MACRO E conomics Unit 7: The Real Sector: ADAS & Classical Theory Economist: Someone who sees something in practice and wonders if it would work in theory.

MACROEconomics

Unit 7: The Real Sector:ADAS & Classical Theory

Economist: Someone who sees something in practice and wonders if it would work in theory.

-- Senator Ernest “Fritz” Hollings

Created: 2007-2013 by Jim Luke.This work is licensed under the Creative Commons Attribution-NonCommercial License

MACROEconomics

Slide 2

Why Theory Matters

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.”

-- John Maynard Keynes

MACROEconomics

AD-AS Model illustrates & analyzes theory using shifts in 3 curves:

AD – Aggregate DemandSRAS –Short-Run Aggregate SupplyLRAS – Long Run Aggregate Supply

MACROEconomics

AD-AS Model is NOT same as micro supply-and-demand. Aggregates behave differently.

Remember the fallacy of composition?

MACROEconomicsUse AD-AS Model to show:

Level & changes in: real output (real GDP) price index How people respond to price level changes

Capacity of the economy (PPF) Economic Conditions

Inflation Recession & Unemployment Stagflation Deflation and depression

MACROEconomics

Understanding the AD-AS Model:Aggregate Demand-Aggregate Supply

(actually it’s AD-SRAS-LRAS)

MACROEconomics

Q Real Output

(amount of real goods & services produced)

PPrice Level(price index)

Graphic Space is Real Output vs. Price Level

MACROEconomics


Q Real Output


Start

Real GDP@start

Price Index @start

Economy at some starting point.

MACROEconomics

Q Real Output



start (now)

Real GDP@start

Price Index @start

after

after real growth in GDP, but no inflation or deflation

Real GDPafter

Economy Grows shifts right

MACROEconomics

Q Real Output



Start

Real GDP@start

Price Index @start

after decline in real GDPunemployment has increasedbecause fewer resources are employed

after

Real GDPafter

Economy shrinks moves left (recession)

MACROEconomics

Created:Jan 2008by Jim Luke.This work is licensed under the Creative Commons Attribution-NonCommercial License

Q Real Output



Start

Real GDP@start

Price Index @start

afterPrice Index after inflation

Inflation

Inflation shift upward

MACROEconomics

Q Real Output



Start

Real GDP@start

Price Index @start

afterPrice Index after deflation

deflation

Deflation shift downward

MACROEconomics

Real Life: both prices & real GDP change“Stagflation” shift up & left

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

afterPrice Index after inflation

Inflation

Real GDPafter

“stagflation”

MACROEconomics

Price Index after inflation

Inflationary Growth up & right

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

after

Inflation

Real GDPafter

MACROEconomics

2 Other Possibilities

Prices decline & real GDP increase down and to the right

Prices decline & real GDP decrease down and to left

MACROEconomics

Reactions to Changes in Prices

Two relationships (curves) show how people react to inflation/deflation: Aggregate Demand (AD)

Willingness to spend. Short-Run Aggregate Supply

(SRAS). Willingness to sell.

MACROEconomicsAD is downward sloping because

of 3 effects:

Wealth & Fixed IncomesInterest Rate & Debt PaymentsInternational Trade

MACROEconomics

Q (or Y) Real Output


PPrice Level

(price index)

Real GDP@start

Price Index @start

AD curve shows changes in willingness to buy real Qin response to changes in price level.

AD

Start

MACROEconomics

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

AD: Inflation reduces ability to buy

MACROEconomics

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

Deflation increases ability to buy.

MACROEconomics

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

AD: buyer reactions to inflation / deflation

MACROEconomics

Now: producers & sellers

Inflation: all prices increase But, inflation is not highly visible. Single-product price changes are.

Producers/sellers see price change of their product. perceive a real price increase when it is really

inflation willing to produce & sell more goods Temporary reaction SRAS, or Short-Run Aggregate Supply.

Eventually costs increase & qty returns to original

MACROEconomics



PPrice Level

(price index)

Real GDP@start

Price Index @start

SRAS curve shows changes in desire to sell real Qin response to changes in price level.

Start

MACROEconomics

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

SRAS: Price change “fools” producer

MACROEconomics

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

Deflation “fools” into reduced output.

MACROEconomics



PPrice Level

(price index)

Real GDP@start

Price Index @start

SRAS curve

Start

MACROEconomics

In a short-run equilibrium, the economy is always where SRAS=AD because the quantity of Real GDP we buy

must equal the amount we sell.

