Chapter 11 Aggregate Demand

1
AD/AS
LRAS
AD Shifters CIgGXn Consumption Gross
Investment Government Spending infrastructure,
military spending, health care Net Exports
PL
SRAS2
AS Shifters REP Resource
cost Environment legal-institutional 1.
Subsidies, 2. Business taxes, 3. Business
regs. Productivity
AD2
SRAS1
AD1
CIG-X
SRAS2
AD2
3
RGDP
YR
Y
YI
Aggregation we are combining all prices into
price level combining all quantities into Real
GDP(Y).
Y indicates 3 things 1. OutputGDP 2. Income
3. Unemployment YR Recession gap YI
Inflation gap Y Full Employ.
Dont confuse FE output with the economys
maximum output, which is the larger output
that would be produced if everyone were
forced to work as much as possible.
2
Macro Law of Demand Law of
AD
Change in AQD
Inverse
Price Level Change Point to Point Movements
AD
PL1
PL2
AQD1
AQD2
AQD
PL
3
Macro Law of Supply
Law of AS
Change in AQS
DIRECT
PL Change, Point to Point Movement
AS
PL1
PL2
AQS2
AQS1
4
Macro Law of Supply Law
of AS
Change in AQS
DIRECT
PL Change, Point to Point Movement
AS

PL1
PL2
AQS2
AQS1
5
Consumption(C)Gross Investment(Ig)GXn
Shifts in the AD Curve
SRAS
AD2
AD1
Price Level
or CIG-X
AD3
Shortage
PL
AQD
AQD
Surplus
Raise PL
Quantity of Output
Y2
Y3
Y
6
REP
Shifts in the AS Curve
SRAS1
SRAS2
AD
SRAS3
Shortage
Price Level
AQS
AQS
Surplus
Raise PL
Lower PL
Productivity
Y3
Y2
Y
Quantity of Output
A 1 increase in productivity can eliminate 1.2
million jobs.
7
The Long-Run AS Curve
LRAS
AD
SRAS
Output at Full Employment
PL
Y
Quantity of Output
8
Decrease in AD
LRAS
SRAS
AD1
Price Level
AD2
PLe
Surplus
PL2
Ye
Quantity of Output
YR
9
Decrease in AS
LRAS
SRAS
AD
Price Level
PLe
Quantity of Output
Ye
10
Stagflation
Decrease in AS
LRAS
SRAS2
Price Level
SRAS1
AD
10
PLe
Quantity of Output
5 YF
10 YR
11
Demand (AD) for everything by everyone or
Amount of goods services that will be
demanded at various price levels by householders,
businesses, government and foreigners AQD will
be greater at lower price levels
Aggregate Demand
Aggregate Supply amount of goods and services
that will be produced at various price
levels AQS will be greater at higher price
levels
Aggregation combining all prices into a single
aggregate price level and combining all
quantities into aggregate quantities AQS or real
GDP
12
Interest Rates

• Nominal interest rate 5
• Measures interest in terms of the current dollars
  paid lets say 5 on a 3-month T-bill
• Appears on the borrowing agreement
• The rate quoted in the news media
• Real interest rate 3
• Equals the nominal rate of interest 5 minus
  the inflation rate lets say 2
• Expressed in dollars of constant purchasing power
  3

13
Interest Rates

• With no inflation, the nominal and real interest
  rates would be identical lets say, 3
• With inflation 2, the nominal interest rate
  5 exceeds the real interest rate 3
• If the inflation rate is high enough 6, the
  real interest rate can actually be negative -1
  or 5 - 6 -1
• The nominal interest would not even offset the
  loss in spending power because of inflation ?
  lenders would lose purchasing power
• This is why lenders and borrowers are concerned
  more about the real interest rate than the
  nominal interest rate

14
MACROECONOMICS FRQ
2006
15
FRQ 2006
Nominal Interest Rate
Real I.R. anticipated inflation nominal I.R.
2



Inflation Premium
Nominal Interest Rate
Real Interest Rate

16
FRQ 2006
Real Interest Rate
Nominal I.R. inflation rate Real I.R.
-

Real Interest Rate
Inflation Premium
Nominal Interest Rate
-

17
FR 2006
2 (c) Suppose that the nominal interest rate has
been 6 with no expected inflation. If
inflation is now expected to be 2, determine the
value of each of the following. (i) The new
nominal interest rate (ii) The new real
interest rate
Answer 2(c)(i) The nominal interest rate is
8. 6 real 2
expected inflation premium Answer 2(c)(ii)
The new real interest rate would be 6.
8 new nominal interest rate 2
anticipated inflation 6 real I.R.
6
Real I.Rates
18
If expected returns exceed the real interest
rate of interest, the firm will normally make
the investment.
Marginal Efficiency of Investment
One firms demand curve for investment
30 25 20 18 15 10 5
MEI 27
This is what we call, interest rate sensitive
Ig.
MEI20
MEI15
Real Interest Rates
MEI12
Add new wing to factory 1 mil.
MEI 7
Acquire additional power facilities 1.5 mil.
Purchase machines 1.5 mil.
Renovate plant 2 million
Install computer system 1 mil.
0 1 2 3 4
5 6
QID Quantity of Investment Demanded (millions)
19
25 15 10
MEI
Macro Economys AD Curve for Ig
Firms invest with their profits also borrow(5)
to invest.(10)
20
A 20 cost of funds attract 100 billion
of investment
Real Interest Rates
I.R. QID
5
A 5 cost of funds attracts 200 bil. Ig
DI (MEI)
150
200
100
0
50
250
QID1
QID2
Change in QID interest rate change, point to
point movements
20
AGGREGATE DEMAND
The amounts of real output that buyers
householders, businesses, government,
foreigners desire to purchase at each
possible price level. Or, the demand for
everything by everyone.

