Chapter 24

Chapter 24: The AD/AS Model

1. Motivation

  • Defined key macroeconomic concepts: real GDP, unemployment, inflation.

  • Focus on understanding the variation of these variables over time.

  • Importance of macroeconomic understanding:

    • General public: influences personal decisions like housing or job searching.

    • Unions: affects wage increase expectations.

    • Firms: impacts investment decisions.

    • Government officials: guides policy-making regarding unemployment.

    • Foreign countries: influences foreign aid contributions.

2. Interconnectedness of Macroeconomic Variables

  • Macroeconomic variables are interdependent.

    • Negative real GDP growth correlates with spikes in unemployment.

    • Inflation typically decreases when unemployment rises.

3. Purpose of the Chapter

  • Construct a model to analyze how different events impact GDP growth, inflation, and unemployment.

  • Models simplify reality to study relationships between variables.

    • They reduce the real-world consequences of testing policies directly.

2. Long-Run Aggregate Supply (LRAS)

Definition

  • Aggregate Supply: relationship between the quantity of real GDP supplied and price levels across the economy.

  • Key inputs in the production process include:

    • Labour (cost is real wages)

    • Physical capital and technology (change infrequently).

Wage Dynamics

  • Nominal wages are often sticky (fixed in the short-run).

    • Example: minimum wage set annually; union contracts specify wage changes.

  • Long-run flexibility: nominal wages adjust one-for-one with price level changes.

  • Real wages remain constant in the long-run, resulting in no change in employment level and potential real GDP.

LRAS Characteristics

  • LRAS is vertical at potential real GDP (Y).

  • Increases in available labour, physical capital, or technology shift the LRAS curve to the right.

3. Short-Run Aggregate Supply (SRAS)

Definition

  • The SRAS curve represents the relationship between real GDP and price level when nominal wages are constant.

Wage Effects

  • Rise in price level leads to a fall in real wages (W/P), increasing demand for labour.

  • SRAS slopes upwards; as price increases, output (Y) also increases.

    • A boom occurs when output exceeds potential real GDP.

Shifting Factors of SRAS

  1. Potential Output Changes:

    • Increases in labour force, capital stock, or technology shift SRAS and LRAS to the right.

  2. Nominal Wage Changes:

    • If nominal wages rise, with a constant price level, SRAS shifts to the left leading to higher unemployment and lower actual output.

4. Aggregate Demand (AD)

Definition

  • AD = Consumption (C) + Investment (I) + Government Spending (G) + Net Exports (X - IM).

Factors Influencing AD

  • Price level, future expectations, government policy, world economy.

  • Price level increase typically results in decreased real GDP demanded.

Shifting Variables of AD

  1. Expectations:

    • Consumer and business confidence can increase current consumption/investments.

  2. Government Policy:

    • Fiscal Policy (spending/tax changes) and Monetary Policy (money supply adjustments affecting interest rates).

  3. World Economic Conditions:

    • Changes in foreign economic performance (e.g., increased U.S. GDP) increase demand for exports.

5. Combining AS & AD

Short-Run Equilibrium

  • Short-run equilibrium occurs where GDP demand equals supply.

    • Excess supply or demand leads to adjustments in production and prices until equilibrium is restored.

Long-Run Equilibrium

  • Achieved when actual GDP equals potential GDP where LRAS, SRAS, and AD intersect.

    • This equilibrium determines real wage adjustments.

6. Explaining Movements in Real GDP Growth, Unemployment & Inflation

Long-Run Dynamics

  • Increases in the labour supply or physical capital stock shift LRAS right, indicating economic growth.

  • Economic growth formula:

    • Economic Growth (%) = ((Y1 - Y0) / Y0) x 100.

  • Shifts in AD can lead to inflationary pressures in the long run.

Short-Run Example of Government Influence

  • Government stimuli can create fluctuations in GDP, leading to different economic conditions each year.

    • Yearly fluctuations in real GDP around long-run GDP potential.

Response to External Shocks

  1. AD Shocks:

    • An increase in foreign demand leads to AD increases. Prices rise, but eventually, real GDP returns to potential GDP with higher prices.

  2. AS Shocks:

    • Rising production costs (like materials) lead to reduced GDP and increased prices, a situation known as stagflation.

Dealing with Stagflation

  • Policy responses solve one issue at a time; increasing AD can rectify output but raises prices, while reducing AD can decrease inflation but worsens recession.

  • Stagflation examples from historical events illustrate the complexities of managing interconnected economic variables.