Introduction to ADAS Model

1
Introduction to AD-AS Model

• AD-AS model is a variable price model.
• AD-AS model provides insights on inflation,
  unemployment, and economic growth.

2
Aggregate demand is a schedule or curve that
shows the various amounts of real domestic output
that domestic and foreign buyers will desire to
purchase at each possible price level.
3
The aggregate demand curve is shown in Figure
11-1.

• It shows an inverse relationship between price
  level and real domestic output.
• The explanation of the inverse relationship is
  not the same as for demand for a single product,
  which centered on substitution and income
  effects.
• a. Substitution effect doesnt apply within the
  scope of domestically produced goods, since there
  is no substitute for everything.
• b. Income effect also doesnt apply in the
  aggregate case, since income now varies with
  aggregate output.

4
What is the explanation of the inverse
relationship between price level and real output
in aggregate demand?

• Real balances effect When price level falls,
  the purchasing power of existing financial
  balances rises, which can increase spending.
  (think savings accounts)
• Interest-rate effect A decline in price level
  means lower interest rates that can increase
  levels of certain types of spending. (thing home
  purchases)
• Foreign purchases effect When price level
  falls, other things being equal, U.S. prices will
  fall relative to foreign prices, which will tend
  to increase spending on U.S. exports and also
  decrease import spending in favor of U.S.
  products that compete with imports.
• All of these dive the demand slope downward.

5
Determinants of aggregate demand

• Determinants are the other things (besides
  price level) that can cause a shift or change in
  demand (see Figure 11-2 in text). Effects of the
  following determinants are discussed in more
  detail in the text.
• Two things cause shifts.
• A. determinates
• B. the multiplier effect

6
Determinants of aggregate demand

• Changes in consumer spending, which can be caused
  by changes in several factors.
• a. Consumer wealth
• b. Consumer expectations
• c. Household indebtedness
• d. Taxes
• Changes in government spending.

• Changes in investment spending, which can be
  caused by changes in several factors.
• a. Interest rates,
• b. Expected returns, which are a function of
• Expected future business conditions
• Technology
• Degree of excess capacity
• Business taxes

7
net export spending

• Changes in net export spending unrelated to price
  level, which may be caused by changes in other
  factors such as
• a. National income abroad
• b. Exchange rates Depreciation of the dollar
  encourages U.S. exports since U.S. products
  become less expensive when foreign buyers can
  obtain more dollars for their currency.
  Conversely, dollar depreciation discourages
  import buying in the U.S. because our dollars
  cant be exchanged for as much foreign currency.

8
Aggregate supply

• Aggregate supply is a schedule or curve showing
  the level of real domestic output available at
  each possible price level.

9
Aggregate supply in the long run (Figure 11-3)

• 1. In the long run the aggregate supply curve is
  vertical at the economys full-employment output.
• 2. The curve is vertical because in the long run
  resource prices adjust to changes in the price
  level, leaving no incentive for firms to change
  their output.

10
Aggregate supply in the short run

• 1. The short-run aggregate supply curve is
  upward sloping.
• 2. The lag between product prices and resource
  prices makes it profitable for firms to increase
  output when the price level rises.
• 3. To the left of full-employment output, the
  curve is relatively flat. The relative abundance
  of idle inputs means that firms can increase
  output without substantial increases in
  production costs.
• 4. To the right of full-employment output the
  curve is relatively steep. Shortages of inputs
  and production bottlenecks will require
  substantially higher prices to induce firms to
  produce.
• 5. References to aggregate supply in the
  remainder of the chapter apply to the short-run
  curve unless otherwise noted.

11
Determinants of aggregate supply

• 1. A change in input prices, which can be
  caused by changes in several factors.
• a. Domestic resource prices
• b. Prices of imported resources
• c. Market power in certain industries
• 2. Changes in productivity (productivity real
  output / input) can cause changes in per-unit
  production cost (production cost per unit total
  input cost / units of output). If productivity
  rises, unit production costs will fall. This can
  shift aggregate supply to the right and lower
  prices. The reverse is true when productivity
  falls. Productivity improvement is very
  important in business efforts to reduce costs.
• 3. Change in legal-institutional environment,
  which can be caused by changes in other factors.
• a. Business taxes and/or subsidies
• b. Government regulation

12
Equilibrium Real Output and the Price
LevelEquilibrium price and quantity are found
where the aggregate demand and supply curves
intersect.
13
Increases in aggregate demand cause demand-pull
inflation

• Increases in aggregate demand increase real
  output and create upward pressure on prices,
  especially when the economy operates at or above
  its full employment level of output.
• 2. The multiplier effect weakens the further
  right the aggregate demand curve moves along the
  aggregate supply curve. More of the increase in
  spending is absorbed into price increases rather
  than generating greater real output.

14
Decreases in AD If AD decreases, recession and
cyclical unemployment may result. Prices dont
fall easily.

• Wage contracts are not flexible so businesses
  cant afford to reduce prices.
• Employers are reluctant to cut wages because of
  impact on employee effort, etc. Employers seek
  to pay efficiency wages wages that maximize
  work effort and productivity, minimizing cost.
• Minimum wage laws keep wages above that level.
• Menu costs are difficult to implement.
• Fear of price wars keeps prices from being
  reduced.

15
Shifting aggregate supply occurs when a supply
determinant changes.

• 1. Leftward shift in curve illustrates
  cost-push inflation (see Figure 11-9).
• 2. Rightward shift in curve will cause a decline
  in price level (see Figure 11-10). See text for
  discussion of this desirable outcome.
• 3. In the late 1990s, despite strong increases in
  aggregate demand, prices remained relatively
  stable (low inflation) as aggregate supply
  shifted right (productivity gains).