• AD curve is downsloping due to
• Real Wealth Money-balances Effect
• monthly flow of money and stock of
  accumulated
• savings balances like bonds CDs really
  buy more
• Interest-Rate Effect - businesses invest more
• Foreign Purchases Effect - foreigners buy more
• There is no income or substitution effect.
• You cant substitute for the whole economy

AD
PL1
PL2
AQD1
AQD2
21
AD
Three Reasons For Downward Sloping AD Curve
Real Wealth Money-balances Effect economys
monetary wealth. If we buy a fixed bundle of
goods services every month (food/clothing/
shelter), at lower prices, it now takes less
money. money. Our accumulated savings balances
401k, CDs, bonds will purchase more.
PL1
PL2
Market Basket
Interest Rate Effect lower interest rates
increase investment and consumption.
Foreign Purchase Effect with lower U.S. prices,
both Americans and foreigners buy more American
goods.
22
Law of Aggregate Demand Change in AQD
Reasons For Downsloping AD Curve if PL
decreases, this happens 1. Interest Rate Effect
more Ig 2. Real-balance Effect more C 3.
Foreign Purchase Effect - foreigners buy more
Macro Law of Demand cause effect PL
decr AQD incr. PL incr AQD decr. AD refers
to whole curve. AQD is a pt on the curve based
on a particular PL.
AD
PL1
Change in AQD 1. Price Level change 2. Movement
up or down the AD curve 3. Pt to pt along
the AD curve
PL
AQD
PL2
Inverse relationship
AQD2
AQD1
AD refers to the whole curve. all
PLs AQD refers to a point on the
curve based on a particular price level.
23
C
Change in AD
1. Non price Level change-either C, Ig, G, or
Xn 2. Whole AD curve shifts There is a change
in AQD but it is not caused by a change in price
level.
Consumption Mariah Carey Concert
Ig
AD2
AD1
AD3
G
PL
Let there be more military weapons
XN
AQD1
RDO
AQD3
AQD2
Chevy Ferarri
Exports-Imports
24
AD2
AD1
What Will Shift AD To The Right?
PL
Change in Consumer Spending
Consumer Wealth increases/decreases
stocks/houses stable prices Consumer
Expectations about future prices
(increases/decreases) Consumer Expectations
about future income positive/negative
Consumer Indebtedness low/high Personal Taxes
increase/decrease Real Interest Rate stable
prices increase/decrease
Change in Investment Spending
High Debt
Real Interest Rates stable prices
increase/decrease Positive/Negative Profit
Returns Business taxes increase/decrease
Depleted/Excess inventory stockpiles in the
supply chain
25
Shifters of the AD Curve


continued
Government Spending purchases either
increases/decreases on infra- structure,
military, health care, etc.
Net Export Spending
AD2
AD1

