrium level of output is below the full employment level as in the graph above the result is unemployment.
Inflation
Demand-pull inflation is inflation caused by an increase in AD. As you can see on the graph below, if there is an increase in AD the price level increases. Inflation is the rate of increase in the price level.
A decrease in AD will cause the level of output to decline indicating\ higher unemployment.
But what happens to the price level when AD decreases? Normally we would expect the price level to decline from PL to PL' on the graph below if AD decreases, but can you remember a time when the price level (the average level of ALL prices in the economy) decreased? It doesn't happen very often. Business are more willing to raise their prices (causing more inflation) than they are to decreases their prices (causing deflation). Economists call this the ratchet effect. Like a ratchet that only works in one direction, prices more easily move in one up than down. Sometimes it is said that prices are "sticky downwards".
On the graph then, if AD decreases instead of going from "a" to "b" (less output and a lower price level), the economy goes from "a" to "c" since prices are sticky downwards and tend not to decrease. Therefore the price level stays the same (at PL), but the level of output drops even more (from RDO-FE to RDO2 instead of only to RDO1).
The causes of the ratchet effect are listed below. For several reasons businesses are reluctant to lower prices even when faced with lower aggregate demand.
a) Wage contracts often mean that businesses have to increase their costs even if AD decreases.b) If businesses lower wages so that they can lower their prices, this may have an adverse effect on morale and productivity
c) If businesses lower wages so that they can lower their prices, they may lose some of best workers in which they have invested much in training
d) To lower their prices business would like to decrease their labor costs (wages), but they may not be able to because of the minimum wage laws.
e) Finally, businesses may have monopoly power, giving them more control over their prices and they may choose to take smaller profits rather than lowering their prices.
Changes in AS and the Macroeconomic Issues
A decrease in AS would decrease output and raise the price level. This would result in more unemployment and more inflation. We call this inflation "cost-push" inflation. It is inflation caused by a decrease in AS.
Stagflation
A decrease in AS results in "stagflation". Stagflation is a decrease in output (an increase in unemployment) accompanied by an increase in inflation - a STAGnant economy with inFLATION. It is caused by a decrease in AS.
An increase in AS would increase output and lower the price level. This would result in less unemployment and less inflation.
Economic Growth
What about economic growth? In an earlier lesson we discussed three definitions of economic growth
- Increasing our POTENTIAL OUTPUT
- Increasing Output, and
- Increasing Real GDP per capita
(1) Increasing our POTENTIAL OUTPUT
I like to call this increasing our ABILITY to produce. This is the definition we used in the 5 Es lesson. This is the most fundamental definition of economic growth. It is the type of economic growth used on our 5 Es diagram.
We can increase our ABILITY to produce goods and services (or increase our POTENTIAL GDP) if we get:
- more resources
- better resources, and
- better technology
Since this increases maximum output that we are able to produce it shifts the PPF outward. On the graph below, economic growth would cause the PPF to move from PP1 to PP2.
This doesn't necessarily mean that the economy IS producing more, just that it CAN produce more. To achieve our new potential levels of output we also need full employment and productive efficiency. It could be possible to have this type of economic growth so that we CAN produce the quantities represented by point E, but if there is unemployment and productive inefficiency we would be at a point beneath this new curve (maybe point C). So we may get new resources or new technology so we CAN produce more (point E on PP2), but if we don't use the new resources (i.e. we have unemployment) or if we don't use the new technology (i.e. we have productive inefficiency) , we may remain on PP1 (point C).
In the AS-AD model INCREASING OUR POTENTIAL OUTPUT is represented by in INCREASE IN AS.
Notice that when AS increases, the full employment level of output increase from RDO-FE1 to RDO-FE2. This is an increase in our potential level of output.
In the 5 Es lecture we said that economic growth is caused by:
- more resources
- better resources, or
- better technology
An increase in the production possibilities curve is caused by having more resources, better resources, or better technology.
An increase in AS is caused by:
- a decrease in the price of resources
- an increase in productivity
- lower business taxes and government red tape
These are all really the same thing.
(2) Increasing Output
The most commonly used definition of economic growth is simply producing more. (Later we will call this INCREASING REAL GDP.)When an economy increases its output it is often said to have achieved economic growth. But if by producing more we are simply ACHIEVING OUR POTENTIAL, then we could also say that it is REDUCING UNEMPLOYMENT or ACHIEVING PRODUCTIVE EFFICIENCY. On our production possibilities graph this would be represented by moving from point D to a point on the curve.
On our AD-AS model we could illustrate this type of growth (achieving our potential) by an increase in AD.
Notice that output increase from RDO-EQUIL to RDO', but the full employment level of output, which is our potential level of output, does not change (RDO-FE).
