Macro Lecture 6

8/12/2019 Macro Lecture 6

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MacroLecture6AS-AD and Potential GDP

Lecture Highlights Output and prices are determined by AS

and AD

In the short run, the AS curve is flat. In thelong run, the AS curve is vertical. It isupward sloping in the medium run

The AS curve describes the priceadjustment mechanism of the economy

Changes in AD, the result of changes infiscal and monetary policy as well asindividual decisions about consumption andinvestment


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AS-AD and Potential GDP

Macroeconomic variables can be divided intotwo groups:

Real variables

Nominal variablesReal variables are items such as real GDP, thereal wage rate, the real interest rate, thelevels of employment and unemployment.

Nominal variables are items such as the price

level (CPI or GDP deflator), the inflationrate, nominal GDP, the nominal wage rate,the nominal interest rate.


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Contd.

The AD-AS model provides a framework for thinkingabout 3 big macroeconomic issues std. of living,cost of living, and economic fluctuation.

The AD-AS model is used by economists to analyse the

behavior of the macroeconomy in both the short-runand in the long-run.

The model outlines the behavior of two macroeconomicaggregates real output or real GDP/ income and theprice level.

AS shows the relationship between the quantity of realGDP supplied and the price level when all otherinfluences on production plans remain the same.


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Contd.

The fall in price

- Brings layoff

- Decrease in production- Real GDP

The rise in price

- Firms hire new workers

- Increase production

- Real GDP


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Contd.

The relationship between real GDPsupplied and the price level can bedescribed as follows:

Other things remaining the same, thehigher the price level, the greater isthe quantity of real GDP supplied, and

the lower the price level, the smalleris the quantity of real GDP supplied.


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Potential GDP

AS

Potential GDP

Yp Real GDP

Pricelevel orGDP

deflator

Potential GDP the level of realGDP that the

economy wouldproduce if it wereat fullemployment.


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Factors determine the qty. of realGDP supplied

The qty. of real GDP supplied (Y), depends on

The quantity of labour employed

The quantities of capital and human capitaland the technologies they embody

The quantities of land and naturalresources used

The amount of entrepreneurial talentavailable


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Contd.

Along the AS curve, the only factorwhich affect the production plans ischanges in the price level. All theother influences on production plansremain constant. Among otherinfluences are

The money wage rate The money prices of other resources


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Aggregate Demand (AD)

The relationship between the quantity ofreal GDP demanded and the price levelwhen all other influences on expenditureplans remain the same.

The relationship between the quantity of realGDP demanded and the price level can bedescribed as follows:

Other things remaining the same, the higherthe price level, the smaller the quantity ofreal GDP demanded, and the lower theprice level, the greater is the quantity ofreal GDP demanded


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Contd.

AD

Pricelevel

Real GDP


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Contd.

The AD curve and equilibrium expenditure are related. The AE curve is the relationship between agg.planned

expenditure and real GDP when all other influences onexpenditure plans remain the same. A movementalong the AE curve arises from a change in real GDP.

A movement along the AD curve arises from a changein the price level.

Equilibrium expenditure depends on the price level.When P, other things remaining the same, AE andequilibrium expenditure .

When P, other things remaining the same, AE andequilibrium expenditure

A change in P changes the buying power of money, the realinterest rate, and the real prices of exports and imports.


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Equilibrium expenditure and AD

AE(Po)

AE(P1)

AE(P2)

AD

P2

Po

P1


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Contd.

The quantity of real GDP demanded isthe total amount of final goods andservices produced that people,businesses, governments, andforeigners plan to buy.

Two factors influence expenditure plans

(i) The price level

(ii)Other factors


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Contd.

(i) The price level influences thequantity of real GDP demandedbecause a change in the price levelbrings changes in

The buying power of money

The real interest rate

The real prices of exports & imports


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Contd.

The buying power of money a rise in the price levellowers the buying power of money and decreases thequantity of real GDP demanded.

The real interest rate when the price level rises, thereal interest rate rises.

the price level the amount of money that people want tohold ( Md).

When Md nominal interest rate

In the short run, the inflation rate doesnt change

nominal interest rate real interest rate

Businesses and people delay plans to buy new capital andconsumer durable goods

Real GDP demanded


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Contd.

The real prices of exports & imports.

When domestic price level and other thingsremain the same

The prices in other countries do not change This makes the Malaysian goods & services more

expensive relative to foreign goods & services.This change in real prices

People to spend less on the Malaysian goods &services

To spend on foreignmade items


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Changes in AD

The factors that change AD are

Expectations about the future

Fiscal policy and monetary policy The state of the world economy


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Macroeconomic Equilibrium

AS & AD determine real GDP and theprice level.

Macroeconomic equilibrium occurs whenthe quantity of real GDP demandedequals the quantity of real GDP

supplied.


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Contd.

AD

Pricelevel

Real GDP

AS

Firms cutproduction andprices

Firms increaseproduction and prices


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Three types of macroeconomicequilibrium

AD2

Pricelevel

Real GDP

AS

ADo

AD1

Potential GDP

Y2 Yp Y1

Yp: full-

employmentequilibrium

Y1: above full-employmentequilibrium

Y2: below full-employmentequilibrium


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The Production Function

- A relationship that shows the maximum qtyof real GDP that can be produced as the qtyof labor employed changes and all other

influences on production remain the same.The production function displays diminishing

returns each additional hour of laboremployed produces a successively smaller

additional amount of real GDP.