• National Income Abroad
• either increases or decreases

• Exchange Rates
• Depreciation-increases AD Appreciation-decrea
  ses AD

PL
More Exports Our products are cheaper
Fewer Exports Our products are more expensive
26
Macro Law of Supply "Law of AS"
Price Level increases AQS increases Price
Level decreases AQS decreases
Direct
AS refers to the whole AS curve refers to
all price levels AQS refers to a point on
the AS curve refers to a particular price
level
AS
Change in AQS 1. Price Level change 2. Movement
(up/down) AS curve) 3. Point to point (along
AS curve)
PL2
PL1
AQS1
AQS2
Reasons For Upsloping AS Curve 1. There is
increasing opportunity cost if firms dont
produce. 2. Current producers produce more
overtime/more shifts 3. New producers are
attracted to the market.
27
Change in AS
1. Non price level change. Either R, E, or
P 2. Whole AS curve shifts. 3. AQS changes but
is not caused by a change in PL
Anything that lowers the cost of
production will shift AS right.
AS Shifters(REP) 1. Resource cost 2. Environment
legal-institutional environment for
businesses change, affecting production
costs subsidies, bus. taxes,
regulations 3. Productivity
AS3
AS1
AS2
So AS Shifters are REP
Increase in the availability of Resources
PL
You save money. We dont require dental or
medical insurance. You dont have to pay us a
pension and we dont take sick days. And
we can dance.
1. Lower business taxes 2. Decrease in
regulations 3. Increase in subsidies
Environment Legal-institutional
AQS1
AQS2
AQS3
Increase in Productivity
28
Recessionary Gap, Inflationary Gap, or no gap
AD/AS
LRAS
SRAS
AD1
10
AD3
AD2
3
1
Recess Gap
Inflat Gap
1 YI YA 11
11 YR YA 9
6 Y YP 10
10(5x2) Inflationary GDP Gap
5(real) cyclical unemployment 10 (5x210)
Recess. GDP Gap
SR output product prices increase/decrease
but input wages prices remain fixed
in the presence of unanticipated
inflation/disinflation. LR both output
product and input wages prices change.
29
Y, Employment, and PL after correction
SRAS2
SRAS
LRAS
SRAS3
AD1
10
AD3
AD2
3
1
Recess Gap
Inflat Gap
1 YI YA 11
11 YR YA 9
6 Y YP 10
10(5x2) Inflationary GDP Gap
5(real) cyclical unemployment 10 (5x210)
Recess. GDP Gap
Input prices have responded to unanticipated
changes in output prices in LR. They respond
to unanticipated inflation or disinflation. Two
sets of prices are changing in LR - output and
input.
30
The 3 Situations No Gap, Recessionary Gap,
Inflationary Gap
SRAS
LRAS
AD1
10
AD3
AD2
3
1
Recess Gap
Inflat Gap
1 YI YA 11
11 YR YA 9
6 Y YP 10
10(5x2) Inflationary GDP Gap
5(real) cyclical unemployment 10 (5x210)
Recess. GDP Gap
No Gap (Y) - Potential Output(10 tr.) equals
Actual Output(10 tr.) Actual Unemployment
rate(6) equals Potential Unemployment
Rate(6) Recessionary Gap - Potential Output(10
Tr.) exceeds Actual Output(9 tr.) Actual
Unemployment Rate(11) exceeds Potential
Unemployment Rate(6) Inflationary Gap Potential
Output(10 tr.) is less than Actual Output(11
tr.) Actual Unemployment. Rate (1) is less than
Potential Unemployment Rate (6)
31
Derivation of the AS Curve
AD4
AS
AD3
PL2
AD1
AD2
Pure Inflation
PL1
Keynesian
RDO
Y1
Y3
Y2
AD1
AS
AD2
PL1
PL2
Classical
Y RDO
YR
AS2
AD
10
AS1
PL(3)
Supply-side
Goal was to increase AS to help Y and decrease
PL
Y RDO
10
AS
Modified Keynesian
Classical segment
PL
Developed in 70s
Eclectic AS Curve
Supply-side segment
Keynesian segment
32
AS - amount of real output firms will produce
at each PL. Higher price levels provide an
incentive to produce more. AS has three ranges
1. Horizontal (Keynesian) 2.
Intermediate 3. Vertical
(Classical)
Three Segmented AS Curve 16
AS
Vertical Classical Range
Horizontal Keynesian Range
Price level
Upsloping or Intermediate Range
Q
Real domestic output, GDP
33
AD/AS 28, 29, 30
PL
AS
Vertical Classical Range
AS6
AD5
PL6
Pure Inflation
AD4
AD3
PL5
Price level
AD2
AD1
PL4
Upsloping or Intermediate Range
PL3
PL1
Horizontal
Q
Y1
Y2
Y4
Y3
Y5
Real domestic output, GDP
34
AS Shifts 32
Beneficial Supply Shock
Adverse Supply Shock
AS3
AS1
AS2
AD
Decrease in AS
AD
Price level
AD
Increase in AS
Q
Real domestic output, GDP
35
Objectives of the AD-AS Chapter
1. Define AD AS AD AQD at various price
levels inverse Everyones demand for
everything AS AQS at various price
levels direct 2. Three reasons for the
down-sloping AD curve a. interest rate effect
b. real-balances effect c. foreign purchase
effect 3. Know the three ranges of the AS
curve 4. Predict effects of an increase in
AD in Keynesian, intermediate, classical
ranges 5. Predict effects of an increase/decrease
in AS on output and price level 6. Know the
four AD shifters CIgGXn 7. Know the three AS
shifters REP 8. Explain the ratchet effect of
a decrease in AD next
36
Ratchet Effect
What goes up in Econ need not come down
at least not to its original level.
A ratchet permits one to crank a tool forward
like a socket wrench but not backward.
Sticky Price Theory
LRAS
AD2
AD3
AD1
Sticky
PL2
PL1
YR1
YR2
Y
Real Domestic Output
37
Sticky Prices
The economy has fallen and cant get up.
Recession
Full Employment
SRAS
Recession
AD2
AD3
AD1
Sticky
Sticky prices lead to sticky wages.
John Maynard Keynes
PL2
PL1
Real Domestic Output
RDO1
RDO2
RDOFE
Because prices are sticky down, the resulting
downturn is worse because prices are higher
which decreases output further.
38
Demand-Pull Inflation
Good News more jobs Bad News higher
prices
AS
AD2
AD1
PL2
Bad News -higher prices
PL1
Good News - more jobs
YI
Y
39
Disinflationary Recessions
Good Newslower prices Bad Newsjob losses
AD1
AS
AD2
PL1
Good news -lower prices
PL2
Bad news - job losses
YR
Y
40
bad news job losses bad news inflation
Adverse Supply Shock
AS2
LRAS
AS1
AD
10
The economy is stagnating but inflating
Inflating
1.
2.
PL1
Stagflation
Stagnating
Y
10
41
good newsjob gains good newsdisinflation
Beneficial Supply Shocks
AS1
AD
AS2
99 cents
3.00
PL1
Good news, lower prices
Good news, more jobs
PL2
Y2
Y1
42
1. The process of combining all individual
product prices and quantities into a single
unit is (deduction/conglomeration/aggregation).2.
The AD curve shows the amount of (real/nominal)
domestic output which will be purchased at
each possible (price/price level).3. The AD
curve is always (up/down) sloping shows a(an)
(direct/inverse) relationship between output
(price/price level). 4. The income
substitution effects (do/do not) apply to the AD
curve. The 3 explanations for the downsloping
AD curve are the interest rate effect,
foreign purchase effect, (econ/real-balances)
effect.
1-4 on NS
Change in AQD Price Level Change Point to Point
movements
AD
PL1 PL2
AQD
PL
AQD1
AQD2
43
NS 5, 6, 7
5. The interest rate effect suggests that an
increase in the PL will (incr/decr) the
demand for money, (incr/decr) interest
rates and (increase/decrease) consumption and
investment which would cause a(an)
(increase/decrease) in (AD/AQD). 6. The
real-balances effect indicates a higher price
level will (increase/decrease) the real
value of money, (increase/decrease)
consumption, and therefore (increase/decrease)
(AD/AQD). 7. The foreign purchase effect
suggests that an increase in PL relative to
other countries (increase/decrease) our exports
and (incr/decr) our imports which would
(incr/decr) (AD/AQD).
AD
PL2 PL1
Higher PL
Lower PL
AQD2 AQD1
44
C
Change in AD
1. Non price Level change-either C, Ig, G, or
Xn 2. Whole AD curve shifts There is a change
in AQD but it is not caused by a change in price
level.
Consumption Britney Spears Concert
Ig
AD2
AD1
AD3
G
PL
Let there be health care for everyone.
XN
RDO
AQD2
AQD1
Corvette Ferarri
AQD3
Exports-Imports
45
What Will Shift The AD Curve Right?

CIgGXn Consumer Spending Increase 1.
Aggregate wealth increases independent of PL
stocks, bonds, land, houses, etc. 2.
Expectations of surging future inflation 3.
Consumer indebtedness is fairly low 4. Consumer
taxes are decreased 5. Interest rates are
decreased independent of PL
AS
AD2
AD1
PL
Investment Spending Increase 1. Interest rates
are decreased independent of PL 2. Positive
profit expectations 3. Factory inventories are
down 4. Business taxes are reduced will also
shift AS
Y1 Y2
100 Bases May Face Closure Rumsfields
cuts would start in 06 100 of the
nations 425 bases would be closed, saving
over 75 billion annually.
Government Spending Government spending increases
on health care, military bases, infrastructure,
etc.
Health care, infrastruc., military
Net Export Spending Increases 1. Foreign incomes
increase will buy more there and here 2. Dollar
depreciates our exports are cheaper
46
What Will Shift The AS Curve Right?
AS2
AS1

• Resource Cost Decrease(domestic)
• Land new raw materials (oil) are found
• Laborlabor force increases or wages decrease
• Capital stock or entrepreneurial ability
  increases
• The number of sellers of resources increase

AD
PL1
PL2
Y1
Y2

• Resource Cost Decrease(overseas)
• Imported resources decrease in price
• Dollar appreciates foreign inputs are cheaper
• OPEC nations cheat by producing more oil

