This outline is based on Cowen and Tabarrok (2011).
Unemployment tends to rise when we have a recession and falls once the economy has recovered.
“More generally, a recession is a time when all kinds of resources, not just labor but also capital and land, are not fully employed. During a recession, factories close, stores are boarded up, and farmland is left fallow. We know that some unemployment is a natural or normal consequence of economic growthin
Chapter 12, we called this level of unemployment the natural
1

Figure 13.1: U.S. Average Annual Real GDP Growth (Blue) and Civilian Unemployment (Red). Recessions, which we defined in Chapter 6 as significant, widespread declines in real income and employment, are shaded.
unemployment ratebut often unemployment exceeds the natural rate. More generally, when there are a lot of unemployed resources, it suggests that resources are being wasted and the
economy is operating below its potential.” Cowen and Tabarrok
(2011)
2

The AS/AD model consists of three relationships, which we will depict graphically and refer to as ‘curves.’
1. Dynamic Aggregate Demand
2. Long-Run Aggregate Supply – Solow Growth
3. Short-Run Aggregate Supply – which is caused by ‘Sticky’
Prices
13.2.1
Dynamic Aggregate Demand
Recall from the last chapter
→
M +
−
=
→
P +
→
Y
R
The arrow indicates rates of change.
This can be interpreted as
Spending growth = Inflation + Real GDP growth
Notice that spending growth (left-hand side) increases when money supply growth increases or when velocity increases. These can lead to either higher inflation or real GDP growth (righthand side).
3

The aggregate demand (AD) is all combinations of π and real GDP growth that are possible for a given rate of spending growth. So, if spending growth,
→
M +
−
= 5%, then the combinations of inflation and real GDP growth are:
Spending growth =
→
M +
−
= 5%
Inflation GDP growth
0%
1%
5%
4%
2%
3%
4%
5%
6%
7%
3%
2%
1%
0%
-1%
-2%
When plotted with inflation on the vertical and real GDP on the horizontal axes looks like this:
If spending increases (due to an increase in money growth or velocity), then AD shifts to the right as shown with the dashed red line.
4

Figure 13.2: Aggregate Demand when spending increases at the rate of 5%.
5

13.2.2
Long-run Aggregate Supply – Solow Growth
Economic growth depends on increases in the stocks of labor and capital and on increases in productivity (driven by new and better ideas and better institutions). It does not depend on inflation. So, the long-run growth rate (Solow Growth) is fixed with respect to inflation. It is drawn as a vertical line at whatever long-run real GDP growth rate resources and technology allow.
13.2.3
Shocks to Solow Growth
A shock is an unexpected (economic) event. These can be beneficial or detrimental to the economy. When shocks affect real economic activity, they shift the Solow curve to the right (a good or positive shock) or left (bad or negative shock).
• Weather (good weather improves agricultural output or tourism and bad weather makes both worse.)
• Energy shocks – bad ones include oil embargoes, or closing of Suez canal. Fracking has been a positive shock to energy production.
• Taxes (higher is bad, lower is good), regulations (can be bad–sometimes good)
6

Figure 13.3: Long-run growth does not depend on inflation. It depends on resources, technology and ideas, and society’s institutions. Here it is shown at 3%, which is close to its historical average in the U.S.
7

Figure 13.4: Shocks to Solow Growth can cause changes in growth – Real
Business Cycle.
• political stability – can improve or deteriorate.
Shocks to our long-run ability to convert resources into output cause real benefits or damage to growth. This is what some refer to as the real business cycle . It is pictured below:
8

13.2.4
Short-run AS – Sticky Wages and Prices
In the short-run, a period when wages and prices cannot adjust very quickly, increases in inflation (unanticipated) will increase real GDP.
Each SRAS curve is associated with a particular expected rate of inflation. When actual inflation exceeds expected ( π >
E ( π )), firms and individuals will produce more, increasing growth.
Once people catch on to the fact that prices have risen and are able to renegotiate wages accordingly, SRAS shifts up and returns to the Solow level, albeit at a now higher rate of inflation.
In the long run, people will always come to expect the actual inflation rate (you can’t fool people forever), and in the long run, the inflation rate is found where the Solow curve intersects the AD curve. Thus, the SRAS curve is always moving toward the point where the Solow curve intersects the new AD curve
(point c in the figure 13.5).
13.2.5
Why are wages and prices sticky?
• Wages usually change once a year. Why? Not sure, but annual evaluations are the norm and based on these and business conditions, etc. determine your raise, if any. Union
9

Figure 13.5: In the short-run, unanticipated increases in inflation increase real GDP growth. Once workers and sellers realize that prices have risen, and that a new higher level of inflation can be expected, they negotiate higher

contracts are multi-year commitments and help make wages sticky. In any event, workers are generally playing catch-up when it comes to unanticipated increases in inflation. During deflationary recessions, wages may be fixed for the time being, but workers are easy to send home when demand is slack!
• Menu Costs – these are the costs associated with changing prices. Customers don’t like frequent price changes–it complicates planning. Firms have to communicate these new prices to consumers and this can be expensive (print a new menu each time the price of an egg changes?!)
• “Prices rise like rockets and fall like feathers.” Why the SRAS is flat when AD/AS shocks are negative and steep when AD/AS shocks are positive? Well, empirically it appears to be so. Several explanations have been put forward. 1) people hate pay cuts (or in this case) reductions in the rate of pay increases. It’s demoralizing since it is easy to think that you got a crummy raise because management thinks you do crummy work. Demoralized workers produce less. 2) a lot of wage contracts already have the higher wage increased baked into the cake. Recall union contracts (which are particularly hard to negotiate) extend many years. 3) It is easier to reduce hours than wages. Reducing hours reduces supply a lot without reducing wages much.
11

13.2.6
Quantity Theory in terms of changes
M × v = P × Y
R
Total change on the left must equal changes on the right:
1
So, if velocity and real GDP aren’t changing, then
→
M + 0 =
→
P + 0
This says that Money growth leads to equivalent growth in prices. If money grows at 5%/year then so will prices.
1 The total derivative: dM × v + M × dV = dP × Y
R
+ P × dY
R
.
12

Figure 13.6: Spending growth falls and AD shifts left along the SRAS. GDP
Growth shrinks as inflation falls. Once wages start to adjust and fall, inflationary expectations fall and SRAS will shift to the right, landing at point c. This may take a while, though.
13

Figure 13.7: Spending growth falls and AD shifts left along the SRAS. GDP
Growth shrinks as inflation falls. If the decline in
− is temporary, then AD should rebound in subsequent quarters and return to point a. If not, then inflationary expectations may fall and lower wages.
14

Figure 13.8: The Great Depression was not so great for most Americans. It was downright awful.
15

Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of
Economics , 2nd edn, Worth, New York.
16