If AD increases so that the new equilibrium is at the full employment level of output, it is analogous to going from a point inside the production possibilities curve to a point on the curve.
(3) Increasing Real GDP per capita
This means increasing output per person. GDP per capita is calculated by dividing output by the population.
SUMMARY OF THE TYPES OF ECONOMIC GROWTH
ECONOMIC GROWTH Increasing output by INCREASING THE POTENTIAL
(Called "economic growth" on our 5Es model)
ECONOMIC GROWTH Increasing output by ACHIEVING THE POTENTIAL
(Called "reducing unemployment" on our 5Es model)
Using the AS / AD Model
Now that we have introduced the AS / AD model, let's learn how to use it. The exam 2 extra credit essay question will be a lot like these examples.
Read this short article from cnnfn.com. Analyze the article by:
(1) Identifying the determinants of AD and/or AS that have changed.
This is important. It all begins with a CHANGE in one of the determinants of AD or AS. You MUST memorize these determinants and know which ones shift the AD curve and which shift the AS curve!(2) Then graph the changes on the AS-AD model.
Next, you must know which way the determinants will shift the curve.(3) Finally use your graph to discuss has happened to UE, IN, and EG.
German GDP grows 0.7%
Export increase lifts economy; OECD raises estimate of growth rate
May 30, 2000: 7:08 a.m. ET
LONDON (CNNfn) - German first-quarter gross domestic product increased 0.7 percent from the previous three-month period, as expected, helped by demand for exports, the Federal Statistics Office said on Tuesday.
The German economy, Europe's biggest, expanded by 3.3 percent in the first quarter of 2000 compared to the same period a year ago, the strongest annual rate of growth since the first quarter of 1998.
The quarter-over-quarter growth rate matched the 0.7 percent pace recorded in the three months ended Dec. 31, aided by a decline in the euro that has made exports cheaper. Economists now predict full-year growth of more than 3 percent.
"It's a very good start to the year 2000 and clearly indicates the upswing is intact and growth is accelerating," said Manuela Preuschl, an economist at Deutsche Bank in Frankfurt.
The Organization for Economic Cooperation and Development Tuesday raised its forecast for German economic growth, predicting GDP would rise 2.9 percent this year and 3 percent in 2001, as exports remain strong and tax cuts boost domestic demand.
In the first quarter, exports grew 15.3 percent from a year earlier while imports rose 11.9 percent. Gross investment in plant and equipment increased 5.7 percent. The pace of growth in private consumption weakened to 0.9 from a year earlier, compared with 2.2 percent in the fourth quarter of 1999.
--from staff and wire reportsOriginal AS/AD graph:
Determinants that are mentioned in the article:
"German first-quarter gross domestic product increased 0.7 percent from the previous three-month period, as expected, helped by demand for exports, the Federal Statistics Office said on Tuesday."So: Xn
ALSO:
"The Organization for Economic Cooperation and Development Tuesday raised its forecast for German economic growth, predicting GDP would rise 2.9 percent this year and 3 percent in 2001, as exports remain strong and tax cuts boost domestic demand."
So:
Draw the changes on the graph:
What happened to UE, IN, and EG as a result of these changes?
Since equilibrium RDO increased from RDOequil to RDO' we can conclude that unemployment (UE) decreased and economic growth (EG) increased. The price level rose slightly from PL to PL' so maybe inflation (IN) increased a little.
Read this short article from http://news.bbc.co.uk. Analyze the article by identifying the determinants of AD and/or AS that have changed. Then graph the changes on the AS-AD model. Finally use your graph to discuss has happened to UE, IN, and EG.
[http://news.bbc.co.uk/hi/english/business/the_economy/newsid_300000/300492.stm]
Again, be sure to follow the same three steps:
(1) Identifying the determinants of AD and/or AS that have changed.
This is important. It all begins with a CHANGE in one of the determinants of AD or AS. You MUST memorize these determinants and know which ones shift the AD curve and which shift the AS curve!(2) Then graph the changes on the AS-AD model.
Next, you must know which way the determinants will shift the curve.(3) Finally use your graph to discuss has happened to UE, IN, and EG.
Wednesday, March 24, 1999 Published at 10:34 GMT
Business: The Economy
OPEC slashes oil production
Oil producers finally agree to restrict output
Ministers from oil producing countries have agreed to cut global production by 7% to bolster depressed oil prices.The members of the Organisation of Petroleum Exporting Countries (OPEC) and others meeting in Vienna have agreed to a reduction in output of 2.1m barrels a day until April next year.
Saudi Oil Minister Ali al-Naimi said the new restrictions were aimed at lifting oil prices back to $18 a barrel within a year.
. . . . . .
Inflation fears
However, this would hit consumers hard, perhaps rekindling inflation.
