Macroeconomic Analysis and Policy

AD-AS Model to Study Business Cycles

Session: 12

Prof. Biswa Swarup Misra

Dean, XIMB

We address
How does the model of aggregate demand and
aggregate supply explain economic fluctuations?

Why does the Aggregate-Demand curve slope

downward?

What shifts the AD curve?

What is the slope of the Aggregate-Supply curve in
the short run?

How does the Aggregate-Supply curve look like in

the long run?

What shifts the AS curve(s)?

33

Time horizons in macroeconomics

Long run:
Prices are flexible, respond to changes in supply
or demand.

Short run:
Many prices are sticky at some predetermined
level.
The economy behaves much
differently when prices are sticky.

34

Frequency of Price Adjustment

Q:How often firms change prices in a typical year?

35

36

The Model of Aggregate Demand and

Aggregate Supply
P

The price
level

The model
determines the
eqm price level
and eqm output
(real GDP).

SRAS

P1
Aggregate
Demand
Y1

Short-Run
Aggregate
Supply
AD
Y

Real GDP, the

quantity of output
37

The Aggregate-Demand (AD) Curve

P

The AD curve
shows the
quantity of
all g&s
demanded
in the economy
at any given
price level.

P2

P1
AD
Y2

Y1

38

Why the AD Curve Slopes Downward

P

Y = C + I + G + NX

Assume G fixed
by govt policy.

P2

To understand
the slope of AD,
must determine
how a change in P
affects C, I, and NX.

P1
AD
Y2

Y1

39

The Wealth Effect (P and C )

Suppose P rises.

The dollars people hold buy fewer g&s,

so real wealth is lower.

People feel poorer.

Result: C falls.

40

The Interest-Rate Effect (P and I )

Suppose P rises.

Buying g&s requires more dollars.

To get these dollars, people sell bonds or other
assets.

This drives up interest rates.

Result: I falls.
(Recall, I depends negatively on interest rates.)

41

What Are Exchange Rates?

Exchange Rate Determination in the Short Run
$/

Supply of Yen
Exchange rate is
determined
by supply and
demand just
like any other
commodity.

$0.0085

Demand for Yen

Market for Yen

Quantity of Yen
42

The Foreign Exchange Market and Exchange

Rates
Equilibrium in the Market for Foreign Exchange

Equilibrium in
the Foreign
Exchange
Market

43

What Are Exchange Rates?

Factors that Shift the Demand Curve

1. An increase (decrease) in the demand for a

countrys exports increases (decreases) the
value of its currency.
2. The more desirable (undesirable) a country is
for foreign investment, the higher (lower) the
value of that countrys currency.
3. An increase in the demand to hold dollar
reserves boosts the value of the dollar.
Lets use the supply and demand model to
illustrate each of these
44

What Are Exchange Rates?

1a. U.S. residents order more Toyotas
$/

Supply of yen

demand for Japans

exports value of
the yen

$0.0090

Demand for yen

w/ orders of
Toyotas

$0.0085

Demand for yen

Market for Yen

Quantity of Yen
45

What Are Exchange Rates?

1b. U.S. residents order fewer Toyotas
$/

Supply of yen

demand for Japans

exports value of
the yen
Demand for yen
w/ orders of
Toyotas

$0.0085
$0.0080

Demand for yen

Market for Yen

Quantity of Yen
46

What Are Exchange Rates?

2. Mexico becomes a better investment
$/peso

Supply of pesos

The Mexican peso

in value

0.090
0.075

Demand for peso

w/ foreign
investment
Demand for pesos

Market for Pesos

Quantity of Pesos
47

The Exchange-Rate Effect (P and NX )

Suppose P rises.

Indias interest rates rise (the interest-rate effect).

Foreign investors desire more Indian bonds.
Higher demand for Rupees in foreign exchange market.
Indias exchange rate appreciates.
Indias exports more expensive to people abroad, imports
cheaper to Indian residents.
Result: NX falls.

