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Aggregate Demand (AD) and Aggregate Supply (AS) Model

Aggregate Demand (AD) and Aggregate Supply (AS) Model. Introduction. AE model is fixed price model, unrealistic Need for a model that considers variable prices Aggregate all individual product markets and equilibrium price levels for products Create the AD-AS model. Need for a Model.

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Aggregate Demand (AD) and Aggregate Supply (AS) Model

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  1. Aggregate Demand (AD) and Aggregate Supply (AS) Model

  2. Introduction • AE model is fixed price model, unrealistic • Need for a model that considers variable prices • Aggregate all individual product markets and equilibrium price levels for products • Create the AD-AS model

  3. Need for a Model • Single product S&D models are insufficient • Why do prices fall in general? • What determines level of aggregate output? • What determines changes in level of aggregate output? • Economists created aggregate model • All prices of individual g/s combined • Combines equil. Q of all g/s into real domestic output

  4. Aggregate Demand • Aggregate Demand--curve that shows how much domestic consumers will purchase at various price levels • Inverse relationship between PL and real domestic output downward sloping AD curve • Why? • Not substitution or income effects • Wealth effect • Interest rate effect • Foreign purchase effect

  5. PL PL1 Aggregate Demand Curve PL2 GDP1 GDP2 Real GDP

  6. Shifts of the AD Curve • “Other things” besides PL can cause a shift in AD • Change in consumer spending • Consumer wealth • Expectations • Consumer debt • Taxes • Change in investment spending • Interest rates • Profit expectations • Taxes (business) • Tech. • Amount of excess capacity • Change in govt. spending • Change in net export spending • Income abroad • Exchange rates Increase in AD Decrease in AD AD2 AD1 AD3

  7. Shifts and the Multiplier PL Increase in AD PL1 { Initial Increase in Spending AD2 AD1 Real GDP (billions/$) GDP1 GDP2

  8. Shifting AD • Any increase in total spending (C,I, G, Xn) will shift the AD right • Shift of AD = change in spending x multiplier

  9. Aggregate Supply • AS curve showing the level of real domestic output which will be produced at each level • All “other things equal,” movement LR along the curve shows real output increases up to a point

  10. Aggregate Supply Curve AS Price Level Vertical Range PL2 Intermediate Range Horizontal Range PL1 GDPu GDPc Real GDP

  11. Determinants of AS • The everything else part • Input prices • Productivity • Prod = total output/total inputs • Per unit prod costs = total input cost total output • Legal institutional environment

  12. Shifts of the AS Curve Price Level AS2 AS1 AS3 Decrease in AS Increase in AS PL2 PL1 PL3 Real GDP

  13. Equilibrium GDP Price Level AS PLe PL AD GDPe Real GDP

  14. Shift of AD Curve Price Level AS PL AD3 AD2 AD1 GDP1 GDP2 GDP3 Real GDP

  15. Shifts of AS • Recall determinants of AS • Lead to shifts of AS curve • Decrease of AS reflects cost push inflation

  16. Price Level AS2 AS1 AS3 Result of cost-push inflation PL2 PL1 PL3 AD GDP2 GDP1 GDP3 Real GDP

  17. Ratchet Effect • Complications in vertical and int. ranges • ↓ AD does not restore original equilibrium price • Prices rise but are “sticky” or downwardly inflexible

  18. Ratchet Effect? AS2 Price Level AS1 C B PL2 PL1 A AD2 AD1 GDPr GDPe GDPc Real GDP

  19. Why? • Wage contracts • Morale, productivity • Training investments • Minimum wage • Menu costs • Price war fears

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