9 AD-AS (1).pptx

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1. AGGREGATE DEMAND & AGGREGATE SUPPLY

2. IS-LM and aggregate demand So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. However, a change in P would shift LM and therefore affect Y . The aggregate demand curve captures this relationship between P and Y.

3. Deriving the AD curve Intuition for slope of AD curve:  P  ( M / P )  LM shifts left   r   I   Y

4. Monetary policy and the AD curve The Fed can increase aggregate demand:  M  LM shifts right   r   I   Y at each value of P

5. Fiscal policy and the AD curve Expansionary fiscal policy ( G and/or  T ) increases agg . demand:  T   C  IS shifts right   Y at each value of P

6. IS-LM and AD-AS in the short run & long run The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will rise fall remain constant

7. The SR and LR effects of an IS shock

8. The SR and LR effects of an IS shock

9. The SR and LR effects of an IS shock

10. The SR and LR effects of an IS shock

11. The SR and LR effects of an IS shock

12. Food for Thought Through the lens of IS-LM, how can we understand classical vs. Keynesian models?

13. The Great Depression

14. THE SPENDING HYPOTHESIS: Shocks to the IS curve asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve. evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

15. THE SPENDING HYPOTHESIS: Reasons for the IS shift Stock market crash  exogenous  C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment Contractionary fiscal policy Politicians raised tax rates and cut spending to combat increasing deficits.

16. THE MONEY HYPOTHESIS: A shock to the LM curve asserts that the Depression was largely due to huge fall in the money supply. evidence: M 1 fell 25% during 1929-33. But two problems with this hypothesis: P fell even more, so M / P actually rose slightly during 1929-31. Interest rates fell, which is the opposite of what a leftward LM shift would cause .

17. THE MONEY HYPOTHESIS: The effects of falling prices asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929-33. This deflation was probably caused by the fall in M , so perhaps money played an important role after all. Why was it not considered a problem?

18. THE MONEY HYPOTHESIS: The effects of falling prices The stabilizing effects of deflation:  P  ( M / P )  LM shifts right   Y Pigou effect :  P  ( M / P )  consumers’ wealth    C  IS shifts right   Y

19. THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of unexpected deflation: debt-deflation theory  P (if unexpected)  transfers purchasing power from borrowers to lenders  if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

20. THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of expected deflation: When firms expect deflation, reluctant to borrow and invest They will have to repay the loan in more valuable money.   I  IS shifts left   Y

21. Short run Aggregate Supply We assumed the price level P was “stuck” in the short run. This implies a horizontal SRAS curve. We relax that assumption by making SRAS upward sloping

22. Three Theories of SRAS In each, some type of market imperfection result: Output deviates from its natural rate when the actual price level deviates from the price level people expected.

23. What the 3 Theories Have in Common: In all 3 theories, Y deviates from Y N when P deviates from P E .

24. 1. The sticky-price Theory Reasons for sticky prices: long-term contracts between firms and customers menu costs firms not wishing to annoy customers with frequent price changes Assumption: Firms set their own prices ( e.g. , as in monopolistic competition).

25. 1. The sticky-price Theory An individual firm’s desired price is: where a > 0. Suppose two types of firms: firms with flexible prices, set prices as above firms with sticky prices, must set their price before they know how P and Y will turn out:

26. 1. The sticky-price Theory Assume sticky price firms expect that output will equal its natural rate. Then, To derive the aggregate supply curve, first find an expression for the overall price level. s = fraction of firms with sticky prices. Then, we can write the overall price level as…

27. 1. The sticky-price Theory price set by sticky price firms price set by flexible price firms Subtract (1  s ) P from both sides: Divide both sides by s :

28. 1. The sticky-price Theory Finally, derive AS equation by solving for Y :

29. 2. The Sticky-Wage Theory Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly. Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on P E , the price level they expect to prevail.

30. 2. The Sticky-Wage Theory If P > P E , labor cost (real wage) is lower. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y , so the SRAS curve slopes upward .

31. 3. The Misperceptions Theory Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above P E , a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y , making the SRAS curve upward-sloping.

32. What the 3 Theories Have in Common In all 3 theories, Y deviates from Y N when P deviates from P E .

33. What the 3 Theories Have in Common

34. SRAS and LRAS The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible misperceptions are corrected In the LR, P E = P AS curve is vertical

35. SRAS and LRAS

36. Why the SRAS Curve Might Shift Everything that shifts LRAS shifts SRAS , too. Also, P E shifts SRAS : If P E rises, workers & firms set higher wages. At each P , production is less profitable, Y falls, SRAS shifts left.

37. The Long-Run Equilibrium In the long-run equilibrium, P E = P , Y = Y N , and unemployment is at its natural rate.

38. The Effects of a Shift in AD Event: Stock market crash 1. Affects C , AD curve 2. C falls, so AD shifts left 3. SR eq’m at B. P and Y lower, unemp higher 4. Over time, P E falls, SRAS shifts right, until LR eq’m at C. Y and unemp back at initial levels.

39. The Effects of a Shift in SRAS Event: Oil prices rise 1. Increases costs, shifts SRAS (assume LRAS constant) 2. SRAS shifts left 3. SR eq’m at point B. P higher, Y lower, unemp higher. From A to B, stagflation , a period of falling output and rising prices.

40. Accommodating an Adverse Shift in SRAS If policymakers do nothing, 4. Low employment causes wages to fall, SRAS shifts right, until LR eq’m at A. Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to Y N , but P permanently higher .

41. The 1970s Oil Shocks and Their Effects

42. Fiscal Policy and Aggregate Supply Most economists believe the short-run effects of fiscal policy mainly work through agg demand. But fiscal policy might also affect agg supply. A cut in the tax rate gives workers incentive to work more, so it might increase the quantity of g&s supplied and shift AS to the right. People who believe this effect is large are called “Supply-siders.”

43. Fiscal Policy and Aggregate Supply Govt purchases might affect agg supply. Example: Govt increases spending on roads. Better roads may increase business productivity, which increases the quantity of g&s supplied, shifts AS to the right. This effect is probably more relevant in the long run: it takes time to build the new roads and put them into use.

44. The Case for Active Stabilization Policy Keynes: “Animal spirits” cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment. Also, other factors cause fluctuations, e.g. , booms and recessions abroad stock market booms and crashes If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers.

45. The Case for Active Stabilization Policy Proponents of active stabilization policy believe the govt should use policy to reduce these fluctuations: When GDP falls below its natural rate, use expansionary monetary or fiscal policy to prevent or reduce a recession. When GDP rises above its natural rate, use contractionary policy to prevent or reduce an inflationary boom.

46. The Case Against Active Stabilization Policy Monetary policy affects economy with a long lag: Firms make investment plans in advance, so I takes time to respond to changes in r . Most economists believe it takes at least 6 months for monetary policy to affect output and employment. Fiscal policy also works with a long lag: Changes in G and T require discussions in cabinet/parliament. The legislative process can take months or years.

47. The Case Against Active Stabilization Policy Due to these long lags, critics of active policy argue that such policies may destabilize the economy rather than help it. By the time the policies affect agg demand, the economy’s condition may have changed. These critics contend that policymakers should focus on long-run goals like economic growth and low inflation.

48. Automatic Stabilizers Automatic stabilizers : changes in fiscal policy that stimulate agg demand when economy goes into recession, without policymakers having to take any deliberate action

49. Automatic Stabilizers: Examples The tax system In recession, taxes fall automatically, which stimulates agg demand. Govt spending In recession, more people apply for public assistance (welfare, unemployment insurance). Govt spending on these programs automatically rises, which stimulates agg demand.