48

The Slope of the AD Curve: Summary

An increase in P
reduces the quantity
of g&s demanded
because:

P
P2

the wealth effect

(C falls)

the interest-rate

P1
AD

effect (I falls)

the exchange-rate
effect (NX falls)

Y2

Y1

49

Why the Aggregate Demand Curve is

Downward-Sloping?

50

Why the Aggregate Demand Curve is

Downward-Sloping?

51

Why the Aggregate Demand Curve is

Downward-Sloping?

52

Shifts in the Aggregate Demand Curve

(Continued)
Factors That
Increase
Aggregate
Demand

Factors That
Decrease
Aggregate
Demand

A decrease in
taxes

An increase in
taxes

An increase in
government
spending

A decrease in
government
spending

An increase in
the money
supply

A decrease in
the money
supply

Other factors

Other factors
53

Factors That Change Aggregate Demand

54

Factors That Change Aggregate Demand

(Continued)

55

Why the AD Curve Might Shift

Any event that changes
C, I, G, or NX
except a change in P
will shift the AD curve.

Example:
P1
A stock market boom
makes households feel
wealthier, C rises,
the AD curve shifts right.

AD2
AD1

Y1

Y2

56

Why the AD Curve Might Shift

Changes in C
Stock market boom/crash
Preferences re: consumption/saving tradeoff
Tax hikes/cuts
Changes in I
Firms buy new computers, equipment, factories
Expectations, optimism/pessimism
Interest rates, monetary policy
Investment Tax Credit or other tax incentives
57

Why the AD Curve Might Shift

Changes in G
Federal spending, e.g. defense
State & local spending, e.g. roads, schools
Changes in NX
Booms/recessions in countries that buy our

exports.
Appreciation/depreciation resulting from
international speculation in foreign exchange
market

58

ACTIVE LEARNING

Exercise

1:

What happens to the AD curve in each of the

following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.

C. A fall in prices increases the real value of

consumers wealth.

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ACTIVE LEARNING

Answers

1:

A. A ten-year-old investment tax credit expires.

I falls, AD curve shifts left.

B. The U.S. exchange rate falls.

NX rises, AD curve shifts right.

C. A fall in prices increases the real value of

consumers wealth.
Move down along AD curve (wealth-effect).

60

The Aggregate-Supply (AS) Curves

The AS curve shows

the total quantity of
g&s firms produce and
sell at any given price
level.

LRAS

SRAS

AS is:

upward-sloping
in short run

vertical in

long run
61

The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of

output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or
full-employment
output.

LRAS

YN

62

Why LRAS Is Vertical

YN determined by the
economys stocks of
labor, capital, and
natural resources, and
on the level of
technology.
An increase in P

does not affect

any of these,
so it does not
affect YN.

LRAS

P2
P1

YN

63

Why the LRAS Curve Might Shift

Any event that changes
any of the
determinants of YN
will shift LRAS.

LRAS1 LRAS2

Example: Immigration
increases L,
causing YN to rise.

YN

Y
N

64

Why the LRAS Curve Might Shift

Changes in L or natural rate of unemployment

Immigration
Baby-boomers retire
Govt policies reduce natural u-rate
Changes in K or H

Investment in factories, equipment

More people get college degrees
Factories destroyed by a hurricane

65

Why the LRAS Curve Might Shift

Changes in natural resources

discovery of new mineral deposits
reduction in supply of imported oil
changing weather patterns that affect
agricultural production

Changes in technology
productivity improvements from technological
progress

66

Using AD & AS to Depict LR Growth and

Inflation
Over the long run,
tech. progress shifts
LRAS to the right
and growth in the
money supply shifts
AD to the right.
Result:
ongoing inflation
and growth in
output.

LRAS2000

LRAS1990

LRAS1980

P2000

P1990
AD2000

P1980

AD1990
AD1980

Y1980

Y1990

Y2000

67

Short Run Aggregate Supply (SRAS)

P

The SRAS curve

is upward sloping:
Over the period
of 1-2 years,
an increase in P
causes an
increase in the
quantity of g & s
supplied.

