as ad model 2010

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Macroeconomic Theory

Introduction to Economics (Econ 101)

T. J. Mukura

Dept of EconomicsUniversityofZimbabwe

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Key Texts

Colander, D. C. (2004), Macroeconomics, 5th Edition,

McGraw-Hill/Irwin

Gwartney, J. et al(2009), Economics: Private & Public

Choice, 12th Edition, Thomson South-Western

Lipsey, R. G., Ragan, C. T. S., & Storer, P. A. (2008),Desk Copy for Economics, Microeconomics &

Macroecononmics,13th Edition, Pearson Education

Inc.

Mconnell, C. R. & Brue, S. L. (2002),

Macroeconomics, 15th Edition, McGraw-Hill Higher

Education

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AS AD Model

Aggregate Supply (AS) captures the production and pricing

decisions by firms Aggregate Demand (AD) captures aggregate spending decisions

The AS-AD Model focuses on aggregate expenditures as the primarydeterminant of short-run income

It consists of three curves:

i. Short-run aggregate supply curve (SRAS) -ii. Long-run aggregate supply curve (LRAS) describes the highest

sustainable level of output

iii. Aggregate Demand Curve

Unlike the microeconomic supply/demand model, the AS-ADModel

i. deals with the general price level of all goods and the aggregateoutput in the economy as opposed to single good prices andquantities

ii. Is a historical model starts at a particular point in time and sayswhat will likely happen when changes affect the economy

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AD Curve

Shows how a change in the price level will change aggregate expenditureson all goods and services in an economy

Indicates the various quantities of domestically produced goods andservices that purchasers are willing to buy at different price levels

TheAD curve slopesdownward to the right, indicating an inverse

relationship between the amount of goods and services demanded andthe price level due to:i. The wealth effect A lower price level increases the purchasing power of

the fixed quantity of money leading to increased consumption expenditure

ii. The interest rate effectA lower price level will reduce the demand formoney and lower the real interest rate leading to an increase in investmentexpenditures

iii. The international effect assuming a constant exchange rate, a lower pricelevel will make domestically produced goods less expensive relative toforeign goods which leads to an increase in exports

iv. The multiplier effect the amplification of initial changes in expenditures

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AD Curve Diagram

Goods & Services(real GDP)

PriceLevel

AD

P2

Y1 Y2

P1

As illustrated above, when the general price level in theeconomy declines from P1to P2, the quantity of goods andservices purchased will increase from Y1 to Y2.

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Shifts in AD

A shift in the AD curve means that at every price level, total expenditures havechanged

Anything other than the price level that changes components of AD (C, I, G,(X-M)) will shift the AD curve

There are five main shift factorsi. Foreign income a rise in foreign income means more domestic goods

demanded (more exports) hence an increase in AD AD curve shifts to the right

ii. Exchange rates a fall in the value of the domestic currency makes domestic

goods more competitive leading to increased foreign demand for domesticgoods AD shifts to the right

iii. Expectations expectations of higher future income leads to lower currentsavings and increased expenditures AD curve shifts to the right

iv. Distribution of income some people save more than others hence as incomedistribution changes, AD will also change accordingly

v. Government policies gvt can manipulate AD through fiscal and monetarypolicies e. g. an increase in gvt expenditure or tax cut shifts the AD curve to theright

Due to the multiplier, the AD curve may shift by more than the amount of the initialshift factor

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Aggregate Supply

When considering theAggregate Supplycurve, it is important to distinguish betweenthe short-run and the long-run. Short-run:

A period of time during which some prices,particularly those in resource markets, are set by priorcontracts and agreements. Therefore, in the short-run, households and businesses are unable to adjustthese prices when unexpected changes occur,including unexpected changes in the price level.

Long-run:A period of time of sufficient duration that peoplehave the opportunity to modify their behavior inresponse to price changes

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SRAS Curve

SRAS indicates the various quantities of goods andservices that domestic firms will supply in response tochanging demand conditions that alter the level ofprices in the goods and services market.

