AD-AS Model and Economic Fluctuations

Economic Fluctuations and the AD-AS Model

  • Introduction to short-run macroeconomic phenomena.
  • The Aggregate Demand and Aggregate Supply (AD-AS) model's role in describing short-term economic fluctuations.

Overview of Topics

  • Nature of economic fluctuations and stylized facts.
  • Explanation of short-term fluctuations using the AD-AS model.
  • Aggregate demand curve: slope and shifting factors.
  • Aggregate supply curve: upward sloping in the short run, vertical in the long run, and shifting factors.

Real GDP and Economic Performance

  • Analysis of the Philippine economy's real GDP since World War II.
  • Steady economic growth since 1946, averaging 5.1%.

Recessions

  • Recessions are periods of economic decline with falling real income and rising unemployment.
  • Examples of recessions in the Philippines:
    • Mid-1980s: Political crisis during Marcos Sr. presidency.
    • Early 1990s: Power crisis with 8-12 hours of daily blackouts.
    • Late 1990s: Asian financial crisis.
    • Early 2020s: COVID-19 pandemic (considered a depression by some).

Stylized Facts of Economic Fluctuations

  • Economic fluctuations are irregular and unpredictable.
    • No discernible patterns.
    • Economic downturns are hard to anticipate.
  • Short-term economic fluctuations are also known as business cycles.

Macroeconomic Quantities Fluctuate Together

  • During recessions, real GDP and investments tend to move in sync.
  • When real GDP falls, investments also fall.
  • Macroeconomic variables tend to decline during economic downturns.

Unemployment Rises During Economic Downturns

  • When the economy fails, unemployment rises.
  • Example: During the COVID-19 pandemic, the unemployment rate more than doubled.

Aggregate Demand and Aggregate Supply Model

  • Useful model to study economic fluctuations.
  • Distinguishes itself from the classical economics perspective, which is primarily focused on the long run.
  • Classical dichotomy: real variables are separated from nominal variables.
  • In the short run, changes in nominal variables affect real variables.

Breakdown of the Classical Dichotomy in the Short Run

  • The AD-AS model highlights the breakdown of the classical dichotomy.
  • Movements in price affect aggregate demand and aggregate supply quantities.

Components of the AD-AS Model

  • The AD-AS model looks like the basic supply and demand model.
  • The basic supply and demand model determines the equilibrium price and the quantity of a particular good.
  • The model of aggregate demand and aggregate supply determines equilibrium price level and real GDP of everything in the economy.

Aggregate Demand Curve

  • Shows the quantity of goods and services demanded in the economy at any given price level.
  • The AD curve is different from the standard demand curve.
  • Standard demand curve is downward sloping because of the income and substitution effect.

GDP Identity and the Slope of AD

  • Recall the GDP identity: Y = C + I + G + NX where:
    • Y = real GDP,
    • C = private consumption,
    • I = investments,
    • G = government spending,
    • NX = net exports (exports minus imports).
  • Assume government spending (G) is fixed or exogenous.
  • Determine how the price level (P) affects consumption (C), investment (I), and net exports (NX).

The Wealth Effect

  • Suppose the price level (P) rises.
  • The value of money decreases, and people feel poorer.
  • Real wealth is lower, and consumption spending falls.
  • When the price level (P) increases, private consumption falls.
  • When the price level falls, consumption spending increases.

The Interest Rate Effect

  • Suppose the price level rises.
  • Buying goods and services requires more pesos.
  • People take out loans or sell assets.
  • Interest rates increase, making it more expensive for firms to borrow money.
  • Investment spending falls.

The Exchange Rate Effect

  • Suppose the price level rises.
  • Interest rates rise.
  • Foreign investors want more Philippine bonds or assets.
  • The demand for pesos increases, and the price of pesos increases.
  • The peso exchange rate appreciates.
  • Imports become cheaper, and Philippine exports become more expensive.
  • Net exports fall.

Summary of AD Curve Slope

  • At price level P1, real income is at Y1.
  • When the price level increases to P2:
    • Consumption falls due to the wealth effect.
    • Investment falls due to the interest rate effect.
    • Net exports fall due to the exchange rate effect.
    • Real GDP falls to Y2.

Factors That Shift the Aggregate Demand Curve

  • Any event that changes either consumption, investment, government spending, or net exports (except for a change in price) will shift the AD curve.
  • A favorable change will increase aggregate demand and shift the AD curve to the right.
  • An unfavorable change will decrease AD and shift the demand curve to the left.

Factors That Change Consumption

  • Optimism or pessimism.
  • Stock market crash or boom.
  • Preference for saving rather than spending.
  • Government influence, e.g., tax hike or tax cut.

Factors That Change Investments

  • Firms investing in technology.
  • Expectations (optimism or pessimism).
  • Government monetary policy.
  • Tax incentives to firms.

Factors That Change Government Spending

  • Increases or decreases in national government spending.
  • Boosting local government spending.

Factors That Change Net Exports

  • Economic activity or recession in countries that the Philippines exports to.
  • Appreciation and depreciation of currencies.