Environment Legal-Institutional Environment for
businesses change 1. Subsidies are increased 2.
Regulations on businesses are decreased 3.
Business taxes decrease
Productivity Increases Technological breakthrough
leads to an increase in productivity more
outputs from same inputs Notice that a decrease
in business taxes increases both AD AS.
47
NS 8-18
8. There are (3/4) AD Shifters, that have nothing
to do with PL. They are consumption(C),
investment(IG), G , Xn. 9. An increase in
consumption will shift the (AD/AS) curve to the
(right/left). 10. (A change in PL/A decline in
the interest rate no change in PL) will cause a
shift in the AD curve to the (right/left). 11.
An increase in the PL will cause a (shift in the
AD curve to the left/shift in the AD curve
to the right/decrease in AQD movement up along a
stable AD curve). 12. An increase in investment
caused by a decline in the interest rate
independent of the PL will (cause a
movement along a stable/shift the) AD curve to
the (right/left). 13. If the government decides
to spend 60 billion on the infrastructure,
this will shift the (AD/AS) curve to the
(right/left). 14. If the national incomes of our
major trading partners were to decrease,
therefore Xn will change our (AD/AS) curve
would shift to the (right/left). 15. (An
increase in the PL/A decline in business taxes)
would not shift the AS curve. 16. Range 1 of
the AS curve is call_____________, range 2
is called _____________, range 3 is called
_________. 17. An increase in the PL will cause
(a(n) (shift to the right of the AS curve/
shift to the left of the AS curve/increase in the
AQS move up a stable AS curve). 18. A decrease
in the PL will cause a(n) (shift to the left of
the AS curve/shift to the right of the AS
curve/decrease in AQS move down a stable AS
curve)
Horizontal
3
Classical
Intermediate
2
1
48
Change in AS
1. Non price level change. Either R, E, or
P 2. Whole AS curve shifts. 3. AQS changes but
is not caused by a change in PL
Anything that lowers the cost of
production will shift AS right.
AS Shifters(REP) 1. Resource cost 2. Environment
legal-institutional environment for
businesses change, affecting production
costs. subsidies, bus. taxes,
regulations 3. Productivity
AS3
AS1
AS2
So AS Shifters are REP
Increase in the availability of Resources
PL
You save money. We dont require dental or
medical insurance. You dont have to pay us a
pension and we dont take sick days. And
we can dance.
1. Lower business taxes 2. Decrease in
regulations 3. Increase in subsidies
Environment Legal-institutional
AQS1
AQS2
AQS3
Increase in Productivity
49
Productivity
Productivity how many outputs (pies) can be
produced from a set amount of inputs (apples).
1 2
3 4
5
1 2 3 4 5
6 7 8 9 10
Productivity 2 outputs10/inputs5
50
Shifters OF AS (REP) continued

Change in Productivity
Environment for businesses change
Legal-institutional environment

• Business Taxes /Subsidies
• Government Regulation

Worker-Hours Required To Produce 100 Bushels
1800 1900 2006 Wheat 373 108
3 Corn 344 147
3
51
Productivity
Productivity changes (measure of average
output) How many outputs can be obtained from a
certain amount of inputs.
Productivity (2) real output (10 units)
Inputs (5
units)
An increase in productivity means more real
output can be obtained from the same
inputs. Does productivity alter per unit
production cost? (If output is 10 units, input
quantity is 5 units, and price of each input is
2)
Per unit production cost(1) Total input
cost(10)2x5
Units of output (10)
Suppose output doubles to 20 units, input
quantity is 5 units, price of each unit is 2.
Per unit production cost(.50) Total input
cost(10) Units
of output (20)
52
Critical factor that determines future living
standards
Productivity Shorts

• What took a worker in 1890 one hour to produce
  takes a worker in a leading economy today 7
  minutes.
• It took 12.5 worker hours to assemble a Ford
  Model T chassis with no assembly line, 6 hours
  with a rope-driven assembly line and 1.5 hours
  with a continuous chain-driven assembly line.
• Annual production of the Model T
• jumped from less than 6,000 to 600,000.
• The price dropped from 950 to 260.

1 of productivity growth can eliminate 1.3 mil.
jobs a year. Of the 2.7 mil. jobs lost from
2001-2003, only 300,000 were lost from
outsourcing. Most of the job losses were due to
increases in productivity.
53
NS 19-27
19. An increase in the price of imported
resources would cause the (AD/AS) curve to
shift (rightward/leftward). 20. A rightward
shift of the PPC will shift the (AD/AS) curve to
the (right/left). 21. An improvement in
productivity technological improvement will
shift the (AD/AS) curve to the (right/left).
Suppose that real domestic output is 40 units,
the quantity of inputs is 20 the price of each
input is 8. 22. What is the level of
productivity? Productivity(__) Output(40)
Inputs (20) 23. What is the per unit
cost of production? Total input cost
160(8x20) Per unit production
cost (___) Units of output (40) 24. If
the price of each input increased from 8 to 12,
productivity would (increase/decrease/
remain unchanged. affects only per unit
cost 25. Increase in input price 8 to 12
wold shift the (AD/AS) curve (right/left).
2
4
26. An increase in the price of imported
resources would increase per unit
production cost and shift the (AD/AS) curve to
the (right/left). 27. A depreciation of the
dollar would cause imported inputs to be more
expensive shift the AS curve to the
(right/left), however, the cost of our
products would decrease so it would shift the AD
curve (right/left).
54
Equilibrium PL Output shortages/surpluses
PL
AD
AS
Price Level
Equilibrium in the Intermediate Range
Surplus
PL2
PLe
PL1
Shortage
Y
AQS1
AQD2
Ye
Real Domestic Output, GDP
55
CHANGES IN EQUILIBRIUM 28
Increasing Demand in the Horizontal Range
PL
AS
AD2
AD1
Price Level
PL1
Y1
Y2
Real Domestic Output, GDP
56
CHANGES IN EQUILIBRIUM 29
Increasing Demand in the Intermediate Range
PL
AS
AD4
AD3
Price Level
PL4
PL3
Y4
Y3
Real Domestic Output, GDP
57
CHANGES IN EQUILIBRIUM 30
Increasing Demand in the Vertical Range
AD6
AD5
AS
PL
PL6
Price Level
PL5
Q
Y5 6
Real Domestic Output, GDP
58
Ratchet Effect
What goes up in Econ need not come down
at least not to its original level.
A ratchet permits one to crank a tool forward
like a socket wrench but not backward.
Sticky Price Theory
LRAS
AD2
Increases in AD ratchet the PL upward. Once
in place, the higher PL remains in place until
it is ratcheted up again. The higher PL tends
to remain with declines in AD. Prices have gone
up every year since 1954.
AD3
AD1
Sticky
PL2
PL1
31. The ratchet effect says that prices
are flexible upward but inflexible
downward.
YR1
YR2
Y
Real Domestic Output
59
Reasons for the Ratchet Effect
Why AD may decrease but PL wages may not
decrease