In other words, it specifies how a shift in the aggregatedemand curve affects the price level and real output inthe short-run, ceteris paribus

The SRAS curve slopes upwards reflecting the fact that,in the short-run, an unanticipated increase in the price

level will improve the profitability of firms

Firms respond to this increase in the price level with anexpansion in output

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SRAS Curve Diagram

Goods & Services

(real GDP)

PriceLevel SRAS

P105

P100

P95

Y1 Y2 Y3

In the short-run, firms will expand output as the price levelincreases because higher prices improve profit marginssince many components of costs will be temporarily fixed asthe result of prior long-term commitments.

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Shifts in the SRAS Curve

Factors that lead to a shift in the SRAS include:

i. Changes in input prices an increase in input prices shiftsthe SRAS up, opposite is true

ii. Changes in expectations about inflation these work

through wages (an expected increase in prices leads todemand for wage increments hence an upward shift inthe SRAS curve)

iii. Excise and sales taxes higher sales taxes shift the SRASup

iv. Import prices when they rise, the SRAS curve shiftsupward

v. Productivity an increase in productivity reduces inputsper unit output , thus reduced cost per unit, leading to adownward shift of the SRAS

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LRAS Curve

LRAS indicates the relationship between the pricelevel & quantity of output after decision makershave had sufficient time to adjust their priorcommitments where possible.

LRAS is related to the economy's productionpossibilities constraint. A higher price level does not loosen the constraints

imposed by the economy's resource base, level oftechnology, and the efficiency of its institutionalarrangements.

Therefore, an increase in the price level will not lead to asustainable expansion in output.

Thus, the LRAS curve is vertical.

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LRAS Curve Diagram


PriceLevel LRAS

YF(full employment

rate of output)

Potential GDP

In the long-run, a higher price level will not expand aneconomys rate of output. Once people have time to adjusttheir long-term commitments, resource markets (and costs)will adjust to the higher levels of prices and thereby removethe incentive of firms to continue to supply a larger output.

P2

P1

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Shifts in the LRAS Curve

The LRAS shifts for the same reasons thatpotential output shifts, i.e. due to changes inthe

i. Capital stockii. Available resources

iii. Growth-compatible institutions

iv. Technological progress

v. Entrepreneurship

An increase in the above shifts the LRAS tothe right and vice versa

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Short-run Equilibrium in the Economy

Short-run equilibrium occurs at the price levelwhere the aggregate quantity demandedis equal to the aggregate quantity supplied.

This occurs (graphically) at the output rate wheretheAD and SRAS curves intersect.

At this market clearing price P, the amount thatbuyers want to purchase is just equal to thequantity that sellers are willing to supply duringthe current period.

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At prices below P, general excess demand pushes pricesupward.

Equally, at prices higher than P, excess supplyforces pricesdown.

Short-Run Equilibrium Diagram

AD

SRAS

P

YGoods & Services

(real GDP)

PriceLevel

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Shift in the AD

A rightward shift of the AD curve changes equilibrium for A

to B, increasing output from Y to Y1 and the price level from P

to P1

AD1

SRAS

P

YGoods & Services

(real GDP)

PriceLevel

P1

Y1

A

B

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Shift in the SRAS

AD

SRAS1

P

YGoods & Services

(real GDP)

PriceLevel

SRAS

Y1

P1

An upward shift in the SRAS curve changes equilibrium from C

to D, reducing output from Y to Y1 and increasing the price

level from P to P1

D

C

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Long-run Equilibrium

When long-run equilibrium is present: Potential GDP is equal to the economys maximum

sustainable outputconsistent with its resource base,current technology, and institutional structure.

The Economy is operating atfull employment. Actual rate of unemployment equals the natural rate

of unemployment.

