Chapter 22: AD/AS Model

Aggregate Supply:

n 2 time frames for supply: Short run Aggregate Supply (SRAS) and Long run aggregate supply (LRAS)

(a) LRAS:

n is determined by size of capital stock (K), full employment quantity of labour (L*), technology. Represents full employment GDP (Y*).

n shifts out to right if size of L* increases, capital stock increase or technology improves

n is a vertical line at Y* (see pg. 501)

(b) SRAS:

n determined by capital stock (K), full employment quantity of labour (L*), technology (ie. All of the same factors that influence LRAS) plus input prices (wages, oil prices).

n positively sloped with price index on vertical axis and real GDP on horizontal axis (see pg. 502).

n SRAS shifts to right if: wages decrease, oil prices decrease, capital stock increases, technology improves or full employment quantity of labour (L*) increases.

n if K, technology or L* change both SRAS and LRAS shift to the right by the same amount (see pg. 503)

n if wages increase, the SRAS shifts up to the left (see pg. 504). The amount of the vertical shift represents the percentage change in wages.

Aggregate Demand (AD):

n represents planned spending at a given price level by households, firms, governments and the rest of the world.

n aggregate spending depends on price level (P), expectations, fiscal policy, monetary policy and the world economy.

n AD with price level on the vertical axis and real GDP on the horizontal axis is negatively sloped because of wealth effects and substitution effects.

(a) Wealth effects: when P increases, other factors held constant, real wealth decreases and therefore spending decreases and AD will be negatively sloped

(b) Substitution effects: if Canadian prices increase (P increases) then foreign goods now relatively cheaper and so Canadian consumers substitute imports for Canadian goods (and sell less exports) so Canadian GDP decreases. Again this suggests that AD is negatively sloped.

Shifts in AD curve:

1. Expectations change: If we expect future disposable income (after tax income) to increase, then consumption expenditures will increase (C increases) and AD increases at any given price level. Therefore, the AD curve will shift to the right. Also if expected future corporate profits increase, planned investment spending (I) will increase again increasing AD which will shift outward to the right.

2. Fiscal Policy or monetary policy changes:

n fiscal policy involves changing government expenditures (G) and or taxes (T). An increase in G or a decrease in T is referred to as an “expansionary fiscal policy” and the AD curve will shift to the right.

n monetary policy consists of the Bank of Canada changing interest rates and/or money supply. If money supply increases or interest rates decrease, planned spending will increase and the AD curve will shift to the right.

3. World Economy:

n especially changes in the exchange rate and foreign GDP levels.

n if the Canadian dollar appreciates against the US dollar, then exports decrease and imports increase and real GDP decreases (i.e., the AD curve would shift to the left)

n if foreign GDP increases then foreigners can afford to buy more goods and services and therefore AD increases (shifts to the right).

Summary:

n If price index changes it is a movement along the same AD curve but

n if any other factor changes, it shifts the AD curve

Macro equilibrium:

n SR macro equilibrium is always located where AD=SRAS (this intersection point determines equilibrium P and equilibrium GDP)

n relevance of LRAS: tells us whether SR equilibrium is greater than/less than/or equal to full employment GDP (Y*).

n SR equilibrium can be >Y* by hiring temporary labour or having existing labour work overtime. But Y>Y* can not be sustained.

Adjustments to LR equilibrium (full employment equilibrium)

n if equilibrium Y < Y* it is a ‘less than full employment equilibrium’ or called a “recessionary gap. Unions are more concerned with job security and exert downward pressure on (real) wages to encourage firms to hire more labour. This will shift the SRAS out to the right (wages falling) increasing Y and decreasing P until Y=Y* (LR equilibrium)

n if equilibrium Y > Y*, it is a ‘greater than full employment equilibrium’ or an “inflationary gap”. This exerts upward pressure on wages and shifts the SRAS upwards to the left (increasing P and decreasing Y) until Y = Y* (LR equilibrium)

Characteristic of LR equilibrium:

n all three curves intersect (SRAS, LRAS, and AD). See page 509.

Answering AD/AS questions:

Procedure:

-each time you are starting from a full employment equilibrium (triple intersection) then an event happens (eg. Change in interest rates, foreign GDP etc)

Steps to follow:

1.-identify which curve shifts and in which direction (due to change in interest rates or change in foreign GDP etc)

2.- identify new SR equilibrium (where relevant AD and relevant SRAS intersect)

3.- identify the type of gap (inflationary or recessionary) and the type of pressure on wages (to increase or decrease)

4.- identify the direction of shift in SRAS due to change in wages

5.- identify new LR equilibrium (new point of triple intersection)

Example:

Suppose interest rates fall. Show the short run and long run effects. Original equilibrium P =110 and Y =1000.

Step 1: The decrease in interest rates increase Consumption expenditures and investment expenditures shifting the AD curve out to the right (see page 512).

Step 2: The new SR equilibrium is where the new AD = original SRAS. (i.e., new equilibrium is P = 115 and Y = 1050)

Step 3: since equilibrium Y (105) is > Y* (1000), we have an inflationary gap which exerts upward pressure on wages

Step 4: the increase in wages shifts the SRAS up to the left (increasing P and decreasing Y) over time until Y = Y* again.

Step 5: New long run equilibrium is where new AD=new SRAS= LRAS (P= 125 and Y=Y*=1000.

Note: an example of the effects of an initial shift in SRAS (due to oil prices) is shown on page 513.