Unit 3: Aggregate Demand and Supply and Fiscal Policy

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Unit 3Aggregate Demand and Supply and Fiscal
Policy
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Review

1. Explain the results of Calvins proposal using AS
   and AD.
2. Draw an Inflationary Gap.
3. Draw a Recessionary Gap.
4. Define Stagflation.
5. Explain the Ratchet Effect.
6. Name 10 College Majors.

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Classical vs. Keynesian
Adam Smith 1723-1790
John Maynard Keynes 1883-1946
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(No Transcript)
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Video Classical vs. Keynesian
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Debates Over Aggregate Supply

• Classical Theory
• A change in AD will not change output even in the
  short run because prices of resources (wages) are
  very flexible.
• AS is vertical so AD cant increase without
  causing inflation.

AS
Price level
AD
Qf
Real domestic output, GDP
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Debates Over Aggregate Supply

• Classical Theory
• A change in AD will not change output even in the
  short run because prices of resources (wages) are
  very flexible.
• AS is vertical so AD cant increase without
  causing inflation.

Recessions caused by a fall in AD are temporary.
AS
Price level
Price level will fall and economy will fix
itself. No Government Involvement Required
AD
AD1
Qf
Real domestic output, GDP
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Debates Over Aggregate Supply

• Keynesian Theory
• A decrease in AD will lead to a persistent
  recession because prices of resources (wages) are
  NOT flexible.
• Increase in AD during a recession doesnt cause
  inflation

AS
Price level
AD
Qf
Real domestic output, GDP
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Debates Over Aggregate Supply

• Keynesian Theory
• A decrease in AD will lead to a persistent
  recession because prices of resources (wages) are
  NOT flexible.
• Increase in AD during a recession puts no
  pressure on prices

AS
Price level
Sticky Wages prevents wages to fall. The
government should increase spending to close the
gap
AD
AD1
Qf
Q1
Real domestic output, GDP
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Debates Over Aggregate Supply

• Keynesian Theory
• A decrease in AD will lead to a persistent
  recession because prices of resources (wages) are
  NOT flexible.
• Increase in AD during a recession puts no
  pressure on prices

AS
When there is high unemployment, an increase in
AD doesnt lead to higher prices until you get
close to full employment
Price level
AD3
AD2
AD1
Qf
Q1
Real domestic output, GDP
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The Ratchet Effect
A ratchet (socket wrench) permits one to crank a
tool forward but not backward.
Like a ratchet, prices can easily move up but not
down!
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Does deflation (falling prices) often occur?

• Not as often as inflation. Why?
• If prices were to fall, the cost of resources
  must fall or firms would go out of business.
• The cost of resources (especially labor) rarely
  fall because
• Labor Contracts (Unions)
• Wage decrease results in poor worker morale.
• Firms must pay to change prices (ex re-pricing
  items in inventory, advertising new prices to
  consumers, etc.)

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Three Ranges of Aggregate Supply
1. Keynesian Range- Horizontal at low output 2.
Intermediate Range- Upward sloping 3. Classical
Range- Vertical at Physical Capacity
AS
Price level
Classical Range
Keynesian Range
Intermediate Range
Qf
Real domestic output, GDP
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• 2006B Practice FRQ

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• 2006B Practice FRQ

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