Aggregate Demand and Aggregate Supply

AD

 Y-axis pricelevel, X-axis real gdp

 AD includes C I G NX
 AD curve is downward sloping
o Wealth effect, real individual wealth falls, C falls
o Interest rate effect, p goes up, demand for money goes up, interest rate goes up, as a
result cost of borrowing goes up, C falls, I also falls
o International trade effect, p goes up, exports go up, imports go up, NX falls
 Determinants of AD
o Changes in C
 Consumer confidence
 Interest rates without change in price levels
 Wealth without change in price level
 Personal income taxes
 Household indebtedness
o Changes in I
 Business confidence
 Interest rates
 Technology
 Business taxes
 Corporate indebtedness
 Legal and institutional environment
o Changes in G
 Political/economic priorities
o Changes in NX
 Changes in national income abroad
 Changes in exchange rates
 Trade protection
o

Short Run AS and AD-AS

 SR: All resource prices inflexible, LR: All prices flexible

 Wage Rigidity:
o Contracts, Min Wage, unions, negative morale effects
 SRAS upward sloping: price up, more profit due to inflexible resource prices. Like usual supply
 Shifts in SRAS
o Change in wages and non-labour resource prices
o Business taxes
o Subsidies
 o Supply shocks such as war, disaster, weather, etc.
 SR equilibirium of AD-AS model, intersection of AD and AS
 3 positions:
o Recessionary gap (eq less than potential) lack in aggregate demand
o Inflationary gap (eq more than potential) excess aggregate demand
o Full employment
 Changes in SRAS and AD are causes of business cycles

LR AS and LR equilibrium for Monetarist New Classical

 When all prices are flexible, LRAS is vertical at potential gdp. Why? Resource prices adjust with
output prices. Recessionary and inflationary gaps caused by AD shocks will be eliminated
through shifts in the SRAS curves via wage flexibility in LR.
 Monetarist view of AD shocks is that it only has nominal effects on price level and no real effects
on output in the long run

AS in the Keynesian model

 Intuition: Economies can be stuck in SR equilibrium for long periods of time

 Wage AND both price DOWNWARD inflexibility
 Cannot move into LR, thus AS looks like rational function -1/x , very flat at gdp levels below
potential and steep above potential.
 AD in Keynesian model is the same
 3 equilibirum states of the economy in Keynesian model: Recessionary, inflationary and full
employment
 The flat portion of AS curve indicates recessions can be severe and with wage and price
downward inflexibility, recessions can be long in duration with the economy unable to
automatically go back into LR equilibrium of full employment.
 Price level effect of AD shifts depends on sections of AS curve

AS shifts over LR

 Increase in quantity of FoP

 Improvement of quality of FoP
 Improvement in technology
 Increases in efficiency
 Institutional changes
 Reducing the natural rate of unemployment
 Aforementioned are long term growth factors which directly shift LRAS
 Short-term fluctuations of SRAS do NOT shift potential output
 Keynesian model is ignorant of supply shifts
 SR and LR AS relationship in monetarist model
o Shift in LRAS must eventually shift SRAS
 o Temporary causes of SRAS shifts do not shift LRAS
o Shifts in AD may also shift LRAS and eventually SRAS

Keynesian Multiplier

 Multiplier = change in real gdp/ initial change in C I G or NX

 1/1-MPC
 MPC + MPS +MPT + MPM = 1 because they leakages and non-leakages must sum to 1
 If price level is constant, full multiplier effect; rising mitigated effect