I.          Introduction to AD-AS Model

A.  AD-AS model analyzes changes in real GDP and the price level simultaneously.

B.     AD-AS model provides insights on inflation, unemployment and economic growth

II.        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.

A.  The aggregate demand curve is shown in Figure 13.1.  It shows an inverse relationship between price level and real domestic output.

B.   Determinants of aggregate demand:  Determinants are the “other things” (besides price level) that can cause a shift or change in demand (see Figure 13.2).  Effects of the following determinants are discussed in more detail in the text.

1.   Changes in consumer spending, which can be caused by changes in several factors.

a.   Consumer wealth,

b.   Consumer expectations,

c.   Household indebtedness, and

d.   Personal taxes.

e.   Applying the Analysis: What Wealth Effect?

      Despite the stock market losing $3.7 trillion of value from March 2000 to July 2002, consumption spending continued to rise.  Why no decline?

      i.    Disposable income (which is the primary determinant of consumption) rose.

      ii.   Personal income tax rates were cut.

      iii.  Increases in home values offset some of the stock market losses.

      iv.  Lower interest rates allowed refinancing of loans and lower monthly payments.

2.   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

c.   Global Snapshot 13.1:  Gross Investment Expenditures as a Percentage of GDP, Selected Nations, 2003.

3.   Changes in government spending.

4.   Changes in net export spending unrelated to price level, which may be caused by changes in other factors such as:

a.   National income abroad, and

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 can’t be exchanged for as much foreign currency.

c.   Global Snapshot 13.2:  Net Exports of Goods, Selected Nations, 2003.

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

A.  Aggregate supply in the long run (Figure 13.3)

1.   In the long run the aggregate supply curve is vertical at the economy’s full-employment real GDP.

2.   The curve is vertical because in the long run resources prices adjust to changes in the price level, leaving no incentive for firms to change their output.

            B.   Aggregate supply in the short run (Figure 13.4)

                  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. 

C.   Determinants of aggregate supply:  Determinants are the “other things” besides price level that cause changes or shifts in aggregate supply (see Figure 13.5 in text).  The following determinants are discussed in more detail in the text.

1.   A change in input prices, which can be caused by changes in several factors.

a.   Domestic resource prices

b.   Prices of imported resources, and

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,

b.   Government regulation.

IV.       Equilibrium:  Real Output and the Price Level

A.     Equilibrium price and quantity are found where the aggregate demand and supply curves intersect.  (See Figure 13.6)

B.     Applying the Analysis: Demand-Pull Inflation (Figure 13.7).

1.   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.   Numerous episodes of demand-pull inflation have occurred since 1960, the most significant during the mid- to late 1960s and late 1980s.

            C.   Applying the Analysis: Cost-Push Inflation (Figure 13.8).

      1.   Shifting aggregate supply occurs when a supply determinant changes. 

2.   Leftward shift in curve illustrates cost‑push inflation (see Figure 13.8).

3.   Oil shocks in the mid- and late 1970s caused significant cost-push inflation.

4.   Recent increases in oil prices have had less of an effect than in the 1970s because of oil’s decreased importance to the U.S. economy (3 percent of GDP versus 10 percent in the mid-1970s).

            D.  Downward Price Level Inflexibility

1.      Fear of price wars keeps prices from being reduced.

2.      Menu costs discourage price changes.

3.      Wage contracts are not flexible so businesses can’t afford to reduce prices.

4.      Employers are reluctant to cut wages because of impact on employee effort, etc.  Employers seek to pay wages that maximize work effort and productivity, minimizing cost.

5.      Minimum wage laws keep wages from falling.

6.      Illustrating the Idea: The Ratchet Effect

a.       Price level changes are asymmetrical – they rise more easily than they fall.

b.      Since 1950, the U.S. price level has fallen in only one year (1955).

            E.   Applying the Analysis: Recession and Cyclical Unemployment

                  1.   Decreases in AD:  If AD decreases, recession and cyclical unemployment may result.                                   See       Figure 13.9. 

                  2.   Cyclical unemployment is exacerbated by downward price level inflexibility.

                  3.   The 2001 recession followed this pattern: Output fell and unemployment rose, but the                                        price level did not decline (though disinflation – a falling rate of inflation – did occur).

            F.   An important caution

                  1.   Foreign competition and declining union power appear to be increasing the downward                                        flexibility of prices and wages.

                  2.   The macroeconomy would be self-correcting if wages and prices were fully flexible                               downward, although policy-makers are generally reluctant to allow this process to run its                                    course without policy intervention.