• Wage Contracts
• Fear of Price Wars
• Efficiency Wages
• Minimum Wage
• Menu Costs
• Morale, Effort, Productivity

AD2
LRAS
AD1
Sticky
PL2
PL1
Y3 Y1 Y2
60
Decreases in AD in Horizontal Range
Decreasing Demand That Worsens A Recession
AS
AD1
AD2
Price Level
P1
Y2
Y1
Real Domestic Output, GDP
61
Decreasing Supply That Causes A Recession
AS1
AS2
AD
Earthquake
Tornado or a Tsunami
P2
Price Level
Stagflation
P1
Q1
Q2
Real Domestic Output, GDP
62
INCREASES IN AD but -
an increase in productivity increases AS,
lowering inflation 32
AD2
AD1
AS2
AS1
P3
P2
Price Level
P1
Q2
Q3
Q1
Real Domestic Output, GDP
63
Bath Tub Approach to Economics
Consumption Investment Gov. Spending Exports
Full Employment Frictional structural
Injections
Income Employment Output
Classicals A leakage down the drain of
saving is returned thru the spigot of
investment.
Saving Taxes Imports
Leakages
An economy in equilibrium at FE
64
Too Much Ig, G, or X
Too Much S, T, or M
LRAS
SRAS
AD1
10
AD3
AD2
3
1
Recess Gap
Inflat Gap
1 YI YA 11
11 YR YA 9
6 Y YP 10
10(5x2) Inflationary GDP Gap
5(real) cyclical unemployment 10 (5x210)
Negative GDP Gap
65
Inflation Too Much Ig, G, or X
Inflationary Gap too much G, Ig, or X
Injections
66
Recession Too much S, T, or M
Recessionary Gap too much S, T, or M
Leakages
67
33-42 on NS
REP
D
___33. Decrease in the availability of key
natural resources (R)? ___34. Increase in
resource productivity (P)? ___35. Increase in
foreign spending on our products (Xn)? ___36.
Substantial reduction in government spending
(G)? ___37. Declines in the prices of imported
resources (R)? ___38. Declines in the incomes of
our trading partners (Xn)? ___39. Improvement in
business profit expectations (Ig)? ___40. Stock
market plunge affects consumer wealth (C)? ___41.
There is an increase in interest rates stable
prices (C Ig)? ___42. Consumer indebtedness is
very low (C)? Extra ___43. Increased government
regulations are forced on businesses (E)? ___44.
The government increases subsidies to all farmers
(E)?
C
A
B
C
B
A
B
B
A
D
C
68
Points of Emphasis for AD/AS Questions

• 1. Wages (labor), this is resource cost, so AS
  shifter
• 2. Increase/decrease in union workers hired
• they get paid more so labor, so AS
  shifter
• 3. Appreciation/depreciation of a currency
  either AD or AS
• a. Resource cost part of REP AS shifter
• b. Exports are part of CIgXn AD shifter
• 4. Regulations and subsidies legal
  institutional
• Environment, part of REP, so AS shifter
• 5. For all CIgGXn, does the situation
  result in
• an increase or decrease in AD therefore
  GDP?
• 6. For REP, think of production costs
• if producers make more money, there is an
  increase in AS,
• if producers make less money there is
  a decrease in AS.

69
Practice Quiz 1

__1. Consumers fear a widespread
depression. __2. Britain and Japan increase their
purchases of U.S. agricultural
products. __3. Our exports are affected by a
depreciation of the dollar. __4. There is a huge
increase in government spending for
health care. __5. Interest rates increase
although prices are stable. __6. 20 increase in
the personal income tax. __7. An increase in
labor productivity. __8. A 15 decrease in
nominal wages. __9. Appreciation of the dollar
affects imported resources. __10. Canada, Mexico,
Japan come out of recession and buy
more American cars.
REP
B
A
A
A
B
B
C
C
C
A
70
An Overview of the AD/AS Model
Change in AQD Change in PL Movement
Point to point
Part 1 Why is the AD Curve Downsloping? 1. The
relationship between the PL and real
domestic output is (direct/inverse). 2. Explain
how each of the following effects explain
why the AD curve, at lower price levels is
downward sloping. A. Interest rate effect - a
lower PL means a lower/higher) interest
rate resulting in (decreased/increased)
output. B. Real-balances effect a lower PL
will (decrease/increase) the value of
our wealth result in (decreased/increase
d) output. C. Foreign purchases
effect a lower PL will make our goods
(cheaper/more expensive) relative to
other countries and will result in
(increased/decreased) output.
AD
PL1
PL2
AQD1 AQD2
Real GDP
71
AD Shifters (CIgGXn) Change in AD non
PL/shift/whole curve
C
D
A
E
B
CIG-X
PL
Part 2 Shifts in AD A. Increase AD? B.
Decrease AD? C. No Change in AD (movement) D.
Do not shift beyond A or E
Real GDP
We will start at AD curve C.
1. Congress funds ten new military bases with 20
billion. AD__Curve__ 2. Due to consumer
pessimism, businesses cut back on Ig.
AD__Curve__ 3. Ten billion G revenues are sent to
Texas to help on High 10. AD__Curve__ 4.
Foreigners increase their demand by 50 for our
computers. AD__Curve__ 5. Business leaders feel
economy is headed for a recession.
AD__Curve__ 6. Stock market collapses and
investors lose billions.
AD__Curve__ 7. Productivity rises for 3rd
straight year due to increases in technology.
AD__Curve__ 8. President and Congress cut defense
spending by 20 AD__Curve__ and there
is no increase in domestic spending.
D

