Supply and Demand graphs- The Basics
Price
Supply
Pe
Demand
Qe
Q
The purpose of this graph is to look at markets.
Free Market Price and Quantity
The Aggregate Market- The Basics
Long Run Aggregate Supply (LRAS)
Aggregate- all together (total)
Price Level
Aggregate Supply (AS)
Measure
of
Inflation
The purpose of this graph is to look at countries.
Total supply and demand at full employment
Pe
Aggregate Demand (AD)
Qe
G.D.P real
Qy
employment
Qy= Quantity at full employment
The law of demand is the same.
There is an inverse relationship- PL up, AD down, PL down AD up
The law of supply is the same
There is a direct relationship- PL up, AS up, PL down AS down
AD= Aggregate Demand
AD= GDP= C + I G + NX
You may find it amazing how a fairly simple
graph can be interpreted in so many different
ways.
Learning the basics of the graph will provide you
an opportunity to learn fiscal and monetary
policy in different ways.
Conflicting Views
Classical Views
F.A. Hayek
Less Government
Equilibrium of market
Neo-Classical
Austrian
Increase consumer or
Monetarist
Investments
Supply-siders
1. Prices and Wages are flexible – markets quickly and
efficiently achieve equilibrium. When applied to the
resource market full employment is maintainedunemployment is not a long term problem
2. Say’s Law- supply creates it own demand- aggregate
product of goods and service produces enough income to
exactly purchase all output
3.
Savings-investment equality-any decrease in output
because of savings is offset an increase in the demand
for investment
Keynesian Views
John M. Keynes
Keynesians
Neo-Keynesians
Demand-siders
More Government
Micro not Macro
Increase Gov’t
spending
Fiscal Policy
1. Prices and Wages are Sticky- Prices and wages respond
slowly to changes in supply and demand and this results in
shortages and surplus- especially with labor.
2. Increase Aggregate Demand to increase GDP- is
influenced by a host of economic decisions both public and
private.
3. “In the Long Run we are all dead”- care more about
Short run and not so much about the long run. Changes in
AD have greater short run effect on real GDP and
employment but not as much on price. What is true in the
short run isn’t always true in the long run
This creates a different market – the money market
Investment is demand
Savings is Supply
Interest rates create equilibrium- Monetarist
4. The multiplier- increases in spending will increase
consumption and increase output- which will lead to more
spending
5. Steer the Market- advocated stabilization policies such
as tax, government spending, laws, and regulation in order
to defend against the sudden and unpredictable changes in
the business cycle
AS/AD/LRAS graphs- Classical vs Keynesian models
Labor Market
Wages
(AS)
We
W1
(AD) 1
Q2 Q1
Q
(AD)
Employment
Classical (Monetarist)- believe that when demand for employment decreases- wages will fall and the market will clear
(return to equilibrium). Some people will choose not to work but most will eventually lower their wages.
Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at
the same wage. This creates a surplus of supply of workers which will remain until demand increases.
Quantity demanded is less than the quantity supplied.
Aggregate Supply (The classical model)
The whole purpose of these graphs is to find
the Price level, GDP, and unemployment
(AS) much like the LRAS
P.L.
AS is vertical and at the same point of full
employment
Classical economist believe that resources
prices and wages are flexible
This model says that the government
doesn’t need to get involved because the
market will fix itself.
Pe
What will happen to price as AD falls?
P1
(AD) 1
Qy
(AD)
G.D.P real
The classical model suggest that the
economy fixes itself and that prices and
resources price will fall to create a new
equilibrium.
When Aggregate demand falls what
happens to. . .
Price?
Employment?
Wage (remember wages are price)?
GDP real?
Aggregate Supply (The classical model)
If there is a decrease in AD
There will be a reduction in price
level and higher unemployment
LRAS
P.L.
SRAS
SRAS 1
Pe
P1
This will give you a new quantity
demanded back at full
employment
(AD) 1
Q1
Qy
Q2
(AD)
G.D.P real
Whether or not the market will clear will also depend on the worker’s
wage expectations.
Rational Expectations
According to classical economist
the SRAS will eventually increase
as wages decrease and the price of
resources decrease
Adapted Expectations
This will occur as long as wages
can adjust. What can keep wages
artificially elevated? Or in other
words what can keep the market
from clearing?
