4. Price Setting in AD-As Framework

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    Dr. U.B. Raju

    *Compiled from different published sources

    *Strictly for academic purpose and for restricted private circulation

    4. Price setting in AD-AS Framework

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    Factors That ShiftAggregate Demand

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    Shifts in Aggregate Demand Theaggregate demand(AD) curve indicates

    the quantity of goods and services that willbe demanded at alternative price levels.

    An increase inaggregate demand(a shiftof theAD curve to the right) indicates that

    decision makers will purchase a largerquantity of goods and services at eachdifferent price level.

    A decrease inaggregate demand(a shiftof theAD curve to the left) indicates thatdecision makers will purchase a smallerquantity of goods and services at eachdifferent price level.

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    Factors that Shift Aggregate Demand

    The following factors will cause a shift in

    aggregate demandoutward (inward): an increase (decrease) in real wealth

    a decrease (increase) in the real interest rate

    an increase in the optimism (pessimism)

    of businesses and consumers about futureeconomic conditions

    an increase (decline) in the expected rateof inflation

    higher (lower) real incomes abroad a reduction (increase) in the exchange rate

    value of the nations currency

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    Shifts in Aggregate Demand

    Goods & Services(real GDP)

    PriceLevel

    AD0

    AD1

    AD2

    An increase in real wealth, such as would result from astock market boom, would increaseaggregate demand,shifting the entire curve to the right (fromAD0 toAD1).

    In contrast, a reduction in real wealth decreases

    aggregate demand, shiftingAD left (fromAD0 toAD2).

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    Shifts in Aggregate Supply

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    Long and Short-Run Aggregate Supply When considering shifts in aggregate supply,

    it is important to distinguishbetween the long run andshort run.

    Shifts in LRAS:A long run change in aggregate supply

    indicates that it will be possible to achieveand sustain a larger rate of output.

    A shift in the long run aggregate supplycurve (LRAS) will cause theshort run

    aggregate supply (SRAS) curve to shift inthe same direction.

    Shifts inLRAS are an alternative way ofindicating that there has been a shift in the

    economys production possibilities curve.

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    Long and Short-Run Aggregate Supply Shifts in SRAS:

    Changes that temporarily alter the productivecapability of an economy will shift the SRAScurve, but not theLRAScurve.

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    Shifts in Aggregate Supply Factors that increase (decrease)LRAS:

    increase (decrease) in the supply of resources improvement (deterioration) in technology and

    productivity

    institutional changes that increase (reduce)

    the efficiency of resource use Factors that increase (decrease)SRAS:

    a decrease (increase) in resource priceshence, production costs

    a reduction (increase) in expected inflation favorable (unfavorable)supply shocks, such as

    good (bad) weather or a reduction (increase) inthe world price of a key imported resource

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    PriceLevel

    Goods & Services(real GDP)

    PriceLevel

    Goods & Services(real GDP)

    LRAS1

    YF1

    SRAS1LRAS2

    YF2

    SRAS2

    Shifts in Aggregate Supply

    Such factors as an increase in the stock of capital or an

    improvement in technology will expand an economyspotential output and shiftLRAS to the right (note that whentheLRAS curve shifts, so too does SRAS).

    Such factors as a reduction in resource prices or favorableweather would shift SRAS to the right (note that here the

    LRAS curve will remain constant).

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    Consider the impact of capital formation or a technologicaladvancement on the economy.

    Growth in Aggregate Supply

    PriceLevel

    LRAS1

    YF1

    P100

    Goods & Services

    (real GDP)

    AD

    SRAS1

    YF2

    LRAS2

    P95

    SRAS2

    BothLRAS and SRASincrease (toLRAS2 and SRAS2);full employment output expands from YF1 to YF2.

    A sustainable, higher level of real output is the result.

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    Unanticipated Changesand Market Adjustments

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    Unanticipated Changesin Aggregate Demand

    In the short-run, output will deviate from fullemployment capacity as prices in the goodsand services market deviate from the pricelevel that people expected.

    Unanticipated changes in aggregate demandoften lead to such deviations.

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    Unanticipated Increasein Aggregate Demand

    Impact ofunanticipated increase inAD: Initially, the strong demand and higher price

    level in the goods & services market willtemporarily improve profit margins.

    Output will increase, the rate ofunemployment will drop below the naturalrate, and output will temporarily exceed theeconomy's long-run potential.

    With time, however, contracts will bemodified and resource prices will rise andreturn to their competitive position relativeto product prices.

    Once this happens, output will recede tothe economy's long-run potential.