-
C
D

E

-
D
-
C
C
NC
-
B
72
Part 3 Why Does The AS Curve Look So Funny?
Classical
PL
Intermediate
Keynesian
Real GDP
1. Under what conditions would AS be in the
Keynesian range? (horizontal)
_______________________________________________ 2.
Under what conditions would AS be in the
classical range? (vertical) ___________________
______________________________ 3. Under what
conditions would AS be in the intermediate
range? ________________________________________
_________________ 4. What range do you think AS
is in today? __________________________________
_______________________ Why?___________________
__________________________________
Very bad recession or a depression
Very hot economy, such as WWII
At, near, or just beyond full employment
Intermediate
We are below FE, but not in a recession.
73
AS Shifters REP Change in AS non
PL/shift/whole curve
C
A
D
E
B
PL
AD
REP
Part 4 Shifts in AS A. Increase AS? B.
Decrease AS? C. No Change in AS (movement) D.
Do not shift beyond A or E
Real GDP
We will start at AS curve C.
B
-
1. Unions grow more aggressive and wages
increase. AS__Curve__ 2. OPEC
successful increases oil prices resource cost.
AS__Curve__ 3. Labor productivity increases
dramatically.
AS__Curve__ 4. Giant natural gas discovery
decreases energy prices. AS__Curve__ 5.
Computer technology brings new efficiency to
industry. AS__Curve__ 6. Government spends
20 billion on highways.
AS__Curve__ 7. Government announces all auto
owners must install 5,000 AS__Curve__
car engines so that all autos can be fueled by
carrot juice. 8. The international value of
the dollar decreases by 20 AS__Curve__
and affects prices of resources bought overseas.

-
A
B

C


D
D
NC
C
-
-
B
74
Part 5 Equilibrium
AS
AD
PL2
PLe
PL1
Qe
Real GDP
1. The equilibrium PL is ____ the equilibrium
output level output is ____. 2. If the initial
PL and output were PL2 rather than Pe,
equilibrium PL would (increase/decrease) and
equilibrium output level would (increase/decrease)
. 3. If the initial PL were PL1 rather than Pe,
equilibrium PL would (increase/decrease) and
equilibrium output would (increase/decrease).
PLe
Qe
75
Part 6 Changes in Equilibrium Illustrate the
change on the AD/AS graph and indicate the effect
on PL and output by underlining either
increase/decrease/stays the same.
1. Congress passes a middle-class tax cut and the
President signs it. PL
(increase/decrease/stays the same) Real
GDP (increase/decrease/stays the same)
AS
PL
AD2
AD1
PL2
E2
PL1
E1
Y1
Y2
2. During a Great Depression the government
increases spending on schools, highways, and
other public works by 2 billion. PL
(increase/decrease/stays the same) Real
GDP (increase/decrease/stays the same)
AS
PL
AD2
AD1
E1
PL1
E2
Y1
Y2
3. New oil discoveries cause large decreases in
energy prices. PL (increase/decrease/s
tays the same) Real GDP (increase/decrease/s
tays the same)
AS1
AS2
PL
AD
PL1
E1
E2
PL2
Y1
Y2
4. Illustrate the effects of demand-pull
inflation. PL (increase/decrease/stays
the same) Real GDP (increase/decrease/stays
the same)
AS
PL
AD2
AD1
PL2
E2
PL1
E1
Y1
Y2
76
Changes in Equilibrium
Continuted
5. Illustrate the effects of cost-push inflation
Stagflation PL (increase/decrease/stays
the same) Real GDP (increase/decrease/stays
the same)
PL
AS2
AS1
AD
E2
PL2
PL1
E1
Y1
Y2
6. New technology and better education increase
productivity. PL (increase/decrease/sta
ys the same) Real GDP (increase/decrease/sta
ys the same)
AS1
AS2
PL
AD
E1
PL1
E2
PL2
Y2
Y1
7. New President says all AP Econ students who
make As in econ can go to college free. G
will pick up the tab PL (increase/decreas
e/stays the same) Real GDP (increase/decreas
e/stays the same)
AS
PL
AD2
AD1
PL2
E2
PL1
E1
Y1
Y2
8. With an unemployment rate at 7, the
government reduces taxes and increases
government spending. PL (increase/decrease
/stays the same) Real GDP (increase/decrease
/stays the same)
AS
PL
AD2
AD1
PL2
E2
PL1
E1
Y1
Y2
77
1776
Adam Smith 1723-1790
Classical v. Keynesian
1936
John Maynard Keynes 1883-1946
78
Classical Theory
AD1
AS
PL1
Price Level
Adam Smith
RDO
YF
79
Classical Theory Cheaper Excess Supply Creates
Its Own Demand
AS
AD1
AD2
With lower PL, the real-balance, interest rate,
foreign purchase effects kick in and the
surplus disappears and FE is regained.
Surplus
PL1
PL2
YF
YR
RDO
80
Markets in Classical Theory
The next four slides will demonstrate how
flexible interest rates, flexible product
prices, and flexible wages will cause the
economy to equilibrate from recession back to FE.
81
Markets in Classical Theory
(a) Loanable Funds market (dollars)
D
S2
S1
Borrowers
Lenders
Increase in savings
8
5
All right, I get to keep my job.
Quantity (s Saving/investment)
More investment more jobs
82
Markets in Classical Theory
(b) Product Market Beef
D1
D2
S
Consumers
Producers
-20
Decrease in demand for beef
QD1
QD2
Lower prices more consumption
83
Markets in Classical Theory
Resource Market Labor
Recession causes decrease in demand for
workers, so surplus of workers.
S1
D1
Employers
Workers
D2
S2
10
8
Hire more workers
Y
YR
Lower Wages hire more
84
Markets in Classical Theory
(d) Self regulating economy
LRAS
Keynes argued the classical model might explain
the economys operation in the long run but it
might take years.
SRAS1
AD1
PL
AD2
SRAS2
-20
10
8
YR
YR
Y
RGDP
Now, with flexible interest rates, flexible
product prices, flexible wages, lets see how
the economy self-corrects after a recession.
85
Classical View of Inflationary Gap
Self-Correction
LRAS
AS2
AS1
AD2
AD1
E3
E2
PL26
Price Level
E1
PL13
Inflat. Gap
0
Y1
Y2
Real domestic output
86
Classical v. Keynesian
LRAS
Classicals 1776 1930s No G intervention in
economy Founder Adam Smith Bible Wealth of
Nations Macro Policy Do Nothing Motto Supply
creates demand The economy will self-correct in
LR.
AD1
SRAS1
AD2
-20
SRAS2
10
8
Smith
YR YR Y YI
Keynesians 1930-1970s 1992-2000 G intervention
in the economy (Fiscal Pol GT) Founder John
Maynard Keynes Bible The General Theory Macro
Stabilization Policy GT watch M work Motto
Demand creates Supply. In the long run we are
all dead. AE C Ig G Xn
Keynes
87
Monetarists
Monetarists 1960 present No G intervention in
the economy. Founder Milton Friedman Bible
Wealth of Nations Macro Stabilization
Policy Monetary Rule Motto Increase the MS
3-5 year M X V P X Q
3-5
Friedman
Quantity theory of Money
Equation of Exchange
88
Monetarists
Monetary Rule Motto Increase the MS 3-5
year M X V P X Q
The G prevents downward wage flexibility with the
minimum wage, pro-union legislation,
pro-business monopoly legislation, and
subsidies to farmers. Their macro
stabilization policy is Dont do
something. Just Sit there.
3-5
Quantity theory of Money
Friedman
Equation of Exchange
89
Classical v. Keynesian Theory
Unemployment the result of a short-lived
adjustment period.
Prices and wages adjust to restore full
employment
Adam Smith 1723-1790
Unemployment the result of long-term
inadequate demand.
Inflexible sticky prices wages result in
persistent unemployment.
90
Keynesian Theory
The General Theory of Employment, Interest, and
Money John Maynard Keynes (1936)
Keynes argues that no self-correcting mechanism
exists for restoring full-employment. If there
is, then where is it in this Great Depression?
So the Classical School was Keynes whipping
boy.
Take that, Classicals!!!
The Great Depression cried out for a solution
and this began the rallying cry for the
beginning of massive government intervention.
91
Quote from The General Theory
I shall argue that the postulates of the
classical theory are applicable to a special case
only and not to the general case . . . with the
result that its teaching is misleading and
disastrous if we attempt to apply it to the facts
of experience.
92
Keynesian Theory