Long-run equilibrium is graphically determined by

the intersection of theAD, SRAS, and LRAScurvesas shown in the diagram below

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L R E ilib i Di

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Long-Run Equilibrium Diagram

Long-run equilibrium is determined at the intersection of the Adcurve and the LRAS curve as shown above

The subscripts onAD indicate that buyers and sellers alikeanticipated the price level P100(where 100 represents an index of pricesduring an earlier base year).

When the anticipated price level is attained, output YFwill equalpotential GDP and full employment will be present.

AD100

P100


PriceLevel

Y

LRAS

YF(full employment

rate of output)

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Shift in AD

SRAS

AD1

P1


PriceLevel

Y

LRAS

YF(full employment

rate of output)

P2

AD2

In the long-run (at potential output YF), the AD curve can only

determine the price level; it does not affect real output level. Asshown above, when AD increases from AD1 to AD2, the price level

increases from P1 to P2 but output remains at YF. Output is not

determined by AD but by potential output.

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Short- & Long-Run Framework

In the above instance, the economy is in both a long-run and short-run

equilibrium since the AD and SRAS intersect at the LRAS curve i.e. allthree curves intersect at the same point

At this point, aggregate demand is growing at the same rate as potentialoutput

Growth and unemployment are at their target rates with no or minimalinflation

SRAS100

AD100

P100


PriceLevel

Y

LRAS

YF(full employment

rate of output)

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A

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Recessionary Gap

SRASo

AD

PF


PriceLevel

Y

LRAS

YF

P1

Y1Recessionary gap

SRAS1

B

A

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The short and long-run equilibriums do not always coincide. The above diagramshows a situation, at point A, where AD is below potential output and resourcesare not fully employed. The distance (Yf Y1) shows the amount of output notbeing produced but could be. This is known as the recessionary gap theamount by which equilibrium output is below potential output.

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Recessionary Gap Contd

With time, costs and wages will fall due to the excess

supply of factors of production resulting in a fall inthe price level

The SRAS curve will then shift down from SRAS0 to

SRAS1 until the long- and shortrun equilibrium is

reached at B

However, usually before prices fall, the government

institutes policies that increase AD resulting in the

AD curve shifting to the right thus eliminating therecessionary gap while maintaining a constant price

level

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Inflationary Gap

SRAS0

AD1

PF


PriceLevel

Y

LRAS

YF

P1

D

C

Y1

SRAS1

Inflationary gap

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Point C shows an economy where the short-run equilibrium is

at a higher income than the potential output. The distance(Y1 YF), the amount by which aggregate expendituresoutstrip potential output that exists at the current price level,is known as the inflationary gap.

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Inflationary Gap Contd The economy will not stay at C for long as resources

are being strained. To increase factors, a firm mustlure resources away from other firms resulting in the

bidding up of factor prices

Factor prices will rise and the SRAS curve will shift up

from SRAS0 to SRAS1 and the new equilibrium will be

at D

However, government may not wait for this but will

institute AD policy which will shift the AD curve tothe left to contract output and eliminate the

inflationary gap

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Summary AS/AD Model

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Summary AS/AD Model

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What shape is it? What determines shape? What shifts the curve?

AD Downward

sloping: As the

price leveldeclines,

expenditure rises

The wealth, interest rate,

international an multiplier

effects

Sudden changes in C, I, G, or

(X-M) caused by changes in

foreign income, expectationsabout future income or

prices, exchange rates,

monetary and fiscal policy

SRAS Upward sloping:

The price level

increases as

output increases.

Firm behaviour. Most firms

change production instead of

price when demand changes.

Some firms will raise prices

when output increases

Increases in input prices shift

the SRAS curve up.

Decreases in input prices

shift the SRAS curve down

LRAS Vertical: Changes

in price level have

no effect onoutput.

Potential output is output

that the economy can

produce when labour andcapital are fully utilized. It is

not affected by prices

Anything that increases

potential output, such as

increases in availableresources and technological

innovation

as ad model 2010

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