AD-AS Model
Part III:
Putting it all together
Stick Wages
Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages.
Nominal wages cannot be sticky forever. The length of their stickyness is the difference in the short and long run
3 Ranges of the Segmented AS Curve
1. Keynesian
2. Intermediate
3. Classical
PL AS
(3)
(2)(1)
RGDP
Long Run Aggregate Supply
Prices are relative. If your pay is cut by 50% but all prices drop by 50% your income has the same value
LR Aggregate SupplyThe upward slope of the
SRAS is due to sticky wages / other prices, BUT wages always adjust / are renegotiated in the LR
LR -- ALL inputs are flexible & PL has NO effect on quantity of output supplied
LR Aggregate Supplyo LRAS’s position on the
horizontal axis represents the speed limit or potential (non-inflationary) level of output (i.e. full employment)
LR Aggregate Supply Actual RGDP is
almost always above or below FE (Full Employment) [i.e. at a SR equilibrium]
Potential output for the U.S. has grown steadily over time
LR Aggregate Supply
Shifts in LRAS due to:
11 in labor force
11 in physical capital
11 in natural resources
14 in human capital
15 in technology
Same reasons the PPC shifts
Moving from the SR to the LR
If the economy is almost always on its SRAS, why is LRAS relevant?
Over time, the SRAS will shift to restore the LR equilibrium
Actual output will eventually reach potential output
Putting AS & AD Together Movement along a curve occurs because the
other curve has shifted. To understand the economy, you need both curves (and LRAS).
PL SRAS
AD0
AD1
RGDP
SR Macroeconomic EquilibriumThe intersection of SRAS &
AD is equilibrium: quantity of total output supplied = Q demanded by C + I + G + (X - M).
It shows PL & RGDPBelow equilibrium, PL will
rise because there is a shortage.
Above equilibrium, PL will fall because there is a surplus.
PLSRAS
AD
RGDP
P*
Y*
Negative Supply Shock
Darth Vader attacks Dathomir.
Shifts in SRAS (Supply Shocks)1. Negative Supply Shock --Some 1 in production costs
(e.g. increasing commodity prices, increasing nominal wages, decline in productivity)
--Shifts SRAS to the left-- PL 1 (inflation up)-- RGDP 1 (unemployment
up)
PL
LRASSRAS1
SRAS0
AD
RGDPFEY1
P*
P1
Negative SRAS Shock: Phillips Connection
Result: stagflation (means stagflation + inflation)
= worst of all possible worlds
= right shift of SR Phillips Curve (cost-push inflation)
What should we try to fix first?
Inflation
Unemployment
SRPC0
SRPC1
Positive Supply Shock
Luke Skywalker comes and saves the day
Shifts in SRAS (Supply Shocks)2. Positive Supply Shock
--Some 1 in production costs (e.g. decreasing input prices, increase in productivity)
--Shifts SRAS to the right-- PL 1 (inflation down)-- RGDP 1 (unemployment down)
Result: best of all possible worlds
Full employment & disinflation creates waves of national optimism
PL
LRASSRAS0
SRAS1
AD
RGDPFE Y1
P1
P*
Negative SRAS Shock: Phillips Connection
2. Positive Supply Shock
The Short Run Phillips Curve shifts LEFT
Improved menu of tradeoffs
How can we keep this going?
inflation
unemployment
SRPC0
SRPC1
Shifts in AD: Demand Shocks
1. Negative Demand Shock:
Recession caused by a leftward shift in AD
(e.g. a 1 in wealth, oversupply of stock of capital, contractionary fiscal or monetary policy)
This dude is literally tightening his belt.
This was actually a movie
Shifts in AD: SR Demand Shocks
When AD shifts left…
Result: Recession
PL 1 (disinflation or deflation)
RGDP 1 (unemployment 1 )
Ex. 2001 Recession & Great Depression
LRASSRAS
PL
RGDP
AD1AD0
P*
P1
Y1 FE
Negative AD Shock: Phillips Connection
Left Shift in Aggregate Demand corresponds to…
Movement downward along the Phillips Curve
Tradeoff between inflation and unemployment
inflation
unemployment
SRPC
Shifts in AD: SR Demand Shocks
2. Positive Demand Shock
-- demand-pull boom caused by a right shift in AD
(e.g. an 1 in wealth, undersupply of stock of capital, expansionary fiscal or monetary policy
Shifts in AD: SR Demand Shocks
AD shifts right…Result: Inflationary
BoomPL 1 (demand-pull
inflation)RGDP 1 (unemployment
1 )Ex. Spending on WWII
& Great Society
LRAS SRAS
PL
P1
P*
FE Y1 RGDP
AD0
AD1
Positive AD Shock: Phillips Connection
Right shift in AD corresponds to…
Movement upward along the Phillips Curve
Tradeoff between unemployment and inflation
inflation
unemployment
SRPC
In the LR the economy self-corrects Negative D shock 1 PL &
RGDP AD moves 1 SRAS b/c sticky
wages are not falling as fast as product market prices (businesses lay off workers or shut down b/c of 1 profitability)
1 unemployment 1 bargaining power of workers; nominal wages 1
1 in cost of production shifts SRAS to the right until FE equilibrium (LRAS equilibrium) is restored
Net result: same FE level (RGDP) at a lower PL
PL LRAS SRAS0
SRAS1
AD1AD0
RGDPRecessionary Gap
1
2
While this explanation makes waiting for the LR adjustment look quite desirable, SR recessions can be very disruptive to
the population.
Positive Ag. Demand Shock 1 PL & RGDP AD moves 1 SRAS b/c sticky
wages are not rising as fast as product market prices (firms ratchet up production, hire more workers, & add shifts b/c of 1 profitability)
Tight labor market 1 bargaining power of firms; nominal wages 1
1 in cost of production shifts SRAS to the left until FE equilibrium (LRAS equilibrium) is restored
Net result: same FE level (RGDP) at a higher PL
PL LRAS SRAS1
SRAS0
AD0AD1
RGDPInflationary Gap
From LR to SRHow long does it take to move from SR to LR?
*answer depends on whether you believe in Adaptive or Rational Expectations
Adaptive Expectations Rational Expectations
Adaptive Expectations
The economy moves from the short run to the long run slowly because individuals respond to events as / after they happen
People are largely reactive to events “on the ground”
Rational Expectations The economy moves from SR to LR
quite quickly b/c people have an intuitive understanding of the economic forces at work & react immediately to where the economy is going.
They make decisions optimally, using all available information.
e.g. if a union is negotiating a contract during a period of current & past low inflation and announced gov’t policy indicates that the G will be trying to trade a 1 PL for 1 unemployment, then the union will put that future inflation into the new contract, sabotaging G efforts to move up the SRAS -- instead go straight to same RGDP at a higher PL.
Implications: LR or “Extended” Phillips Curve
3 Generalizations
1. Under normal circumstances there is a SR tradeoff between the rate of inflation & the rate of unemployment
2. Aggregate supply shocks can cause both 1 rates of inflation & 1 rates of unemployment
3. There is no significant tradeoff between inflation & unemployment over long periods of time
Inflation
Unemployment
SRPC0
SRPC1
LRPC
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