• Keynesian Theory
• Assumptions
• Businesses may resist lower prices.
• Unions workers may resist lower wages.

Suppose a recession . . .
93
The Keynesian Model the Great Depression.
Keynes The economy is driven by AD.
B
A
AS
P1
AD1
1929 103.1 bil. 1930 90.4 bil.
1931 75.8 bil. 1932 68.0 bil. 1933
56.0 bil.
YF1
Y2
94
The Keynesian Model the Great Depression.
Recall AD C Ig G (X-M)
1929 to 1934
Only thing left
B
A
AS
P1
Exports 67
AD1
YF1
Y2
95
Whats the Keynesian solution?
96
The Keynesian Solution to the Great Depression.
Recall AD C I G (X-M)
B
A
AS
P1
AD1
Y2
YF1
YF3
Keynes Use government spending to stimulate
AD to increase GDP.
97
C l a s s i c a l s Who Are They?
Also, invented S D method for analyzing
markets. Differentiated between shifts of D and
S curves and movements along D and S curves.
D/QD and S/QS By doing so, he cleared up
2,000 years of faulty reasoning.
Jean Say
John S. Mill
Alfred Marshall
David Ricardo
Keynes and Lydia
Thomas Malthus
Adam Smith
Classicals
Doomsday prediction
98
The Classical School includes Adam Smith, Jean
Baptiste Say, Jeremy Bentham, David Ricardo,
Alfred Marshall, Thomas Malthus, and John
Stuart Mill. Summary of Major Classical Ideas 1.
The economy is always close to or on its PPF. 2.
There is no involuntary unemployment, meaning
that anyone who wishes to work can work at
the going wage. The economy is always close
to or at full-employment. 3. What output is
produced will be demanded. Since the output
of an economy is the full-employment output, this
implies that there will be enough spending to
purchase the full-employment. 4. Overall, the
Classical economists believed that the market
economy is a self-adjusting mechanism that
stabilizes itself at FE output. This position
rested on a foundation composed of A. Says
Law, Cheaper excess Supply Creates more
Demand B. Interest Rate Flexibility. The
leakage down the drain of saving is
returned through the spigot of investment.
C. Price Flexibility. Cheaper prices more
AQD D. Wage Flexibility. Lower wages
more workers being hired E. Quantity Theory
of Money. X V X Q
AS
AD
PL
YF
99
Classical No G v. Keynesian G Theory
Classical AS determines output 1.Supply
Creates Demand Says Law Whatever output is
produced will be demanded. There will be
enough spending to purchase the output. The
AD curve is relatively stable if money supply
is constant
Keynesian AD determines output. 1.Demand
Creates SupplyKeyness Law S doesnt create
D. Supply was there during the depression. The
G Might need to create demand. The AD
curve is unstable. because of the volatility of
investment
AD
AS
AS
AD
Ig dropped 87 from 1929-1933.
AD
PL
Y1929 (3)
YD 1933(25)
YF
100
Classicals 2. Savings(leakage)investment(injectio
n) This is so because of interest
rate flexibility. The interest rate is the
cost of borrowing. The interest rate
alone determines the level of investment. A
leakage down the drain o of saving is returned
through the spigot of investment.
Keynesians 2. Savers and investors are two
completely different groups who save invest
for different reasons. Saving is more related to
income than the interest rate. Investment is more
responsive to business expectations,
technological chgs, innovations than to changes
in the interest rate. Gr. Depression
We save for downpayments for cars and houses,
retirement, college, illness, and a rainy day
fund.
Investment depends on profit expectations, tech.
changes, innovation, and interest rates.
S
Saving
C
C
45
Y1 Y2 Y3
101
Classicals 3. Savings increase with the interest
rate. Savers save more at higher interest
rates. So, this is a direct relationship. Repeat
quote from previous slide A leakage down the
drain of saving is returned through the spigot
of investment.
Keynesians 3. Savings are inverse to the
interest rate. You dont have to save as
much at higher interest rates to get the
same amount of money. A retirement goal of
100,000 by the time you are 65 will require
less money at 12 than at 6. So again,
savings consumption are a function of income,
not the interest rate.
More investment
102
Classicals say Cheaper Excess Supply
Creates Its Own Demand
Classicals 4. Prices wages are flexible
downward. By lowering prices, businesses may
lower profits, but with flexible wages
they dont have to pay the workers as much so
profits are the same. Price/wage flexibility is
the central difference.
LRAS
PL
AD1
SRAS1
SRAS2
AD2
-20
10
8
YR YR Y
103
Keynesians4. Prices/wages are inflexible
downward. StickyThe economy is not flexible
enough to allow wage-price flexibility.
Monopolistic elements prevent prices from
falling quickly. Labor unions prevent wages from
falling quickly.
Full Employment
SRAS
AD2
Recession
Recession
AD1
AD3
The economy has fallen and cant get up.
Sticky
PL2
PL1
Real Domestic Output
RDO1
RDO2
RDOFE
Because prices are sticky down, the resulting
downturn is worse because prices are higher
which decreases output further.
104
Classicals 5. ASAD at full employment equilibrium
. There is no invol- untary unemployment. The
economy will naturally equi- librate to full
employment. If you are unemployed, you can
always work at a lower wage but prices have
dropped. Abnormal circumstances, like wars or
droughts, could prevent full employment
temporarily. Adjustments within the market system
should restore the economy to
full-employment. In the long run, the economy
will correct.
Keynesians 5. There is no mechanism capable
of guaranteeing full employment. The
classical argument that wage and
price flexibility will ensure full
employment is thus flawed by the fallacy of
composition. One market, like autos, might
adjust, but markets in the rest of the
economy may not adjust at the same time.
In the long run, we are all dead.
105
Classical v. Keynesians continued
6. The economy is always close to or at
full-employment.
6. The economy is not always close to or at
full-employment.
Will work for Food
7. The government does not have an economic
management role to play in the economy.
7. There is a very definite management role for
the G. It is called fiscal policy, or
government spending and taxes to stimulate the
economy.
106
Classical Theory
AD1
AS
PL1
Price Level
Adam Smith
YF
Real Domestic Output
107
Classical Theory Cheaper Excess Supply Creates
Its Own Demand
AS
AD2
AD1
With lower PL, the real-balance, interest rate,
foreign purchase effects kick in and the
surplus disappears and FE is regained.
Surplus
PL1
PL2
YF
Real Domestic Output
108
Keynesian Theory
LRAS
The economy has fallen and cant get up.
SRAS
AD1
AD2
PL1
But prices may not fall because businesses
dont want them to fall.
YR
Y1
Real Domestic Output
109
Keynesian Theory
The economy has fallen and cant get up.
Even if prices drop
LRAS
SRAS
Wages may not fall workers dont want this so
G interven- tion is needed.
AD3
AD2
G
Prices may not be flexible down. Even if they
were, wages may not drop so easily either.
PL1
PL2
Y1
YR
Real Domestic Output
110
Summary of Classical Theory
The Wealth of Nations was their Bible. Reigned
supreme until Gr. Depression. 1. Says Law
Supply Creates Demand (centerpiece). Peoples
supply of goods they produce will buy what they
need. In a money economy, interest rate
flexibility insures that Says Law still
holds. Although people may save more, lower
interest rates mean business will invest more. 2.
Saving Investment. A leakage down the drain of
saving would be returned to the tub through the
spigot of investment. The interest
rate connected the drainpipe and the spigot. 3.
Price-wage flexibility - Competition ensures
price flexibility. With falling prices, workers
would accept lower wages and more would be
hired. Keynes focused much of his attack on
the price-wage flexibility theory. 4. Involuntary
unemployment was impossible. Although wages
would drop, prices had also, so your purchasing
power would be about the same. Their
macro policy during a depression was DO NOTHING
OK, Ill take this lower paying job because with
lower prices I can buy the same things.
111
Classical Theory
A Recession, no problem, just - - - Do Nothing.
No G
Adam Smith
112
Summary of Keynesian Revolution
The Great Depression was a collision of
theory and fact. The classical show was over as
the economy had no self-correcting ability.
Classical Economists kept saying, In the long
run, it will work itself out. Keynes replied,
In the long run, we are all dead. General
Theory was their bible. 1. The economy seldom
has full employment. Saving and investment
decisions may cause recessions. Using GT,
Keynes came up with Keyness Law, Demand
Creates Its Own Supply. 2. Prices and wages
tend to be inflexible downward. 3. More saving
does not equal more investment. The interest
rate does not connect the saving drain to
the investment spigot. Savers and investors save
and invest for different reasons. Lower
Interest Rates Mean You Need More Money.
Investment needed to provide 1,000 lifetime
monthly income. Interest Rate Male 65 Female
65 women live longer
8 103,750 118,110 5 128,220 150,760
113
SRAS/LRAS Question on 95 AP Exam
AD2
LRAS
AD1
SRAS1
SRAS2
YR
Y

