Key Insight of the Keynesian AS/AD Model
Short-run equilibrium output may differ from long-run potential output assuming a fixed price level
•
Equilibrium output is the level of output toward which the economy
gravitates in the short run because of the cumulative cycles of declining or
increasing production
•
Potential output is the highest amount of output an economy can
sustainably produce using existing production processes and resources
Aggregate demand falls → firms decrease output and lay off people → consump on and AD
decreases further: VICIOUS DOWNWARD SPIRAL
Paradox of Thrift
In the long run, saving leads to investment and growth but in the short run, saving may lead to a
decrease in spending, output, and employment
Increases in saving → Decreases consumption → firms decrease output and lay off people →income
decreases → saving decreases
THE AGGREGATE DEMAND CURVE
AD curve shows how a change in the price level will change aggregate expenditures on all goods and
services in an economy where aggragate expenditures is the sum of consumption, investment,
government expenditures and net exports.
In the micro D/S model the shapes of the demand and supply curve is based on the concepts of
substitution and oppurtunity cost. Here the reason for downward sloping AD curve is
i)
ii)
iii)
the interest rate effect,
international effect,
money wealth effect.
Interest rate effect: the effect that a lower price level has on investment expenditures through the
effect that a change in the price level has on interest rates.
Prices level falls → purchasing power increases → saving increases → bank loans increases →
interest rates fall → investment (I) increases
International effect, as the price level falls (assuming the exchange rate does not change), net
exports (E) will rise
Money wealth effect, a fall in the price level will make the holders of money richer, so they buy more
Prices level falls → purchasing power increases → consumption (C) increases
Multiplier effect, the amplification of initial changes in expenditures
DYNAMIC PRICE LEVEL ADJUSTMENT FEEDBACK EFFECTS
Dynamic effects exist that counteract and overwhelm the standard AD shift factors
 Especially important when aggregate demand is declining
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Expectations of falling aggregate demand
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Lower asset prices (declining nominal wealth)
•
Financial panics
 These forces counteract the standard shift factors
 If strong enough, dynamic forces can cause aggregate demand to fall (shift to the left) when
the price level falls
MOVEMENT ALONG THE AD:
 If the price level goes down, economic output will move downwards along the same AD curve and
vice-versa.
 Thus a change in the price level will cause a movement along the same AD curve.
SHIFTS IN THE AD CURVE
 A shift in the AD curve means that at every price level, total expenditures have changed. Five
important shift factors are:
 Foreign income: This relates Turkey’s economic output with the income of its
trading partners in the world. When foreign income rises, Turkish exports
will increase causing aggregate demand to increase and shifts to the right.
 Exchange rates: When a country's exchange rate increases, its currency gains
value relative to other curencies, making its products more expensive
relative to competitiors’ products, then net exports will decrease and
aggregate expenditure will go down at all prices. This means that AD will
decrease and shift to the left. If exchange rate decreases AD will increase and
shift to the right.
 Distribution of income: This is directly related to wages and profits. Some
people save more than others. The wealthier people save a greater
proportion of their income than the poor do. When worker's real wages
increase, then people will have more money on their hands because their
overall income has increased. When this happens they tend to consume
more causing the consumption expenditures to increase. AD shifts to the
right. As the proportion of the income going to profit increases, total
expenditures are likely to fall , shifting the AD curve to the left.
 Expectations: Consumers tend to have certain expectations about the future
of the economy and will adjust their spending accordingly. If they would
expect the economy to not do so well in the future, saving would increase
thus decrease overall expenditures.AD curve shifts to the left. If consumers
expect the price level to rise in the near future, they might just go out and
buy that good now, increasing the consumption expenditures in AD, shifting
AD to the right.
 Monetary and fiscal policy: The government has some ability to impact AD.
They can spend money or increase taxes in order to influence how
consumers spend or save. An expansionary fiscal policy causes AD to
increase (shifts to the right), while a contractionary monetary policy causes
AD to decrease (shifts to the left).
 Deliberate shifting of the AD curve is what most policy makers mean by macro policy
MULTIPLIER EFFECTS OF SHIFT FACTORS
The aggregate demand curve may shift more than the amount of the initial shift factor
because of the multiplier effect.
Gov. increase spending → firms increase production → hires more people → income
increases → people increase consump on (C) → AD shi s further to the right → firms
increase production again → …… (con nues)
Each round the increase gets smaller until it becomes negligible. In the end AD curve will
have shifted by a multiple of the initial shift.
If for example exports increase by 100 and the multiplier is 3 then the AD curve will shift to
the right by 300. Extra 200 are due to the multiplier effect.
THE AGGRAGATE SUPPLY CURVES
We divide the supply side into long run and short run components:
THE SHORT RUN AGGREGATE SUPPLY CURVE (SAS)
•
The SAS curve is upward sloping because of:
– Auction markets
• Prices are determined by demand and supply and supply curves are upward
sloping
– Posted price markets
• Firms’ tendency to increase their markup when demand increases
The SAS curve is upward sloping because a rise in the price level with no change in costs induces
firms to increase production; and a fall in the price level with no change in costs induces firms to
decrease production.
MOVEMENT ALONG THE SAS CURVE:
A change in the price level with no change in the money wage rate results in a movement along the
SAS curve. If price level increases, it brings a movement rightwards on the SAS curve- meaning an
increase in the output, and vice versa.
