Price

Q

Supply

Demand

Q e

P e

Supply and Demand graphs- The Basics

The purpose of this graph is to look at markets. Free Market Price and Quantity

Price Level

Measure of

Inflation

G.D.P real

employment

Aggregate Supply (AS)

Aggregate Demand (AD)

Q e

P e

Aggregate- all together (total)

The Aggregate Market- The Basics

Long Run Aggregate Supply (LRAS)

Qy

Qy= Quantity at full employment

The purpose of this graph is to look at countries. Total supply and demand at full employment

You may find it amazing how a fairly simple graph can be interpreted in so many different ways.

Learning the basics of the graph will provide you an opportunity to learn fiscal and monetary policy in different ways.

The law of demand is the same.

There is an inverse relationship- PL up, AD down, PL down AD up

The law of supply is the same

There is a direct relationship- PL up, AS up, PL down AS down

AD= Aggregate Demand

AD= GDP= C + I G + NX

Conflicting Views

Classical Views Keynesian Views

1. Prices and Wages are flexible – markets quickly and efficiently achieve equilibrium. When applied to the resource market full employment is maintained- unemployment is not a long term problem

2. Say’s Law- supply creates it own demand- aggregate product of goods and service produces enough income to exactly purchase all output

3. Savings-investment equality-any decrease in output because of savings is offset an increase in the demand for investment

This creates a different market – the money market

Investment is demandSavings is Supply

Interest rates create equilibrium- Monetarist

1. Prices and Wages are Sticky- Prices and wages respond slowly to changes in supply and demand and this results in shortages and surplus- especially with labor.

2. Increase Aggregate Demand to increase GDP- is influenced by a host of economic decisions both public and private.

3. “In the Long Run we are all dead”- care more about Short run and not so much about the long run. Changes in AD have greater short run effect on real GDP and employment but not as much on price. What is true in the short run isn’t always true in the long run

4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending

5. Steer the Market- advocated stabilization policies such as tax, government spending, laws, and regulation in order to defend against the sudden and unpredictable changes in the business cycle

Less Government

Equilibrium of market

Increase consumer or Investments

F.A. Hayek

Neo-ClassicalAustrianMonetaristSupply-siders

John M. Keynes More GovernmentMicro not Macro

KeynesiansNeo-Keynesians Increase Gov’tDemand-siders spending

Fiscal Policy

Wages

Employment

(AS)

(AD)

Q

W e

AS/AD/LRAS graphs- Classical vs Keynesian models Labor Market

(AD) 1

Classical (Monetarist)- believe that when demand for employment decreases- wages will fall and the market will clear (return to equilibrium). Some people will choose not to work but most will eventually lower their wages.

W 1

Q 1

Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at the same wage. This creates a surplus of supply of workers which will remain until demand increases.

Quantity demanded is less than the quantity supplied.

Q 2

P.L.

G.D.P real

(AS) much like the LRAS

(AD)

Q y

P e

The whole purpose of these graphs is to find the Price level, GDP, and unemployment

AS is vertical and at the same point of full employment

Classical economist believe that resources prices and wages are flexible

This model says that the government doesn’t need to get involved because the market will fix itself.

Aggregate Supply (The classical model)

What will happen to price as AD falls?

(AD) 1

P 1The classical model suggest that the economy fixes itself and that prices and resources price will fall to create a new equilibrium.

When Aggregate demand falls what happens to. . .

Price?

Employment?

Wage (remember wages are price)?

GDP real?

P.L.

G.D.P real

LRAS

(AD)

Q y

P e

Aggregate Supply (The classical model)

SRAS

(AD) 1

If there is a decrease in ADThere will be a reduction in price level and higher unemployment

P 1

Q 1

SRAS 1

Q 2

According to classical economist the SRAS will eventually increase as wages decrease and the price of resources decrease

This will give you a new quantity demanded back at full employment

This will occur as long as wages can adjust. What can keep wages artificially elevated? Or in other words what can keep the market from clearing?

Unions

Min. Wage laws

Unemployment benefits

Whether or not the market will clear will also depend on the worker’s wage expectations.

Rational Expectations

Workers will revise their expectations instantaneously

Adapted Expectations

It may take workers weeks, months, or years but eventually they will adapt their wage expectations.