SRAS
P2
P1

Y1

Y2

68

Why the Slope of SRAS Matters

If AS is vertical,
fluctuations in AD
do not cause
fluctuations in output
or employment.
If AS slopes up,
then shifts in AD
do affect output
and employment.

LRAS

P
Phi

SRAS

Phi

ADhi

Plo
AD1

Plo

ADlo
Ylo

Y1

Yhi

69

Three Theories of SRAS

In each,

some type of market imperfection

result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.

70

1. The Sticky-Wage Theory

Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.

Due to labor contracts, social norms.

Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.

71

1. The Sticky-Wage Theory

If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.

Hence, higher P causes higher Y,

so the SRAS curve slopes upward.

72

2. The Sticky-Price Theory

Imperfection:
Many prices are sticky in the short run.
Due to menu costs, the costs of adjusting
prices.
Examples: cost of printing new menus,
the time required to change price tags.

Firms set sticky prices in advance based

on PE.

73

2. The Sticky-Price Theory

Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.

In the short run, firms without menu costs can

raise their prices immediately.

Firms with menu costs wait to raise prices.

Meantime, their prices are relatively low,
which increases demand for their products,
so they increase output and employment.

Hence, higher P is associated with higher Y,

so the SRAS curve slopes upward.
74

3. The Misperceptions Theory

Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.

If P rises above PE, a firm sees its price rise

before realizing all prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.

So, an increase in P can cause an increase in

Y,
making the SRAS curve upward-sloping.
75

What the 3 Theories Have in Common:

In all 3 theories, Y deviates from YN when
P deviates from PE.

Y = YN + a (P PE)
Output
Natural rate
of output
(long-run)

Expected
price level

a > 0,
measures
how much Y
responds to
unexpected
changes in P

Actual
price level

76

What the 3 Theories Have in Common:

Y = YN + a (P PE)
P
SRAS

When P > PE

the expected
price level

PE

When P < PE
Y

YN

Y < YN

Y > YN

SRAS and LRAS

The imperfections in these theories are
temporary. Over time,
sticky wages and prices become flexible
misperceptions are corrected

In the LR,
PE = P
AS curve is vertical

78

SRAS and LRAS

Y = YN + a (P PE)
P
In the long run,
PE = P
and
Y = Y N.

LRAS
SRAS

PE

YN

Y
79

Why the SRAS Curve Might Shift

Everything that shifts
LRAS shifts SRAS, too.

Also, PE shifts SRAS:

If PE rises,
workers & firms set
higher wages.
At each P,
production is less
profitable, Y falls,
SRAS shifts left.

LRAS
SRAS
SRAS

PE
PE

YN

Y
80

The Long-Run Equilibrium

In the long-run
equilibrium,

LRAS

SRAS

PE = P,
Y = YN ,
and unemployment
is at its natural rate.

PE

AD

YN

81

Changes in Short-Run Aggregate Supply

82

Short-Run Equilibrium

83

Changes in Short-Run Equilibrium in

the Economy

84

How a Factor Affects the Price Level, Real GDP,

and the Unemployment Rate in the Short Run

85

Supply Shocks
Supply shocks are
external events that shift
the aggregate supply
curve.

Adverse supply shocks can

cause a recession (a fall in
output) with increasing
prices. This phenomenon
is known as stagflation.

86

A Summary Exhibit of AD and SRAS

87

How to Study the Impact of

Economic Fluctuations
Caused by events that shift the AD and/or
AS curves.

Four steps to analyzing economic fluctuations:

1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR eqm to new LR eqm.
88

The Effects of a Shift in AD

Event: stock market crash
P

1. affects C, AD curve

LRAS

2. C falls, so AD shifts left

3. SR eqm at B.
P and Y lower,
unemp higher
4. Over time, PE falls,
SRAS shifts right,
until LR eqm at C.
Y and unemp back
at initial levels.

SRAS1
A

P1

P2

SRAS2

P3

AD1

C
AD2
Y2

YN

89