• If AD remains constant, the equilibrium price
  levels in the
• short run and in the long run will be _____
  _____?
• 2. If the government uses fiscal policy to get
  out of the
• recession, price level will end up at _____?

OB
OA
OC
114
AD/AS Review
Chg in AQD
Chg in AD
1. Price level changes cause (shifts of the AD or
AS curve/movements from one point to another on a
stable AD or AS curvechanges in AQD or AQS. 2.
What 3 effects cause an increase or decrease in
AQD? _____________, ___________________,
________________ effects. 3. What will not shift
the AD or AS curves? ________________ 4. How does
a decrease in price level affect the real value
of wealth? (increase/decrease) consumption?
(incr/decr) increases/decreases)
(AD/AQD). 5. What does an increase in price level
do to the demand for money?
(increase/decrease) affect interest rates?
(incr/decr) affect consumption?
(incr/decr) incr/decr) (AD/AQD). 6. A
decreasing U.S. price level (incr/decr) U.S.
exports and (increases/decreases)
(AD/AQD). 7. An increase in the national incomes
of our trading partners (incr/decr) our net
exports which will lead to an (incr/decr)in
(AD/AQD). 8. An appreciation of the dollar will
(incr/decr) AS but (incr/decr) AD. A
depreciation of the dollar will (incr/decr) AS
but (incr/decr) AD.
Foreign purchase
Real-balance
Interest Rate
change in price level
115
9. If the interest rate decreases because price
level decreases we will have an
(increase/decrease) in (AD/AQD).10. If the
interest rate decreases but price level remains
constant we will have an (increase/decrease)
in (AD/AQD).
11. If the PPC shifts out (more resources or
technology), then the (AD/AS) curve shifts
(right/left). 12. Productivity (is/is not)
affected when resource cost decreases. 13. What
economic event brought the curtain down on the
classical show?_____________________________
__________ What economic event brought the
curtain down on the Keynesian show?
_______________________________________ 14. Who
said Suply creates demand? ________________ 15.
During a depression, the policy of the
(Classicals/Keynesians) is Do
nothing. 16. The (Classicals/Keynesians) believe
government should take an active role. 17.
The (Classicals/Keynesians) said, Savers save
more at higher interest rates.
The Great Depression
Stagflation
Joseph Say
Slide 116