The oil price has increased 30% in the last month on the belief that OPEC would finally agree to cap output. Oil has risen from its low in December of below $10 a barrel, for Brent crude for May delivery, to $13.75 as the decision was announced.. . . . . . .
Original AS/AD graph:
Currently the economy of the United States is operating at the full employment level of output as shown in the graph below:
Determinants that are mentioned in the article:
"The oil price has increased 30% in the last month on the belief that OPEC would finally agree to cap output. Oil has risen from its low in December of below $10 a barrel, for Brent crude for May delivery, to $13.75 as the decision was announced."So the determinant that has changed is the Price of Resources:
Price of resources
Draw the changes on the graph:
What happened to UE, IN, and EG as a result of these changes?
Since equilibrium RDO decreased from RDO1 to RDO' we can conclude that UE increased and EG decreased. The price level will rise from PL1 to PL' indicating inflation. With output down and prices up, this increase in oil prices may result in stagflation.
Is an increase in exports good for an economy? Most students will quickly answer "yes" to this question, as would most newspaper writers. But WE know better. It depends.
Currently the economy of the United States is operating at the full employment level of output as shown in the graph below:
An increase in exports will do what to the graph above? An increase in exports will increase AD.
GRAPH IT!
The result: INFLATION! So is an increase in exports good for THIS economy? NO.
But, if initially the economy is experiencing high unemployment like in the graph below:
Then, an increase in exports would increase AD and move the economy closer to the full employment level of output with only a little inflation. See graph:
This would of course be good for the economy. So is an increase in exports good for an economy? - - It depends.
Now you try it. Read this short article from cnn.com. Analyze the article by identifying the determinants of AD and/or AS that have changed. Then graph the changes on the AS-AD model. Finally use your graph to discuss has happened to UE, IN, and EG.
Remember to:(1) Identify the determinants of AD and/or AS that have changed.
This is important. It all begins with a CHANGE in one of the determinants of AD or AS. You MUST memorize these determinants and know which ones shift the AD curve and which shift the AS curve!(2) Then graph the changes on the AS-AD model.
Next, you must know which way the determinants will shift the curve.(3) Finally use your graph to discuss has happened to UE, IN, and EG.
- Click on the link below
to see that article that you are to analyze:
U.S. consumer confidence index jumps to 144.4; second-highest level ever (5/30/00)
MORE EXAMPLES / REVIEW:
For more exercises see: http://www.harper.cc.il.us/mhealy/eco212i/lectures/asad/adasprac.htm
Macroeconomic Policies
Now that we have this handy tool, let's use it to discuss government policies (NOTE: when I use the term "policies", I always mean "government policies"). What is the role of the government in a market economy? In a market economy (capitalist economy) the government has a limited role, but some people believe that the government should try to help the economy maintain full employment and low inflation. We have discussed in the 5 Es lesson that unemployment results in greater scarcity since some resources are not being used so less will be produced. Government policies may be able to help the economy achieve full employment and therefore reduce scarcity.
In a previous chapter we discussed the five economic functions of governments in capitalist economies. Here we will begin our discussion of how to "promote stability".
Economic Functions of Government in a Market (Capitalist) Economy
- Providing the legal structure
- Maintaining competition
- Redistributing income
- Reallocating resources
- negative externalities
- positive externalities
- public goods and services
- Promoting stability
Stabilization Policies
Definition: government policies design to reduce unemployment (UE) and/or inflation (IN). All the policies discussed here can be classified as stabilization policies.There are two major types of stabilization policies:
- demand-management policies
- supply-side policies
Demand-Management Policies
Definition: Policies design to shift the AD curve in order to reduce unemployment or to reduce inflation.Tools -- Some of the determinants of AD can be manipulated by the government to achieve these goals.
There are two types of demand-management policies depending upon WHO conducts the policy:
- fiscal policy is undertaken by the president and the congress, and
- monetary policy is undertaken by the Federal Reserve Board (often called the "fed").
FISCAL POLICY
There are two types of fiscal policy:
- expansionary fiscal policy
- contractionary fiscal policy
The goal of expansionary fiscal policy is to reduce unemployment. Therefore the tools would be an increase in government spending and/or a decrease in taxes. This would shift the AD curve to the right increasing real GDP and decreasing unemployment, but it may also cause some inflation.
The goal of contractionary fiscal policy is to reduce inflation. Therefore the tools would be an decrease in government spending and/or an increase in taxes. This would shift the AD curve to the left decreasing inflation, but it may also cause some unemployment.
MONETARY POLICY
There are two types of monetary policy
- easy money
- tight money
The goal of an easy policy is to reduce unemployment. Therefore the tool would be an increase in the money supply. This would shift the AD curve to the right decreasing unemployment, but it may also cause some inflation.
MSThe goal of a tight money policy is to reduce inflation. Therefore the tool would be a decrease in the money supply. This would shift the AD curve to the left decreasing inflation, but it may also cause some unemployment.
