Macroeconomics: The AD-AS Model

• Aggregate demand-aggregate supply model helps in understanding the economy.

Macroeconomics

• Involves two study paths: Long-run growth/development and short-run fluctuations/business cycles.
• Long-run growth and development concentrates on theories and policies affecting economies over decades.
• Short-run fluctuations or business cycles concentrates on time horizons of five years or less.

AD & AS Model

• The AD & AS Model is a tool used to study business cycles.
• It builds on the demand and supply model.
• It takes into account demand and supply for all final goods in an economy.
• Aggregate equals total.

Aggregate Demand

• Aggregate demand refers to the total demand for final goods and services in an economy.
• Aggregate demand is equal to the sum of spending in the economy.
• AD = C + I + G + NX

Aggregate Demand Components

• Consumption is C
• Investment is I
• Government spending is G
• Net exports is NX
• There is an inverse relationship between Aggregate Demand and price
• Inflation is related to lower Aggregate Demand.
• Deflation is related to higher Aggregate Demand.

Slope of AD Curve

• There are three reasons why the quantity of AD & the price level are negatively related.
• Those three reasons are: The wealth effect, the interest rate effect, and the international trade effect.

Wealth Effect

• Wealth effect is a change in the quantity of AD because of wealth changes from price-level changes.
• Wealth is the net value of one's accumulated assets.

Interest Rate Effect

• Interest rate effect occurs when a price level change leads to an interest rate change and thus a change in AD quantity.
• This happens through the loanable funds market.
• Changes in the price level impact saving, directly impacting the supply of loanable funds.
• Example: If price levels increases, saving decreases, interest rates increase, and investment decreases.

International Trade Effect

• International trade effect happens when a price level change leads to a change in the quantity of net exports demanded
• International trade effect change exists due to changes in relative price levels.
• If Japanese goods are cheaper relative to Australian goods, more people will demand Japanese goods.

Shift Factors in Aggregate Demand

• When people's demand for goods and services at all price levels changes, AD will shift.
• Consumption, investment, government spending and net exports are the main categories.
• If real wealth increases, the AD increase and if it decreases the AD decreases.
• If expected future income increases, the AD increases and if it decreases the AD decreases.
• If taxes increase the AD decreases, and if taxes decrease, the AD increases.
• If business firm confidence increases the AD increases and if it decreases the AD decreases.
• If interest rates increases, the AD decreases, and if interest rates decrease, the AD increases.
• If quantity of money increases the AD increases and if quantity of money decreases the AD decreases.
• If federal/state/local government spending inceases the AD increases and if government spending decreases, the AD decreases.
• If foreign income increases the AD increases and if it decreases the AD decreases.

Movement Along AD Curve

• Movement Start is with a change in the price level
• Affect the quantity of AD through the wealth effect, interest rate effect, and international trade effects

Shifts in the AD Curve

• Shift occurs when something other than the price level changes.
• Shifts can happen wealth, businesses confidence, or value of the dollar

Function of a Firm

• Inputs are labor, capital, and raw materials.
• Output are goods and services
• Output prices are set by firm or market

Aggregate Supply

• How price level changes impact the firm's supply decisions depends on context.
• Economists use two different time horizons to determine supply decisions.
• 1. Long-run
• 2. Short-run

Long-Run AS (LRAS)

• Long run is a period of time sufficient for all prices to adjust.
• The level of output produced when an economy is at the natural rate of unemployment.
• It depends on an economy's resources, technology, and institutional structures.
• LRAS is not affected by changes in price.
• An economy's ability to produce is the same regardless of how much paper money is present.
• LRAS changes when a nation's ability to produce output changes.
• This happens with changes in: resources, technology, and institutions

Short-Run Aggregate Supply

• Short run is the period of time in which some prices have not yet adjusted.
• There are three reasons why there is a positive relationship between the price level and the quantity of aggregate supply
• Sticky input prices
• Menu costs
• Money illusion

Sticky Input Prices

• Resource (input) prices tend to be sticky.
• Prices are not based on what is produced.
• Output prices can be changed easier and more flexible.
• Not all prices adjust at the same rate.
• When the aggregate price level is increasing but input prices are fixed for the period, higher output price increases profit potential for the firm.
• Firm responds by producing more output because costs are not changing.

Menu Costs

• Menu costs: the costs of changing prices.
• Firms do not adjust their output price when the price level changes because of this expense.
• Buying from the firm is now relatively cheaper with more consumers buying more.

Money Illusion

• Money illusion happens when people interpret nominal changes in wages or prices as real changes.
• If there is deflation, workers are reluctant to accept pay decreases, even if the pay decrease is nominal.
• Firms will reduce output in response to decreases in the price level rather than cut wages.

Shifts in Short-Run Aggregate Supply

• When the long-run AS curve shifts, it takes the short-run AS curve with it.
• Factors that shift solely the short-run AS curve are:
  • changes in resource prices
  • changes in expectations of prices
  • supply shocks, with these being surprise events that change a firm's production costs.

Using the AD and AS Model

• To determine how the economy moves from one long-run equilibrium to another:
• 1. Begin with the model in long-run equilibrium.
• 2. Determine which curve(s) are affected by the change(s) and the direction(s) of the change(s).
• 3. Shift the curve(s) in the appropriate direction(s).
• 4. Determine the new short-run and/or long-run equilibrium points.
• 5. Compare the new equilibrium(s) with the starting point.

Long-Run Equilibrium

• Long-run equilibrium is reached when the quantity of AD is equal to the quantity of AS in the short run and long run.
• Delimited as "A."
• The economy is at full employment.
• The unemployment rate is equal to the natural rate.

Shifts in the Long-Run AS

• When a Technology shock happens, it affects the supply curve Both LRAS and SRAS curves shift
  • To the right
  • Shifts include a increase to output, employment stays the same and price levels go down

Shift in the Short-Run AS

• SRAS shifts due to a negative supply shock.
• Example: Oil pipeline leak
• The Short run curve shifts
  • To the left
  • Shifts include A decrease in output, unemployment increases, and price level increases

Shift in Aggregate Demand

• AD shifts due to an expansion
• Example: An increase to consumer confidence
  • AD shifts
  • To the right
    • With shifts including output increasing, unemployment goes down and price level increases