The Aggregate Demand -Aggregate Supply Model
Fundamental inflexibility
assumptions:
W -- inflexible (short-run)
-- flexible (long-run)
P -- flexible
i -- flexible.
Overriding theme -- policies affect
the price level as well as real GDP.
Properties of Aggregate
Demand (AD) Curve
Downward sloping.
Expansionary shifts in the IS or LM
curves shift the AD curve rightward
(fiscal or monetary policy).
Contractionary shifts in the IS or LM
curves shift the AD curve leftward
(fiscal or monetary policy).
Properties of the Short-Run
Aggregate Supply Curve
Upward sloping (W inflexible)
Variables that enhance production
shift the SAS curve rightward.
Variables that hinder production
shift the SAS curve leftward.
Shift variables -- SAS Curve
Nominal Wage Rate (W)
Capital Stock
Labor Productivity
Price of Energy
Properties of the Long-Run
Aggregate Supply Curve
Vertical at Y = YN.
Variables that enhance production
shift the LAS curve rightward.
Variables that hinder production
shift the LAS curve leftward.
Shift Variables -- LAS Curve
(Variables That Change YN)
Capital Stock
Labor Productivity
(output)/(labor hours)
Price of Energy
Labor Force
Household Attitudes Toward Work
Transfer Payments
Lengthening the Short-Run
(Demand Policy)
Encourage long-term, non-indexed
nominal wage contracts.
Keep inflation expectations down.
-- seek gradual policy changes
(“soft landing”)
-- verbal reassurances on inflation
Watch closely for unusual
increases in nominal wage rates.
Rational Expectations
Rational Expectations -- People
form expectations using all
available information in the most
efficient way.
Truly the “best guess.”
Errors between actual expected
variables are totally unpredictable,
and independent from the set of
available information.
Rational Expectations,
Continued
Corresponds to fundamental
assumption on human behavior,
rationality (according to the
economic definition).
Application -- efficient markets
(Finance), and predicting
movements in stock prices.
Supply Shocks
Supply Shock – large increase in
the price of energy (US: 1973,
1978, 1990, 2007).
-- shifts SAS curve leftward
 P*, Y*.
Possible Policy Responses
to Supply Shocks
Extinguishing Response (1973) –
attempts to extinguish the increased
inflation  practice contractionary
demand policy.
Validating Response (1978) – attempts
to protect output, keep the economy
out of recession  practice
expansionary demand policy.
Do nothing (2007) – best solution
Positive Supply Shifts
Shifts both SAS curve and LAS
curve rightward  P*, Y*, YN
-- decrease price of energy
-- increase labor productivity
-- increase the capital stock.
The Record of
US Labor Productivity
Steadily increasing over time
Tripled since 1960
Increased after Great Recession,
has leveled off (good sign for
hiring?)