SHIFTS IN THE SAS CURVE
 Shifts in the SAS are caused by changes in:
• Input prices
• Input prices: If input prices rise the SAS curve shifts up, if input prices fall SAS shifts
down.
• Productivity: An increase in productivity, by reducing the amount of inputs required
for a given amount of output, shifts the SAS curve down. A fall in productivity shifts
the SAS curve up.
• Import prices: Import prices are a shift factor because they are a component of an
economy’s price level. When import prices fall, SAS curve shifts down (and vice
versa)
• Excise and sales taxes: By raising the cost of goods, higher sales taxes shift the SAS
curve up, (and vice versa)
 When production costs increase, the SAS curve shifts up
THE LONG RUN AGGRAGATE SUPPLY CURVE
 The long-run aggregate supply (LAS) curve shows the long-run relationship between output
and the price level
 The position of the LAS curve depends on potential output which is the amount of goods and
services an economy can produce when both capital and labor are fully employed
 The LAS curve is vertical because potential output is unaffected by the price level (i.e.: If all
prices doubled, including your wage, your real income would not change.)
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•
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Potential output is assumed to be in the middle of a range bounded by high and low levels of
potential output
When resources are over-utilized (point C), factor prices may be bid up and the SAS shifts up
When resources are under-utilized (point A), factor prices may decrease and SAS shifts down
SHIFTS IN THE LAS CURVE:
Since LAS curve is determined by output, it shifts for the same reasons that potential
output shifts. Increases in the LAS are caused by increases in:
– Capital
– Resources
– Growth-compatible institutions
– Technology
– Entrepreneurship
–
EQULIBRIUM IN THE AGGREGATE ECONOMY:
SHORT-RUN EQUILIBRIUM IN THE AD/AS MODEL:
•
•
Short-run equilibrium is where the SAS and AD curves intersect and point E is short-run
equilibrium
A shift in the aggregate demand curve to the right changes equilibrium from E to F,
increasing output from Y0 to Y1 and increasing price level from P0 to P1

A shift up in the short-run aggregate supply curve changes equilibrium from E to G,
decreasing output from Y0 to Y2 and increasing price level from P0 to P2
LONG-RUN EQUILIBRIUM IN THE AD/AS MODEL:
•
•
Long-run equilibrium is where the LAS and AD curves intersect
A shift in the aggregate demand curve changes equilibrium from E to H, increasing the price
level from P0 to P1 but leaving output unchanged
INTEGRATING THE SHORT RUN AND LONG RUN FRAMEWORKS:
Initially at E economy is both in the short-run equlibrium and long run equlibrium. This is
what economists hope for –aggregate demand grows at just the same rate as potential
output. So growth and unemployment are at target rates, with no or minimal inflation.
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•
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A recessionary gap is the amount by which equilibrium output is below potential output.
At point A, some resources are unemployed and the recessionary gap is YP – Y1
Excess supply of factors of production → cost and wages go down →price level falls →SAS
shifts down until reaches back to E.
But in reality we do not see decrease in price level because economy does not stay in this
point for a long time. Instead it either picks up on its own or by expansionary government
policies and AD shifts right to eliminate the recession.
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An inflationary gap is the amount by which equilibrium output is above potential output
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At point B, resources are being used beyond their potential and the inflationary gap is Y2 – YP
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Eventually wages and prices increase and SAS shifts to return the economy to a long and
short-run equilibrium at E
AGGREGATE DEMAND POLICY
 A primary reason for government policy makers’ interest in the AS/AD model is that
monetary or fiscal policy shifts the AD curve
 Monetary policy involves the Federal Reserve Bank changing the money supply and
interest rates
 Fiscal policy is the deliberate change in either government spending or taxes to
stimulate or slow down the economy
•
If the economy is at point A, there is a recessionary gap equal to YP – Y0
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The appropriate fiscal policy is to increase government spending and/or decrease taxes
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AD shifts to the right and output returns to potential output YP and prices increase to P1
•
If the economy is point B, there is an inflationary gap Y2 – YP
•
The appropriate fiscal policy is to decrease government spending and/or increase taxes
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AD shifts to the left, output returns to potential output YP and inflation is prevented
Limitations of the AS/AD Model
LIMITATIONS OF THE AS/AD MODEL:
 The AS/AD model assumes away many possible feedback effects that can significantly affect
the macroeconomy and lead to quite different conclusions
 Implementing fiscal policy through changing taxes and government spending is a slow
legislative process
•
There is no guarantee that government will do what economists say is
necessary
 Potential output (the level of output that the economy is capable of producing without
generating inflation) is difficult to estimate
•
We do have ways to get a rough idea of where it is
 There are many other possible interrelationships in the economy that the model does not
take into account
 The aggregate economy can become dynamically unstable, so a shock can set in motion
changes that will not automatically be self-correcting
 There are two ways to think about the effectiveness of fiscal policy: in the model and in
reality
 The effectiveness of fiscal policy depends on the government’s ability to perceive and to
react appropriately to a problem
 Countercyclical fiscal policy is fiscal policy in which the government offsets any change in
aggregate expenditures that would create a business cycle
 Fine-tuning is used to describe such fiscal policy designed to keep the economy always at its
target or potential level of income