Aggregate Supply and Demand The AS-AD model is the basic macroeconomic tool for studying output fluctuations

and the determination of the price level and the inflation rate. It is also a tool to understand why the economy deviates from a path of smooth growth overtime and to explore the consequences of government policies intended to reduce unemployment, smooth output fluctuations and maintain stable prices. Aggregate Supply Curve (AS curve) Describes the quantity of output firms are willing to supply at a given price level. It is upward sloping because firms are willing to supply more output at higher prices. Aggregate Demand Curve (AD curve) Shows the combination of the price level and level of output at which the goods and money markets are simultaneously in equilibrium. It is downward sloping because higher prices reduce the value of the money supply which reduces the demand for output. Situation: Suppose the BSP increases the money supply. What will happen to the price level and output? Will it increase the price, thus producing inflation? Or does the level of output rise? Or both? An increase in the money supply, shifts AD curve to the right. Thus an increase in the money stock causes both the level of output and the price level to rise. P AS P Po AD Yo Y Y AD

AS Curve In the short run, AS curve is horizontal (Keynesian AS curve) In the long run, AS curve is vertical (Classical AS curve)

The Classical Supply Curve

AS curve is vertical. Indicating that the same amount of goods will be supplied whatever the price level. Assuming that the labor market is in equilibrium or with full employment of the labor force. Situation: In a single market, manufacturers faced with high demand raise prices for their products and would increase their Factors of Production. The effect of these increase in prices shifts the FoP away from lower demand sectors and into this market. But, if high demand is economywide and FoP are at work, there will be no way to increase overall production, only prices. Introducing the Potential GDP Potential GDP The level of output corresponding to the full employment of the labor force. It grows as the economy accumulates resources and as technology improves making the AS curve moves to the right over time. Potential GDP changes each year but does not depend on the price level.

Keynesian AS curve This is horizontal, indicating that firms are willing supply whatever amount of goods is demanded at the existing price level. Underlying idea: there is unemployment, wherein firms can obtain as much labor as they want at the current wage. This is based on the Great Depression, wherein output increases without increasing prices, because firms are putting idle capital and labor to work. This is what we call: short-run price stickiness. Note: in the short run, price level is unaffected by current levels of GDP.

AS curve and Price adjustment The AS curve describes the price adjustment mechanism of the economy. Pt-1= Pt(1 + Y Y*) If Y is greater than Y*, prices will rise and will be higher the next period; but if Y is less than Y*, prices will fall and will be lower the next period. If Y=Y*, todays price will be equal to tomorrows price. The difference between Y-Y* is called the GDP gap or the output gap. The speed of price adjustment is controlled by the parameter . If is large, AS curve moves quickly or equivalently the counterclockwise rotation. If is small, prices adjust very slowly.\

AD curve It is related to the expansionary policies such as increases in government spending, cuts in taxes and increase in money supply (moves AD curve to the right). Consumer and investor confidence also affects AD curve. The relationship between aggregate demand, output and prices depend on the real money supply. As real money supply increases, interest rates will fall and investment rises, leading to an increase in the aggregated demand. Expansion from the goods market and money supply, moves AD curve to the right. The quantity theory of money is a simple way to hold on to the aggregate demand curve. M x V= P x Y The Keynesian AD curve Situation: there is an increase in government spending, a cut in taxes or an increase in money supply. This will shift AD curve to the right. P

P AD AD Y Y Y

AS

Firms are willing to supply any amount of output at the level of prices, there is no effect on prices.

The Classical Case Price level is not given, but rather, on the interaction between supply and demand. P P Po E E AS

AD AD

Yo

At price level Po the demand for goods has risen and spending in the economy rise to E. But firms cannot obtain the labor to produce more output, and output supply cannot respond to the increased demand. As firms try to hire more workers, they bid up wages with their cost of production, thus increasing prices for their output. The increase in the demand for goods therefore leads only to higher prices and not to higher output. The increase in prices reduces the real money stock and reduces spending. The economy moves up to AD until prices have risen enough and the real money stock has fallen enough, to reduce spending to a consistent level with full employment. At E AD, at the higher government spending will be once again equal to AS.