Aggregate Supply Curve

  • Shows the total quantity of goods and services that firms produce and sell at any given price.
  • The slope of the aggregate supply curve depends on the time horizon.
    • In the short run, the aggregate supply curve is upward sloping (SRAS).
    • In the long run, the aggregate supply is vertical (LRAS).

Long-Run Aggregate Supply Curve

  • Over a long period, the aggregate supply curve is vertical at the natural rate of output (YN).
  • The natural rate of output is the output when the economy is at the natural rate of unemployment.
  • YN is also called potential output or full employment output.
  • Full employment means unemployment is at the natural rate, not zero.

Factors That Shift the Long-Run Aggregate Supply Curve

  • Changes in the determinants of the natural level of output.
  • A good change will increase the long-run aggregate supply curve and shift it to the right.
  • A bad change will decrease the long-run aggregate supply curve and shift it to the left.

Factors Affecting the Natural Level of Output

  • Change in labor endowment or the natural rate of unemployment.
  • Immigration can increase the population.
  • Demographic changes.
  • Government policy.
  • Changes in physical or human capital.
  • Endowments of natural resources.
  • Changes in technology.

Long-Run Trajectories of Growth and Inflation

  • Over the very long run, technological progress increases the natural level of output.
  • The long-run aggregate supply curve shifts to the right because of technological progress.
  • Money supply growth needs to accommodate this.
  • In the long run, money supply is increasing because it needs to accommodate a growing economy.
  • Because the money supply increases, aggregate demand increases, shifting the curve to the right.

Short-Run Aggregate Supply Curve

  • In contrast with the long-run aggregate supply curve, which is vertical, the short-run aggregate supply curve is upward sloping.
  • In the short run, changes in the price level will change the quantity supplied of goods and services in the economy.
  • Movements in prices will affect movements in real variables.

Slope of the Short-Run Aggregate Supply Curve

  • If the aggregate supply curve were vertical, then any fluctuations in aggregate demand will only translate to price movement.
  • If the aggregate supply curve is upward sloping, fluctuations in aggregate demand will change output.

Theories of Upward Sloping Short-Run Aggregate Supply Curve

  • Sticky Wage Theory
    • Nominal wages are slow to change.
    • Contracts are based on expected price levels.
    • Higher prices increase revenue, but wages are stuck.
    • Firms hire more and produce more.
  • Sticky Price Theory
    • Output prices are slow to change because changing prices involve costs, which are called menu costs.
    • Firms set prices based on their expected price level.
    • Firms with menu costs wait to increase prices, leading to increased demand and output.
  • Misperceptions Theory
    • Firms confuse overall price level increases with changes in the relative price of their products.
    • They increase output and employment.

The Equation of the Aggregate Supply

  • Y = Y_N + A(P - P^e)
    • Where:
      • Y is current output
      • Y_N is the long-run natural rate of output
      • P is the actual price level
      • P^e is the expected price level
      • A measures the responsiveness of the economy to deviations of actual price level from the expected price level

Expectations and the Long Run

  • In the short run, people may be fooled about the price level or locked into wages or prices.
  • In the long run, expectations catch up to reality.
  • Price will be equal to the expected price level, and output Y will be equal to the natural rate of output.

Shifts in the Short-Run Aggregate Supply Curve

  • Everything that will shift the long-run aggregate supply curve will also shift the short-run aggregate supply curve.
  • Labor endowments, human or physical capital, natural resources, technology.
  • Price expectations as a short-run aggregate supply curve shifter.

Analyzing Economic Fluctuations

  • Four steps to analyze economic fluctuations:
    • Determine whether an event shifts the aggregate demand or aggregate supply curve.
    • Determine whether those curves shift to the left or shift to the right.
    • Determine how the shift changes equilibrium output and price level in the short run.
    • See the dynamics as it transitions from the short-run equilibrium to the new long-run equilibrium.

Example: A Stock Market Crash

  • Reduces consumer wealth, depressing spending.
  • The aggregate demand curve shifts to the left.
  • New short-run equilibrium at point B.
  • Prices are lower than the initial equilibrium point at point A.
  • Over time, the expected price will fall, and wages will fall.
  • The short-run aggregate supply curve moves rightwards.
  • The economy self-corrects, and output eventually goes back to its natural level.
  • Fiscal or monetary policy could be used for government intervention.

Example: An Oil Price Increase

  • Due to war or adverse event.
  • Input prices increase, increasing the short-run cost of the firms.
  • The short-run aggregate supply curve will shift to the left.
  • New equilibrium point: lower level of output and increased price level.
  • This is called stagflation.

Dynamics of Increasing Oil Prices

  • In the short run, the new short-run equilibrium will be at point B.
  • Transition from the short run to the long run:
    • Option 1: Government does nothing.
      • People's expectations of prices will change.
      • Workers will bargain for higher wages in the future.
      • Wages will fall, spurring some firms to hire more workers.
    • Option 2: Government is more proactive.
      • Governments can spend or do what's called pump-priming the economy.
      • Government increases its spending. The aggregate demand curve shifts to the right.
      • Highlights the short-term tradeoff between inflation and unemployment.