Jim’s Notes

AD-AS Model

The AD-SRAS-LRAS model

Model to illustrate and analyze theory

Not really same as S&D (micro)

Aggregates behave differently

Risk of fallacy of composition

Total Real Output vs.Price Level

Example: plotting price index vs. real GDP

Three ‘curves’

AD

SRAS

LRAS

AD-AS Objective is to show in 1 model:

Level and changes in price index (changes represent inflation or deflation)

Level and changes in real output (changes represent growth or contraction)

How do buyers/producers respond to inflation/deflation

Capacity of the economy (and level of unemployment relative to full employment)

Economic Conditions

Inflation
Recession and Unemployment
Stagflation
Deflation and depression

Understanding the AD-AS Model:

Two axes:

vertical: price level of finished goods, generally represented as CPI or GDP Deflator index
labeled as ‘P’
horizontal: level of real output (real GDP), usually represented by real GDP or real national Income (GDI).
labeled as either ‘Q’ (real GDP) or ‘Y’ (real National Income) – it makes no difference

Economy at some starting point.

Meaning: each point represents a hypothetical combination of real ouput priced at that particular price level

When the points move (the economy experiences a change over time to another price level-output combination):

Economy Grows –> shifts right
Economy shrinks –> shifts left. (recession)
Inflation –> shift upward
Deflation –> shift downward
Real Life: both prices and real GDP change at same time
‘Stagflation’–> shift up and left
Inflationary Growth –> up and right
Recession/Depression and deflation –> shift down and left
Deflationary growth –> shift down and right (virtually impossible)

Three Curves:

One curve shows the capacity of the economy to produce real output, regardless of the price level

LRAS, also called ‘Potential GDP’ or ‘Full Employment GDP’

Two relationships (curves) show how people react to inflation/deflation:

Aggregate Demand (AD) shows willingness to spend (buy quantities of real output or services/labor)
Short-Run Aggregate Supply (SRAS).shows willingness to sell quantities of real finished goods/services (real output )

Long-Run Aggregate Supply

Shape of LRAS

vertical line at the level of real output (real GDP) that represents the capacity of the economy to produce real goods

Why?

capacity depends on real physical resources and technology available, not the price levels. (capacity in this sense is like the PPF curve in micro)

Shifts in LRAS curve

Shifts to right are increases in capacity
improved technology
discovery or acquisition of more natural resources
labor force growth or skill/education improvement
increased capital stock from previous capital accumulation (more factories, tools, etc)
Shifts to the left are decreases in capacity
destruction of capital resources or labor resources due to:
war
natural disasters
disease
failure to replenish capital stock as assets are used up
failure to replenish educated/skilled workforce as older workers die/retire

Meaning

represents an ongoing, sustainable level of production
in the very short-run, it is possible to produce at a level greater than ‘capacity’ or LRAS, but it is only temporary
LRAS represents the level of real GDP produced at full employment
therefore, any point to the left of LRAS represents some level of cyclical unemployment.

Aggregate Demand

Shape of AD:

Steeply sloped inverse relationship of Real GDP and Price Level
Inflation reduces ability/willingess to buy, so lesser quantities of real output are purchased, if they are available
Deflation increases ability/willingness to buy, so increased quantities of real output are purchased, if they are available

Why?

Wealth Effect
Fixed Income Effect
Interest Rate Effect
Int’l. Trade Effect
but these effects are relatively weak

Changes/events that Shift the whole curve to either the right (increase or stimulus) or left (reduce)

Anything that changes the fundamental decisionmaking behind C, I, G, or X-M
Household expectations about future (C)
more optimism says spend/buy more now and save less of current household income
more fear, pessimism, or uncertainty means households save more of their current income and spend less on new goods
Firm expectations about future market and economic conditions (I)
more optimism (‘this boom will last forever’) means more willingess to do more investment spending and buy more capital goods
more pessimism or expected economic decline means less willingness to do investment spending
Government changes taxes (change in T, but affects C)
a tax cut means more after-tax income available for spending, so households are likely to spend more on goods, although they may save part of the tax cut
a tax increase means less after-tax income. Households will ‘pay’ for the increased taxes by reducing both current spending on goods (C) and reducing savings (S)
Government spending (G)
an increase in government spending (G) without an offsetting increase in taxes (T) will shift total AD curve to right (increase AD)
an decrease in government spending (G) without an offsetting increase in taxes (T) will shift total AD curve to left (reduce AD)
Net Exports
events that increase exports and/or reduce imports such as change in foreign exchange rates (domestic currency gets weaker) will increase AD
events that decrease exports and/or increase imports such as change in foreign exchange rates (domestic currency gets stronger) will decrease AD

SRAS – Short-run Aggregate Supply curve

Shape of SRAS:

a positive relationship between Price Level and output
a curve that starts very flat/horizontal, but as real GDP increases, the curve begins to bend upward and eventually becomes nearly vertical

Why:

at low levels of output relative to capacity, firms can increase their output and buy more inputs profitably without raising output prices.
as the economy approaches capacity (LRAS), firms have more trouble finding additional workers to hire. Various inputs such as labor or unused factory capacity are hard to obtain. Input prices are bid up as firms compete for them. This causes firms to required higher output prices to maintain profits.

Meaning of SRAS:

SRAS represents the productivity or profitability and feasibility of producing final goods.

Changes/Shifts in SRAS:

anything that changes fundamental profitability
Input, labor or raw material price changes
lower real wage rates or lower critical resource (such as oil) prices will shift SRAS to right (increase)
higher real wage rates or lower critical resource (such as oil) prices will shift SRAS to left (decrease)
anything that changes productivity
improved technology
improved workflows, rules, or management practices
government changes have complex and unpredictable effects
regulatory changes have complex effects. In some cases, reduced regulation improves profitability and increases SRAS, while in other cases improved regulation improves productivity and increases SRAS.
lower business tax rates should, in theory, shift SRAS to right, but empirical evidence of such reactions is weak and rare

When SRAS is greater than LRAS:

It is temporarily possible for an economy to produce and supply real GDP (SRAS) at a level greater than LRAS says is possible. In other words, the economy produces in excess of capacity.
done temporarily with extra, unsustainable overtime hours by workers or with temporary workers who do not want long-term jobs.
can occur when firms misperceive (are fooled) by inflation. They see price increases in their products as indicating a real increase in demand (a micro interpretation) and respond with more production, but only later find that inflation is also raising the price of inputs, especially labor.
firms meet demand for production by reducing inventories and hoping to replace inventory later

Interpreting the AD-SRAS-LRAS model: 3 scenarios

Equilibrium is where SRAS and AD intersect

plans of firms and buyers are mutually consistent

no unplanned changes in inventory are occurring

Interpreting condition of economy

Where is present equilibrium (intersection of SRAS and AD) relative to LRAS?

Three possibilities”.

Full employment equilibrium

SRAS and AD intersect at the LRAS
Full employment exists
Economy is producing to sustainable physical capacity
No inflationary pressures exist.
THE GOAL!

Recessionary Gap (also called Contractionary gap)

SRAS and AD intersect to the left of LRAS
Economy is in recession or depression
Cyclical unemployment exists
Economy is producing less than capacity
possible deflationary pressures exist

Inflationary Gap (also called Expansionary gap)

SRAS and AD intersect to the right of LRAS
Economy is ‘overheating’. It’s grown too fast and is trying to produce more than it’s capacity.
Labor markets are very tight. Reported unemployment rates will likely be below the ‘natural’ or ‘full employment’ rate.
Significant inflationary pressures exist. Prices begin to rise and inflation takes on a momentum of it’s own.