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Contd.

PF

attainable

unattainableRealGDP

Labor (billions of hours per year


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The Labor Market

The qty of labor employed depends on firmsdecisions about how much labor to hire(DL).

It also depends on households decisionsabout how to allocate time betweenemployment and other activities (SL).

It depends on how the labor market

coordinates the decisions of firms andhouseholds (labor market equilibrium).


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Contd.

Demand for labor (DL) = total labor hours thatall the firms in the economy plan to hireduring a given time period at a given real

wage rate.The DL is the relationship between the qty of

labor demanded and the real wage ratewhen all other influences on firms hiring

plans remain the same.The real wage rate is the nominal wage rate

divided by the price level i.e. W/P.


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Contd.

DL

Realwage

rate

Qty of labor (billions of hours/year

A rise in the real wage ratedecreases the qty of labor

demanded

A fall in the real wage rateincreases the qty of labordemanded


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Contd.

The qty of labor supplied (SL) = thenumber of labor hours that all thehouseholds in the economy plan to

work during a given time period at agiven wage rate.

The SL is the relationship between theqty of labor supplied and the real

wage rate when all other influenceson work plans remain the same.


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Contd.

Realwage

rate

Labor (billions of hours/year)

A rise in the real wage rateincreases the qty of laborsupplied

SL

A fall in the real wage rate

decreases the qty of labor supplied


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Labor market equilibrium

SL

DL

200 labor

Realwage

rate

30FEequilibrium

PF

200

Real GDP

10

PotentialGDP

Fullemployment

qty of labor


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Changes in AS

AS changes when any influence onproduction plans other than the pricelevel changes.

AS changes when

Potential GDP changes

The money wage rate changes

The money prices of other resourceschange


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An increase in potential GDP

ASo

AS1

Yp Yp Real GDP

Increase in potential GDP

Increase in AS when potentialGDP increases

Pricelevel


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Changes in money wage rate andother resource prices

A change in the money wage rate orin the money price of anotherresources changes AS because it

changes firms costs.

An increase in the money wage rateor the price of another resources

decreases AS.


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Contd.

AS1

ASo

Yp Real GDP

Decrease in AS when money

wage rate rises

Pricelevel

The AS curve shifts leftwardfrom ASo to AS1. A rise inthe money wage rate does

not change potential GDP


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Changes in AD

A change in any factor that influencesexpenditure plans other than the price levelbrings a change in AD.

When AD increases, the AD curve shifts

rightward.When AD decreases, the AD curve shifts

leftward.The factors that change AD are

Expectations about the future Fiscal policy and monetary policy The state of the world economy


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Contd.

AD2ADo

AD1

Real GDP

Pricelevel

AD curve shifts to the rightwhen (i) expected futureincome, inflation or profits

increase, (ii) the governmentincreases planned expenditure,and (iii) the exchange rate fallsor the global economyexpands.

AD curve shifts to the left when(i) expected future income,

inflation, or profits decrease,(ii) the government decreasesplanned expenditure, and (iii)the exchange rate rises/ theglobal economy contracts.


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Factors that shifts AD curve to theright (summary)

in consumption spending (C)

in investment spending (I)

in government spending (G)

in exports (X)

in imports (M)

in taxes (which C and I)

in household wealth ( C)

in Ms (this i C, I)


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Factors that shift the AD curve tothe left (summary)

C

I

G

X

M

T

household wealth

Ms


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AD fluctuations

ADoAD1

AD2

Real GDP

Pricelevel Potential GDP

AS


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AD fluctuations

AD4AD3

AD2

Real GDP


AS


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AS fluctuations

AD

Real GDP


ASoAS1

A rise in the price ofoil decreases AS. AScurve shiftsleftward from ASoto AS1.

Real GDP , and theprice level


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AS fluctuations (contd.)

AD

Real GDP


ASo

A fall in the price ofoil decreases AS. AScurve shiftsrightward from ASoto AS2.

Real GDP , and theprice level

AS2


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Adjustment toward full employment

When the economy is away from FE, forces begin tooperate that move it back toward FE.

AS is ASo, AD from ADo to AD1 Real GDP above FE

Inflationary gapa gap that exists when real GDP > potentialGDP and that brings a rising price level.

Workers have experienced in the buying power.

Workers DD higher wages.

AS decreases and AS curve shifts leftward from ASo to AS1.

Real GDP is back at potential GDP. (see next slide)


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Contd.

AD1

Real GDP


AS1

ASo

ADo

Inflationary gap


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Contd.

As is AS1 and a decrease in AD from AD1 to AD2 realGDP below FE deflationary gap gap that existswhen potential GDP > real GDP and that brings afalling price level.

Buying power Firms profits shrink

With a labor surplus, the money wage rate gradually falls

AS curve shifts rightward from AS1 to AS2

Real GDP is back at potential GDP (see next slide)


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Contd.

AD1

Real GDP


AS1

AS2

AD2

deflationary gap

Macro Lecture 6

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