MS
"Supply-Side Economics"
Supply-Side economic policy occurs when the government tries to increase the AS curve. this will reduce both unemployment and inflation.
There are three determinants of AS:
a. change in input prices
price of resourcesb. changes in the productivity of resource
productivityc. legal-institutional environment
business taxes and gov't red tapeSupply-Side Policies
Supply-side policies try to increase productivity. Often this includes less government regulations. Also, in the 1980s President Reagan decreased marginal income tax rates as a supply-side policy (sometimes called "Reaganonmics"). The idea was that people will work more if they can keep more of their incomeWe have said that decreasing income taxes will INCREASE AD. But here we said that it may also INCREASE AS. Which is it? both may be true, but the effect on AD is probably quicker. In this class a tax cut will increase AD, UNLESS we mention that is is a "supply-side" tax cut. Then we will increase the AS curve.
REVIEW
Short-Run and Long-Run Aggregate Supply
Definition: Short-run and long-run.For macroeconomics the short-run is a period in which wages (and other input prices) do not respond to price level changes because workers may not be fully aware of the change in their real wages due to inflation (or deflation) and thus have not adjusted their labor supply decisions and wage demands accordingly or employees hired under fixed wage contracts must wait to renegotiate regardless of changes in the price level.
In the long run the aggregate supply curve is vertical at the economy's full-employment output. The curve is vertical because in the long run resources prices adjust to changes in the price level, leaving no incentive for firms to change their output.
Why is the long run aggregate supply curve vertical?
Let's see what happens first in the short run (assuming wages do not change), and then see what happens when wages do change. (Note: when wages change the short run aggregate supply curve will change - this is the price of resources determinant.)INFLATION
Let's begin by seeing what happens if there is demand-pull inflation. If AD increases it will in the short run increase the price level and increase real output. On the graph below this can be illustrated as an increase of AD from AD1 to AD2 and the equilibrium point moves from "a" to "b". So the price level rises from P1 to P2 and output increases from Qf to Q2. (Note that Qf is the "full employment level of output.) Earlier we discussed how an economy can produce more than the full employment level of output.
What happens when workers see that prices are rising but their wages are staying the same? Remember, by definition, in the short run wages do not change, but they can in the long run. An economy can temporarily produce more than the full employment level as people work more than they want to, but in the long run they will demand higher wages. When wages increase this will be an increase in the price of resources and the the short run AS curve will decrease, shift to the left. On the graph below this is a movement from AS1 to AS2 and the economy moves from point "b" to point "c". This causes the price level to rise from P2 to P3 and the level of output decrease back to the full employment level (from Q2 to Qf). The long run result is that the level of output in the economy has stayed at Qf and the price level has risen. The long run aggregate supply curve is therefore vertical (the blue line below).
What happens in the long run if in the short run there is cost-push inflation? Cost push inflation is caused by increases in the cost of production at each price level maybe caused by the increase in the price of a key resource. This shifts the short run supply to the left on the graph below from AS1 to AS2. the result is that the economy moves from point "a" to point "b" and there is a recession (unemployment increases) and inflation. Earlier we called this "stagflation". What should the government do?
If government attempts to maintain full employment by using expansionary fiscal or monetary policy to increase AD (from AD1 to AD2 on the graph above) an "inflationary spiral" may occur. If government doesn't do anything when there is cost push inflation, a recession will occur with high unemployment and a loss of real output.RECESSION
When aggregate demand shifts leftward a recession occurs. Let's see what will happen in the short run and in the long run. If prices and wages are downwardly flexible, the price level will fall form P1 to P2 when AD decreases from AD1 to AD2. With the price level falling the real wages of workers (i.e. the purchasing power of their wages) increases. It's as if they are being paid more. Since businesses are selling less and getting less, but workers are getting more, business owners will want to reduce the wages of their workers restoring their purchasing power to what it was before the recession started. This decrease in wages will cause an increase in the short run AS (price of resources determinant) and the economy will move from point "b" to point "c". So, in the long run (remember that "long run" means that wages have time to change) the economy is back at the full employment level of output but the price level is lower. Again, the long run aggregate supply curve is vertical.
This is the most controversial application of this new "extended" AD-AS model. The key point of dispute is how long it would take in the real world for the necessary price and wage adjustments to take place to increase AS and bring the economy back to full employment. If policy makers think that it will take a long time to move back to full employment then they may want to enact some expansionary fiscal or monetary policy. BUT, if the prices and wages change quickly, then the government does not have to do anything. If there is a recession they can just wait a short time and the economy will quickly adjust back to full employment.
Economic Growth and the Long Run Aggregate Supply
Now we can add another graph to illustrate economic growth
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Increasing output by INCREASING THE
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