Module 6: Short Run Aggregate Supply with LRAS & AD

When did the classical model work well?

To explain economic recessions before the Great Depression

What is the classical model also called?

The AD/LRAS Model

What were past recessions based on?

Supply disruptions with items from sPENT decreasing

What happens when items from sPENT decrease?

• Prices rise

• GDP falls

• Unemployment rises

What is the Keynesian Model used for?

The short-run

What are the Key Assumptions of the Keynesian model?

Sticky or rigid prices/wages

What are the sources of price rigidities (sticky)?

• Union and other long-term contracts

• Menu costs

• Slow to adjust

What is the opposite of sticky prices?

Rigid prices

Capitalism may not be WHAT?

Self-regulating

What does the Keynesian model look like?

What are the characteristics of the classical model of economics?

• Flexible prices

• Long run view

• LRAS determines output

What are the characteristics of the keynesian model of economics?

• Rigid (stuck) prices

• Short run view

• AD determines output (GDP)

What does the impact of a change in AD depend on?

The shape of the SRAS

What does the level of price flexibility determine?

The SRAS shape

Why do prices rise in the long run?

The economy can only create goods and services based on the keys to long run growth

If there is more demand for goods and services, what do firms eventually do?

Raise prices because they cannot sustainably continue to create more based on the level of sPENT

What does the AD-AS model look like?

What happens in the short run of the AD-AS if aggregate demand falls?

Prices decrease and real GDP decreases

In the long run, where is the economy?

At the intersection of LRAS and AD

In the short run, where is the economy?

At the intersection of SRAS and AD

What causes both aggregate supply curves to shift right?

• Discoveries of new raw materials (N incr.)

• Increased competition (P incr.)

• A reduction in international trade barriers (P incr.)

• Fewer regulatory impediments to business (P incr.)

• An increase in labor supplied (N incr.)

• Increased training and education (E incr.)

• A decrease in marginal tax (N incr.)

What happens if sPENT increases?

LRAS and SRAS shift right

Are magnitudes of shift important?

Yes

What causes the short run aggregate supply curve to shift left?

• Increased inflationary expectations

• Increase in input prices

What are input prices?

• Energy (oil, gas, etc.)

• Raw Materials (steel, lumber, etc.)

• Wages

What happens if supply shifts?

price and real GDP move in opposite directions

What happens if demand shifts?

price and real GDP move in the same direction

What is an Aggregate Demand Shock?

Any shock that causes the aggregate demand curve to shift inward or outward

What is an Aggregate Supply Shock?

Any shock that causes the aggregate supply curve to shift inward or outward (supply chain issues)

What is a recessionary gap?

• GDP < LRAS

• Actual GDP < Potential GDP

How do you see if recessionary gap is getting bigger?

Potential GDP - Actual GDP

What does a growing recessionary gap mean?

Growing unemployment rate

What does it mean if short run equilibrium is to the left of long-run equilibrium?

Recessionary gap

What is an inflationary gap?

• GDP > LRAS

• Actual GDP > Potential GDP

How do you see if an inflationary gap is getting bigger?

Actual GDP - Potential GDP

Can you have a recessionary gap with inflation/deflation (and vice versa)?

Yes

What are the economic corrections for a recessionary gap?

• Inflation expectations and/or input prices fall

• SRAS shifts right

• Prices fall more but GDP increases

What are the economic corrections for an inflationary gap?

• Inflation expectations and/or input prices rise

• SRAS shifts left

• Prices rise and GDP falls back to potential

What does economic correction mean?

Without intervention

How can the simple model be misleading?

• No long-run growth (real potential GDP)

• Deflation in model is too common

What are the new assumptions for the complex aggregate demand and aggregate supply model?

• Potential Real GDP increases

• AD increases

• SRAS increases

Why do LRAS and SRAS rise?

Due to increases in sPENT

Why does AD rise?

Due to increases in income, business spending, public goods, international growth, money

What can the dynamic model illustrate?

Real world outcomes