Unit 3: Aggregate Demand and Supply and Fiscal Policy 1
Nov 08, 2014
Unit 3:Aggregate Demand and Supply and Fiscal Policy
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1. Explain the results of Calvin’s 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.
Review
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Adam Smith1723-1790
John Maynard Keynes1883-1946 3
Classicalvs.
Keynesian
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Video: Classical vs. Keynesian
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Debates Over Aggregate SupplyClassical Theory1. A change in AD will not change output even in the short run
because prices of resources (wages) are very flexible. 2. AS is vertical so AD can’t increase without causing inflation.
Price level
Real domestic output, GDP
AS
Qf
AD
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Debates Over Aggregate SupplyClassical Theory1. A change in AD will not change output even in the short run
because prices of resources (wages) are very flexible. 2. AS is vertical so AD can’t increase without causing inflation.
Price level
Real domestic output, GDP
AS
Qf
AD
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Recessions caused by a fall in AD are temporary.
Price level will fall and economy will fix itself.
No Government Involvement Required
AD1
Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession doesn’t cause inflation
Price level
Real domestic output, GDP
AS
Qf
AD
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Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices
Price level
Real domestic output, GDP
AS
Qf
AD
9Q1
“Sticky Wages” prevents wages to fall.
The government should increase spending to
close the gap
AD1
Debates Over Aggregate SupplyKeynesian Theory1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible. 2. Increase in AD during a recession puts no pressure on prices
Price level
Real domestic output, GDP
AS
Qf
AD2
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AD1
Q1
When there is high unemployment, an
increase in AD doesn’t lead to higher prices
until you get close to full employment
AD3
The Ratchet EffectA ratchet (socket wrench) A ratchet (socket wrench)
permits one to crank apermits one to crank a tool forward but not backward. tool forward but not backward.
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Like a ratchet, prices can easily move up but not down!
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 Supply1. Keynesian Range- Horizontal at low output2. Intermediate Range- Upward sloping3. Classical Range- Vertical at Physical Capacity
Price level
Real domestic output, GDP
AS
Qf13
Keynesian Range
IntermediateRange
ClassicalRange
2006B Practice FRQ
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2006B Practice FRQ
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