Aggregate demand

AD and AS intersection at point E determines the level of output Yo and price level, Po.

Aggregate Supply & Demand

An increase in the price level leads to a decrease in output

The Derivation of the Aggregate Demand Curve

PM

Pi dem and Y

An increase in money stock shifts the aggregate demand curve from AD to AD’. The equilibrium moves from E to E’ resulting in higher prices rather than entirely in higher output.

An Increase in the Nominal Money Stock Shifts Aggregate Demand to the Right

Aggregate supply

Aggregate supply is the total supply of all goods and services in the economy.

The aggregate supply (AS) curve is a graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.

The Aggregate Supply Curve

Aggregate supply

The aggregate supply curve is built up from the links among wages ,prices, employment and output.

The AS curve describes, for each given price level, the quantity of output firms are willing to supply

The AS curve is upward sloping since firms are willing to supply more at higher prices

In the short run the AS curve is horizontal (the Keynesian AS curve)

In the long run the AS curve is vertical (the classical AS curve)

The Aggregate Supply Curve

Keynesian & Classical Aggregate Supply Functions

The classical AS curve◦ Is vertical, indicating that the same amount of

goods will be supplied whatever the price level

Assumption◦ The labour market is in equilibrium at full

employment and all factors of production are fully utilised

Implication◦ Increases in AD do not increase output but merely

raises prices

The Classical AS Curve

The Keynesian AS curve

◦ Is horizontal, indicating firms will supply whatever amount of goods is demanded at the existing price

Assumption

◦ There is unemployment, so firms may obtain as much labour as they want at the current wage

Implication

◦ AD determines the level of output, with prices ‘sticky’ in the short run.

The Keynesian AS Curve

Fiscal and monetary policy under alternative supply assumptions.

A fiscal expansion –in Keynesian case output is perfectly elastic supply at a given price level, a fiscal expansion increases equilibrium income from y to y’.

Aggregate Demand Expansion:The Keynesian Case

The supply of output is perfectly inelastic at the full employment level of output Y*.

A fiscal expansion raises spending, excess demand , firms are willing to supply that much output.

Prices increase lower real balances, higher interest rate and reduced private spending.

Full Crowding out in classical case.

Aggregate Demand Expansion:The Classical Case

Why wages and prices sticky ? Wages move slowly over time rather than

being fully and immediately flexible so as to ensure full employment.

Why wages and prices are adjust slowly to changes in aggregate demand.

Why output increases when price rises?

Models of aggregate supply Aggregate supply shows relationship between

price level and output. Short run Aggregate supply curve is upward

sloping. Long run Aggregate supply curve is vertical. Why aggregate supply curve is upward sloping

in short run? various models explain this

Sticky wage model The sticky model of upward sloping short run aggregate

supply is based on labor market Short run wages are set by contracts.

When economy changes, the wages the workers receive cannot adjust immediately.(wages are sticky)

When price level rises, nominal wage is fixed ,but real wages fall.

When real wages that firms pay employees falls, labor becomes cheap, since the amount of output produced for each unit of labor is still the same, firms choose to hire more workers and increase revenues and profits.

Firms employs more labors, output increases.

Rational expectations According to rational expectations,

economic agents such as workers and firms do not know future with uncertainty and therefore base their decisions on the expectations of future.

According to Lucas people can be confused temporarily by monetary surprises, an expansion of price level may temporarily fool workers.

Workers misconception model(Lucas rational expectations model )

Based on labor market Price level increases, nominal wages of labor

increases. Workers in short run are in misconception that

their real wages has increased, but only nominal wage has increased.

Workers are induced to work more Output increases. Thus when price increase output increases

because of workers misperception.

Imperfect information Neither the worker nor the firm has complete information. In this model producers are concerned to be aware of

the price of the goods and services they produce. They believe that prices of only their goods and services increase.

Whereas there is overall price rise, producers mistake for it for a relative increase in price level.

So it producers more output.

Sticky price model Firms do not adjust their prices instantly to

changes in the economy. Reasons :First ,Prices like wages are set in relatively long term

contracts.

Second, firms hold prices stable to keep from annoying

customers .Third , firms hold prices stable due to menu costs ( printed

catalogues and menus)

Inside outside model Firms negotiate with the workers who

have jobs, not with the people who are unemployed.

It is costly for firms to turn over their labor force-firing cost, hiring costs, training costs, as a result the insiders have a advantage over outsiders.

Threatening insiders with unemployment unless they accept wage cuts is not very effective for two reasons.

People who are threatened may have to give in but they will respond poorly in terms of morale effort and productivity.

If the firms actually fired high wage workers and brought in unemployed at low wages, the unemployed would now become insiders and present exactly the same resistance to wages cuts.

Thus firms would face many costly rounds of labor turnover before getting labor force.

Far better to deal with insiders than outsiders who are eager to work for low wages.

Thus this explanation of inside outside model predicts that wages will not quickly respond to unemployment and this offers a reason why we do not quickly return to full employment once economy experiences recession.

Aggregate supply

The theory of aggregate supply is one of the least settled in macroeconomics, with competing schools of thought each offering their own explanations.

Economists widely agree that wages, employment, and output adjust only slowly to changes in aggregate demand, but there are several explanations for the reasons for the slow wage and price adjustment.