P.L.

G.D.P real

LRAS

(AD)

Q yfull

P e

Aggregate Supply (The Keynesian Model)

Y1

According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t change and output will remain low.

When output is below full employment, the price level doesn’t fall because wages/resource prices don’t fall (wages are sticky)

(AD) 1

P.L.

G.D.P real

LRAS

Q yfull

P e

Aggregate Supply (The Keynesian Model)

Y1

According to Keynes, only with the help of the help of the government can Aggregate demand increase.

Demand side economics- focus on demand

Fiscal approach- government spending and taxationMonetarist approach is to increase investments

(AD) 1

(AD) 2 (AD) 3

Any aid past Qy- is purely inflationary

(AD) 4

(AD) 5

P.L.

G.D.P real

LRAS

Q yfull

P e

Aggregate Supply – So what Model is correct?

They Both have some valid points

Keynesian Phase

AD

When in the Keynesian Phase

Output can increase with no change in price.No increase in price level, no inflationary pressure, spare room to grow.

Intermediate Phase

AD

When in the Intermediate Phase

As AD approaches the curve

An increase in AD and decrease in unemployment

Result in a gradual increase of price and some inflationary pressure

ClassicalPhase

AD

When in the Classical Phase

The economy is operating at full employment

Any and all increase in AD will result in an increase in price and in increase in inflation

P.L.

G.D.P real

(AS)

(AD)

Q e

P e

If Aggregate Demand increases

AS/AD/LRAS graphs- how it works during Expansion

(LRAS)

Qy

(AD) 1

P 1

Q 1

Both Prices and GDP will increase.

In the long run – an increase in price will not lead to an increase in output.

Why?

Because as prices increase so does the price of resources including labor, wages, and materials.

(AS) 1

As a result the Aggregate supply will shift to the left (decrease) and we will find ourselves back at full employment.

A

B

CP 2

P.L.

G.D.P real

(AS)

(AD)

Q e

P e

If Aggregate Demand decreases.

AS/AD/LRAS graphs- how it works during Recession

(LRAS)

Qy

(AD) 1

Q 1

P 1

Both Price Level and output will decrease.

In the long-run a decrease in price will not lead to a decrease in output.

Why?

Because as prices decrease so does the price of resources including labor, wages, and materials.

As a result the Aggregate supply will shift to the right (increase) and we will find ourselves back at full employment.

(AS 1)

P 2

A

B

C

Inflationary and Recessionary Gaps- Steering the Market

Economic Activity

Time (years)

Potential GDP

Inflationary Gap

Recessionary Gap

The Government can steer the economy in different ways1. Laws and Regulations- stabilizers2. Fiscal Policy- changes in government spending or taxation to influence the economy3. Monetary policy- changes in monetary supply to influence the economy

AS/AD/LRAS graphs- Inflationary Gap

AS

AD 1

GDP real

Price Level

Q1

Fiscal Policy:

Monetary Policy:

LRAS

Q yFE

Actual GDP > Potential GDPOutput is beyond full employment

Unemployment very lowPrices very high

P1Government wants to limit inflation by reducing demand

AD 2

P2 How do they do it?

Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE

Federal Reserve can decrease money supply or increase interest rates. AD = C + I + G + NE

AS/AD/LRAS graphs- Recessionary Gap

AS

AD 1

GDP real

Price Level

Q1

Fiscal Policy:

Monetary Policy:

LRAS

Q yFE

Actual GDP < Potential GDPOutput is below full employment

High unemployment

P1

Government wants to limit unemployment by increasing demand

AD 2

P2

How do they do it?

Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE

Federal Reserve can increase money supply or decrease interest rates. AD = C + I + G + NE

Supply-side theory in AS/AD/LRAS

v v v

LRAS 1 LRAS 2 LRAS 3

Supply side economics

1. Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.

2. This increases potential output

3. There are a number of methodsa. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment

benefitsb. Invest in educationc. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)d. Lower corporate tax ratese. Invest in infrastructure

4. Eliminate safety nets and allow for profit and loss

http://econstories.tv/

http://www.econedlink.org/lessons/index.php?lid=593&type=educator

Phillips Curve and problems with curve