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    In response to an unanticipated increase inAD for goods& services (shift fromAD1toAD2), prices rise toP105and output will increase to Y2, temporarily exceedingfull-employment capacity.

    Increase inAD: Short RunPriceLevel

    LRAS

    YF Y2

    P100

    AD2

    Goods & Services

    (real GDP)

    AD1

    Short-run effects ofan unanticipatedincrease inAD

    SRAS1

    P105

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    AD2AD1

    With time, resource market prices, including labor, rise dueto the strong demand. Higher costs reduce SRAS1 to SRAS2.

    Increase inAD: Long RunPriceLevel

    YF Y2

    Goods & Services(real GDP)

    Long-run effects ofan unanticipatedincrease inAD

    SRAS2

    P110

    In the long-run, a new equilibrium at a higher price level,P110, and output consistent with long-run potential will occur.

    So, the increase in demand onlytemporarily expands output.

    YF

    LRASSRAS1

    P100

    P105

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    Unanticipated Decreasein Aggregate Demand

    Impact ofunanticipated reduction inAD: Weak demand and lower prices in the goods

    & services market will reduce profit margins.Many firms will incur losses.

    Firms will reduce output, the unemployment

    rate will rise above the natural rate, andoutput will temporarily fall short of theeconomy's long-run potential.

    With time, long-term contracts will bemodified.

    Eventually, lower resource prices and lowerreal interest rates will direct the economyback to long-run equilibrium, but this may bea lengthy and painful process.

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    The short-run impact of an unanticipated reduction inAD(shift fromAD1 toAD2) will be a decline in output (to Y2),and a lower price level (P95).

    Decrease inAD: Short RunPriceLevel LRAS

    YFY2

    P100

    Goods & Services(real GDP)

    AD1

    Short-run effects ofan unanticipatedreduction inAD

    SRAS1

    AD2

    Temporarily, profit margins decline, output falls, and

    unemployment rises above its natural rate.

    P95

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    PriceLevel

    AD2AD1

    In the long-run, weak demand and excess supply in theresource market lead to lower resource prices (includinglabor) resulting in an expansion in SRAS (SRAS1 to SRAS2).

    Decrease inAD: Long RunLRAS

    YFY2

    P100

    Goods & Services(real GDP)

    Long-run effects ofan unanticipated

    reduction inAD

    SRAS1

    P95

    A new equilibrium at a lower price level,P90, and an outputconsistent with long-run potential will result.

    SRAS2

    P90

    YF

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    Unanticipated Changes inShort-Run Aggregate Supply

    Unanticipated changes in short-run aggregatesupply (SRAS) can catch people by surprise.

    Thus, they are often referred to as supplyshocks.

    A supply shock is an unexpected event thattemporarily increases or decreases aggregatesupply.

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    Impact of Increase in SRAS SRAS shifts to the rightoutput temporarily

    exceeds the economy's long-run potential. Since the temporarily favorable supply

    conditions cannot be counted on in thefuture, the economys long-term productioncapacity will not be altered.

    If individuals recognize that they will beunable to maintain their current high levelof income, they will increase their saving.Lower interest rates, and additional capital

    formation may result.

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    Unanticipated Increase in SRASPriceLevel

    LRAS

    YF Y2

    P100

    Goods & Services(real GDP)

    AD

    SRAS1

    SRAS2

    P95

    Consider an unanticipated, temporary, increase in SRAS, suchas may result from a bumper crop from good weather.

    The increase in aggregate supply (to SRAS2) would lead toa lower price levelP95 and an increase in current GDP to Y2.

    As the supply conditions are temporary,LRAS persists.

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    Impact of Decrease in SRAS SRAS shifts to the leftoutput falls short of

    the economy's long-run potential temporarily. If an unfavorable supply shock is expected tobe temporary, long-run aggregate supply willbe unaffected.

    Households may reduce their current saving(dip into past savings).

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    Quantity of

    resourcesQ2

    D

    Pr2

    Q1

    S1

    ResourceMarket

    Pr1

    S2

    Suppose there is an adverse supply shock, perhaps as theresult of a crop failure or a sharp increase in the world priceof a major resource, such as oil.

    Supply Shock: Resource Market

    Here we show the impact in the resource market: prices

    rise fromPr1 toPr2.

    PriceLevel

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    PriceLevel

    AD

    Supply Shock: Product Market

    YFY2

    P100

    Goods & Services(real GDP)

    P110

    As shown here, the higher resource prices shift SRAS to theleft in the product market; in the short-run, the price levelrises toP110and output falls to Y2.

