Unit 3: Aggregate Demand and Supply and Fiscal Policy

1. Unit 3:Aggregate Demand and Supply and Fiscal Policy 1

2. Review • Explain the results of Calvin’s proposal using AS and AD. • Draw an Inflationary Gap. • Draw a Recessionary Gap. • Define Stagflation. • Explain the Ratchet Effect. • Name 10 College Majors.

3. Classical vs. Keynesian Adam Smith 1723-1790 John Maynard Keynes 1883-1946

5. Video: Classical vs. Keynesian 5

6. 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 can’t increase without causing inflation. AS Price level AD Qf Real domestic output, GDP

7. 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 can’t 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 7

8. 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 doesn’t cause inflation AS Price level AD Qf Real domestic output, GDP 8

9. 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 Q1 Qf Real domestic output, GDP 9

10. 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 doesn’t lead to higher prices until you get close to full employment Price level AD3 AD1 AD2 Q1 Qf Real domestic output, GDP 10

11. 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! 11

12. 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.) 12

13. 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 13

14. 2006B Practice FRQ 14

15. 2006B Practice FRQ 15