PPrice Level

(price index)

Real GDP@start

Price Index @start start

SR-AS

AD

Short-Run Equilibrium:Purchases = Sales where AD intersects SRAS.


MACROEconomics

AD and SRAS curves only show Real GDP vs Price Level changes. Other changes shift the curves.

MACROEconomicsAD curves shift (move) when

changes such as…

Expectations about future More optimism shifts AD right More pessimism shifts AD left.

Growth in other countries boosts exports.

Government decisions change T or G

MACROEconomics

Q Real Output


PPrice Level

(price index)

Start

Real GDP@start

Price Index @start

AD shift: more optimism or more G or lower T or more X

AD before

AD after

MACROEconomics

Next: Shifts in SRAS curve

Factors that shift SRAS: Changes in expectations about future

economic conditions. Technology improves. Cost increases: Firms realize that

resource prices have risen but they cannot pass the increase on to customers.

MACROEconomicsInput cost increases shift SRAS

left/up – but there is a lag.

SRAS: short-run reaction only “fooled” by price change

Once inflation is perceived, then SRAS curve shifts upward/left.

MACROEconomics

PPrice Level

(price index)

Real GDP@start


SR-AS start

Sellers react to inflation

Initial reaction

Price Index after inflation

Finalreaction

SR-AS after

MACROEconomics

PPrice Level

(price index)

Real GDP@start

Price Index @start

SR-AS start

Improved technology can shift SRAS also.

SR-AS after

start

MACROEconomics

PPrice Level

(price index)

Real GDP@start


SR-AS start

External input cost increases also shift SRAS - example: oil.

SR-AS after

MACROEconomics

Both AD & SRAS are short-runreactions to price changes – ignoring physical capacity.

MACROEconomics

LRAS is missing piece representing capacity and resources.

MACROEconomics

Q Real Output


PPrice Level

(price index)

LRAS:long-run aggregate supply(“capacity of economy” or “sustainable production rate” when all resources are employed)

Production Possibilities determined by available resources / technology, not prices

MACROEconomics

Q Real Output


PPrice Level

(price index)

LRAS:long-run aggregate supply

any point in this region indicates the economy is not using all resources --- unemployment exists

Economy left of LRAS unemployment exists

MACROEconomics

Q Real Output


PPrice Level

(price index)


Amount of unemployment

Unemployment.

MACROEconomics

Q Real Output


PPrice Level

(price index)


attempting to produce more than capacity, only possible for short run, actually draws down inventory

What if we sell more than we can produce (SRAS > LRAS)?

reduce inventories

MACROEconomics

Q Real Output


PPrice Level

(price index)

LRAS1

Long run growth is a shift in LRAS.

LRAS2

MACROEconomicsPutting them altogether.

We’re now ready to put all three curves together.

Short-run equilibrium is where SRAS = AD, but…

Where is that relative to LRAS?Three possibilities…….

MACROEconomics


Real GDP@start

Price Index @start

start

LRAS

SR-AS

AD

Long-Run Full-Employment Equilibrium -- the goal

MACROEconomics

Recessionary Gap (also known as “contractionary gap”)


Real GDP@start

Price Index @start

start

LRAS

SR-AS

AD

Real GDPif we had full employment

Gap represents amount of

unemployment

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Real GDP@start

Price Index @start

start

LRAS

SR-AS

AD

Inflationary Gap (also known as Expansionary Gap)

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LRAS: Beneficial Supply Shocks

Abundant harvests Discovery of natural resources Technology breakthroughs Population growth & immigration

MACROEconomicsShocks cause a gaps.

“Supply shocks” New technology More people/resources Destruction of people/resources

War Natural Disaster

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LRAS: Adverse Supply Shocks

Examples Drought Natural Disasters Suddenly reduced supply of any

critical resource Government instability Terrorist attacks War Any permanent reduction of

economy’s ability to produce real goods and services

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Aggregate Demand Shocks

Changes in: confidence/optimism perceived wealth foreign economic events fiscal policy (G or T) monetary policy (interest rates)

MACROEconomics

Short-Run Aggregate Supply Shocks

Changes in: external input cost short-run supply restrictions uncertainty re: profits?

MACROEconomics

That’s it. Our AD-AS model is now complete.

MACRO E conomics Unit 7: The Real Sector: ADAS & Classical Theory Economist: Someone who sees something in practice and wonders if it would work in theory.

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