    What happens in the long-run depends on whether the supplyshock is temporary or permanent.

    LRAS

    SRAS1 (Pr1)

    SRAS2 (Pr2)

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    PriceLevel

    Effects of Adverse Supply ShockLRAS

    YFGoods & Services

    (real GDP)

    AD

    If the adverse supply shock istemporary, resource prices willeventually fall in the future, shifting SRAS2 back to SRAS1,returning equilibrium to (A).

    If the adverse supply factor ispermanent, the productivepotential of the economy will shrink (LRAS shifts left and Y2becomes Y

    F2

    ) and (B) will become the long-run equilibrium.

    YFY2

    P100

    P110

    SRAS1 (Pr1)

    SRAS2 (Pr2)

    B

    A

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    The Price Level, Inflation,and the AD-AS Model

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    Price Level, Inflation,and theAD-ASModel

    The basicAD-ASmodel focuses on how thegeneral level of prices influences thechoices of business decision makers.If the price level in the product market changes,

    this indicates that this price has changedrelative to other markets.

    This structure implicitly assumes that the actual

    and expected rates of inflation are initially zero. When inflation is present this model can be

    recast in a dynamic setting.

    i l fl i

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    Price Level, Inflation,

    and theAD-ASModel

    When the actual and expected rates ofinflation are equal:Inflation will be built into long term contracts.

    Prices will rise in both resource and productmarkets, but the relative price between the twowill be unchanged.

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    Actual and Expected Rates of

    Inflation Differ An actual rate of inflation that is less than

    anticipated is the equivalent of a reductionin the price level. As a result, firms willincur losses and reduce output.

    An actual rate of inflation that is greaterthan anticipated is the equivalent of anincrease in the price level. Profits will beenhanced and firms will expand output.

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    Unanticipated Changes,Recessions, and Booms

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    The AD-AS Model and Instability The AD-AS model indicates that

    unanticipated changes will disrupt macroequilibrium and result in economic instability. Recessions occur because prices in the goods

    and services market are low relative to thecosts of production and resource prices.

    The two causes ofrecessions are: unanticipated reductions inAD, and, unfavorable supply shocks.

    An unsustainable boom occurs when prices inthe goods and services market are high relative

    to resource prices and other costs. The two causes ofbooms are: unanticipated increases inAD, and, favorable supply shocks.

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    Two Forces Directing theEconomy Back to Equilibrium

    The AD-AS model indicates that there aretwo forces that will help direct an economyback to long-run equilibrium:

    Changes in real resource prices:

    During arecession, real resource priceswill tend to fall because the demand forresources will be weak and the rate ofunemployment high.

    During aboom, real resource prices will

    tend to rise because demand for resourceswill be strong and the unemployment ratelow.

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    Two Forces Directing theEconomy Back to Equilibrium

    The AD-AS model indicates that there aretwo forces that will help direct an economyback to long-run equilibrium:

    Changes in real interest rates:

    During arecession, real interest rateswill tend to decline because of the weakdemand for investment. The lower interestrates will stimulate AD and help direct theeconomy back to full employment.

    During aboom, real interest rates willtend to rise because of the strong demandfor investment. The higher rates willretard AD and help direct the economyback to full employment.

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    LRAS

    AD1

    SRAS1

    If output is temporarily less than long-run potential YF

    PriceLevel

    P100

    Y1 YF

    Goods & Services(real GDP)

    Lower real interestrates increaseAD

    falling interest rates will shiftAD (fromAD1 toAD2)

    The Macro-Adjustment Process

    AD2

    SRAS2

    Lower resourceprices increase SRAS

    In the short-run,output may exceed

    or fall short ofthe economys

    full-employmentcapacity (YF).

    while lower resource prices decrease production costs andthereby increase SRAS (from SRAS1 to SRAS2) and sodirect output toward its full-employment potential (YF).

    YF

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    Goods & Services(real GDP)

    If output is temporarily greater than long-run potential YF

    PriceLevel

    P100

    LRAS

    SRAS1

    AD1

    YF Y1

    Higher real interest

    rates reduceAD

    higher interest rates will reduceAD (fromAD1 toAD2)

    The Macro-Adjustment Process

    AD2

    SRAS2 Higher resourceprices reduce SRAS

    In the short-run,output may exceed

    or fall short ofthe economys

    full-employmentcapacity (YF).

    while higher resource prices increase production costs andthereby reduce SRAS (from SRAS1 to SRAS2) directingoutput toward its full-employment potential (Y

    F

    ).

    YF

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