3.2 - models, AD, SRAS, LRAS, deflationary and inflationary gaps

aggregate demand AD

total demand for goods and services in an economy at a given average price level and in a given time period

AD = C + I + G + (X-M)

AD ↑ = economic growth

AD curve shifts

right shift → increase of any determinants of AD

left shift → decrease of any determinants of AD

factors influencing consumption of AD

• consumer confidence ↑ = c↑

• interest rates↑ = c↓

• wealth ↑= c↑

• income tax ↑= c↓

• level of household indebtedness ↑ = c↓

factors influencing investment of AD

• business confidence ↑= i ↑

• interest rates ↑ = i ↓

• technology ↑= i↑

• business taxes ↑= i↓

• level of corporate indebtedness↑ = i ↓

factors influencing government spending of AD

• political priorities

• economic priorities

factors influencing net exports of AD

• income of trading partners ↑= x ↑

• exchange rates (domestic currency↑ = m↑ / x↓

• trade policies↑ = m ↓

short- run aggregate supply SRAS

total supply of goods/services produced within an economy at an average price level at a given time

• wages and other factors are inflexible

  • only shifted by change in costs of

    • raw materials

    • energy

    • indirect taxes

SRAS curve shifts

left shift → increase in costs/ decrease in SRAS

right shift → decrease in costs/ increase in SRAS

factors shifting SRAS curve

• input costs (wages, costs of resources) ↑ = SRAS ↓ = left

• indirect taxes ↓ = costs ↓= SRAS ↑ = right

• subsidies ↑ = costs ↓ = SRAS ↑ = right

• supply shocks = output ↓ = SRAS ↓ = left

impacts of changes of SRAS and AD on short run equilibrium

long run aggregate supply LRAS (monetarist view)

• all factors of production are utilized efficiently.

• negative and positive output gaps will self-correct

• only average price level will change

• economy will always return to this full employment in long run

deflationary gap → fall in AD

• real GDP < potential GDP

• unemployment> natural rate of unemployment

• not enough demand in the economy to make it worthwhile produce potential GDP

• caused by decrease (left shift) in AD

  • decreased price level

  • decreased real GDP

solving deflationary gap → rise in SRAS

• real GDP > potential GDP

• unemployment < natural rate of unemployment

• caused by increase (right shift) in SRAS

  • decreased price level

  • increased real GDP

inflationary gap → rise in AD

• real GDP > potential GDP

• unemployment < natural rate of unemployment

• to too much demand in the economy

• caused by increase (right shift) in AD

  • higher price level

  • higher real GDP

solving inflationary gap → fall in SRAS

• real GDP < potential GDP

• unemployment > natural rate of unemployment

• caused by decrease (left shift) in SRAS

• stagflation

  • increased price level

  • decrease in real GDP

deflationary gap creation + correction & result

creation:

• fall (left shift) in AD

  • decreased price level

  • decreased real GDP

  • deflationary gap

correction:

• increase (right shift) in SRAS

  • decrease in production costs

  • good supply shock

result:

• economy is back at LRAS curve at point *

• fall in price level

assumptions:

• wage and price flexibility in the long run

  • allowed economy to shift back to full employment of output

inflationary gap creation + correction & results

creation:

• rise (right shift) in AD

  • increased price level

  • increased real GDP

  • inflationary gap

correction:

• decrease (left shift) in SRAS

  • increase in production costs

  • bad supply shock

result:

• economy is back at LRAS curve at point *

• rise in price level

Keynesian model

LRAS is L shaped with 3 distinct sections

• elastic supply section

• relatively elastic supply section

• perfectly inelastic supply section

• will not always self-correct

• may get stuck below potential GDP

• needs government intervention to aid it

• increase in AD may not necessarily result in increase in price level

elastic supply section

• unemployment of resources & spare capacity

• easy to increase output without rising prices

relatively elastic supply section

• spare capacity begins to run out

• output (rGDP) increases

• resources’ price increase

  • higher costs of production

  • increased selling prices

perfectly inelastic supply section

• full employment of all available resources

• real GDP can no longer increase

• any effort to increase output results in higher price

deflationary gap Keynesian model

• Ye < Yp

• unemployment > natural rate of unemployment

• AD is too weak to induce firms to produce at Yp

inflationary gap Keynesian model

• Ye > Yp

• unemployment < natural rate of unemployment

• strong AD

output gaps definition

the difference between

• actual level of output (rGDP)

• maximum potential level of output (Yp)

difficulty with measuring output gaps

• hard to know the exact maximum productive potential

• due to factors like

  • changes in technology

  • labor force participation

  • variations in consumer demand.

factors affecting AS and LRAS

(economic growth/fall & Yp increase/ fall)

changes in quality + quantity of:

• land

• labor

• capital

• enterprise

classical model

• wages are flexible

• natural rate of unemployment

• gaps are automatically corrected

• resources are free to change as price level changes

• markets should work as freely as possible

• AD changes result in change in price level

• (demand side policies <supply side) are better in generating economic growth

Keynesian model

• sticky prices

• sticky wages

• severe recessionary gaps

• requires government intervention to stimulate demand and reduce unemployment.

• gaps can persist over long time

• increase/ decrease in AD don’t need to result in change of price level