Unions
Min. Wage laws
Workers will revise their
expectations instantaneously
It may take workers weeks,
months, or years but eventually
they will adapt their wage
expectations.
Unemployment benefits
Aggregate Supply (The Keynesian Model)
LRAS
P.L.
Pe
(AD) 1
Y1
(AD)
Qy
full
G.D.P real
According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t
change and output will remain low.
When output is below full employment, the price level doesn’t fall because wages/resource prices don’t
fall (wages are sticky)
Aggregate Supply (The Keynesian Model)
LRAS
P.L.
Pe
(AD) 5
(AD) 3 (AD) 4
(AD) 1
(AD) 2
Y1
Qy
full
G.D.P real
According to Keynes, only with the help of the help of the government can Aggregate demand increase.
Demand side economics- focus on demand
Fiscal approach- government spending and taxation
Monetarist approach is to increase investments
Any aid past Qy- is purely inflationary
Aggregate Supply – So what Model is correct?
They Both have some
valid points
LRAS
P.L.
Classical
Phase
When in the Classical Phase
The economy is operating at full employment
Pe
Any and all increase in AD will result in an
increase in price and in increase in inflation
Intermediate
Phase
Keynesian
Phase
AD
AD
AD
Qy
full
G.D.P real
When in the Keynesian Phase
When in the Intermediate Phase
Output can increase with no change in price.
No increase in price level, no inflationary
pressure, spare room to grow.
As AD approaches the curve
An increase in AD and decrease in
unemployment
Result in a gradual increase of price and
some inflationary pressure
AS/AD/LRAS graphs- how it works during Expansion
(LRAS)
P.L.
P2
Both Prices and GDP will increase.
(AS)
C
P1
Pe
If Aggregate Demand increases
(AS) 1
In the long run – an increase in price will
not lead to an increase in output.
B
Why?
A
(AD) 1
Because as prices increase so does the price
of resources including labor, wages, and
materials.
(AD)
Qe
Qy
Q1
G.D.P real
As a result the Aggregate supply will shift to
the left (decrease) and we will find
ourselves back at full employment.
AS/AD/LRAS graphs- how it works during Recession
If Aggregate Demand decreases.
(LRAS)
P.L.
(AS)
Both Price Level and output will decrease.
(AS 1)
P1
Why?
A
Pe
B
Because as prices decrease so does the
price of resources including labor, wages,
and materials.
C
P2
(AD) 1
Q1
Qe
Qy
In the long-run a decrease in price will not
lead to a decrease in output.
(AD)
G.D.P real
As a result the Aggregate supply will shift to
the right (increase) and we will find
ourselves back at full employment.
Inflationary and Recessionary Gaps- Steering the Market
Economic
Activity
Potential
GDP
Inflationary Gap
Recessionary Gap
Time (years)
The Government can steer the economy in different ways
1. Laws and Regulations- stabilizers
2. Fiscal Policy- changes in government spending or taxation to influence the economy
3. Monetary policy- changes in monetary supply to influence the economy
AS/AD/LRAS graphs- Inflationary Gap
Price
Level
Actual GDP > Potential GDP
Output is beyond full
employment
LRAS
AS
Unemployment very low
Prices very high
P1
Government wants to limit
inflation by reducing demand
P2
How do they do it?
AD 2
Qy
FE
Fiscal Policy:
Q1
AD 1
GDP real
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can decrease money supply or increase interest rates.
AD = C + I + G + NE
AS/AD/LRAS graphs- Recessionary Gap
Price
Level
Actual GDP < Potential GDP
Output is below full employment
LRAS
High unemployment
AS
Government wants to limit
unemployment by increasing
demand
P2
P1
How do they do it?
AD 2
AD 1
Q1
Fiscal Policy:
Qy
FE
GDP real
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can increase money supply or decrease interest rates.
AD = C + I + G + NE
Supply-side theory in AS/AD/LRAS
LRAS 1
v
v
LRAS 2
LRAS 3
v
Supply side economics
1. Supports any action by the government that enables business to lower cost, boost efficiency, and
competitiveness.
2. This increases potential output
3. There are a number of methods
a. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment
benefits
b. Invest in education
c. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)
d. Lower corporate tax rates
e. Invest in infrastructure
4. Eliminate safety nets and allow for profit and loss
http://econstories.tv/
http://www.econedlink.org/lessons/index.php?lid=593&type=educator
Phillips Curve and problems with curve