marco2 -750 or 800 words
dodo1995
Week2StudentSlidesTopic2AD-ASandtheGreatDepressionMelb.pptxAD-AS and The Great Depression
Topic 2
Aggregate Demand
Aggregate Demand shows the amounts of goods and services (RGDP) that will be purchased at any given price level.
An increase in the price level decreases the value of money because each dollar you have buys less.
When the price level increases how much we can buy with $1 decreases, in other words, the value of money decreases in terms of goods and services purchased.
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Aggregate Demand Curve
Any change in Aggregate Expenditure
(AE = C + I + G + NX) will cause the AD curve to shift.
Price
level
RGDP
Demand Shocks
A demand shock is a significant change in desired spending.
Consumption: Changes in consumer confidence, stock market prices and housing prices.
Planned Investment: Changes in business optimism and expectations of future profits.
Fiscal and Monetary Policy:
Changes in government spending and taxation.
Changes in the money supply affect the interest rate, which affects interest-sensitive components of C and I.
Exchange Rates: Changes in the exchange rate can affect net exports
Check Your Knowledge
Explain whether each of the following will cause a movement along or a shift of the Aggregate Demand (AD) curve. In each case, specify which of the four components of AE will be impacted, and explain how.
Rising interest rates cause a drop in consumer optimism as households become concerned about their ability to meet mortgage payments.
The value of the Australian dollar falls against the US dollar and other major currencies.
Aggregate Supply
The Short-Run Aggregate Supply (SAS) curve shows the amount of output that business firms are willing to produce at different price levels, holding constant the nominal wage rate.
The Long-Run Aggregate Supply (LAS) curve shows the amount that business firms are willing to produce when the nominal wage rate has fully adjusted to any changes in the price level.
A supply shock is a significant change in costs of production for business firms, including wages and the prices of raw materials, like oil.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
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Deriving the SAS Curve
The SAS is upward sloping, showing that in the short-run firms will produce more in response to higher prices. The reason for this is that the price of inputs tends to rise more slowly than the price of final products due to wage and price rigidities.
Nominal Wages Rigidities
If the price level falls, real wages rise, production costs increase; firms hire less labour, thus producing a smaller output.
Prices are Sticky
Not all firms adjust prices immediately in response to changes in the price level; affecting their competitiveness, sales and thus production.
Shifts of the SAS Curve
The variables that shift the SRAS curve include:
Changes in input prices
Expected changes in the future price level.
Adjustments of workers and firms to errors in past expectations about the price level.
Unexpected changes in the price of an important natural resource.
Plus any factor that shifts the LRAS curve.
Note: Factors 1-4 shift only the SRAS curve not the LRAS curve
Movement Along vs Shifts
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
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Shifts of the LAS Curve
Shifts in the long-run aggregate supply curve occur because natural/potential GDP increases over time. Anything that shifts the LRAS also shifts the SRAS.
Increases in GDP (or economic growth) which shift the LRAS are due to:
An increase in resources.
An increase in the capital stock.
New technology
Changes in government policy (Incentives to work and invest)
Macroeconomic Equilibrium
Price Level
RGDP
SRAS
AD
YN
P0
LRAS
Price Level
RGDP
SRAS
AD
YN
P0
LRAS
Y0
Price Level
RGDP
SRAS
AD
YN
P0
LRAS
Y0
Output gap/GDP gap
Output gap/GDP gap
Check Your Knowledge
What effects might each of the following have on aggregate demand and/or aggregate supply and why?
A widespread fear of depression among consumers.
A tax leading to a 2% increase in petrol prices.
A decrease in interest rates.
A decrease in government spending on higher education.
The discovery of cheaper energy sources.
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Check Your Knowledge
Several European economies had high rates of unemployment in the late 1990s. For example, by the end of 1999, France had an unemployment rate of 10.8%, Germany 10.2%, Italy 11.1%, Spain 15.4%. While some economists have argued that these high unemployment rates are largely reflect high natural rates of unemployment, others suggest that insufficient aggregate demand may be responsible.
Illustrate how this debate over high unemployment in Europe reflects disagreement on where European aggregate demand curve lies relative to full-employment levels of output.
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Self-Correction
Price Level
RGDP
SAS0(W0)
AD0
YN
P0
LAS
AD1
SAS1(W1)
SAS2(W2)
A
B
C
D
P1
P2
P3
Y1
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Self-Correction – when prices and wages are perfectly flexible
Price Level
RGDP
AD0
YN
P0
LAS
AD1
A
B
P1
Stabilising and Destabilising Effects of Falling Prices
Stabilising Effects of P
The Pigou or Real Balance Effect is the direct stimulus to AD caused by an increase in the real money supply and does not require a decline in the interest rate.
The Keynes Effect is the stimulus to AD caused by a decline in the interest rate.
Destabilising Effects of P
The Expectations Effect is the decline in AD caused by the postponement of purchases when consumers expect P.
The Redistribution Effect is the decline in AD caused by the effect of falling prices in redistributing income from high-spending debtors to low-spending savers.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
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The Failure of Self-Correction
The Great Depression
Crash of the US stock market wiped out a significant proportion of household wealth.
Bank failures – households lost their savings.
Sharp falls in consumption and real investment
Inappropriate monetary policy
Many other nations fell into recession and depression.
Protectionist trade policies of nations
The Keynesian Revolution started with publication of John Maynard Keyne’s The General Theory in 1936 in response to failures of classical economic ideas during The Great Depression.
Controversies Surrounding AS
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
The three possible shapes of the AS curve has created decades of controversy.
The horizontal AS curve assumes prices are fixed, but is unrealistic because it cannot explain inflation.
The vertical AS curve assumes prices are perfectly flexible and is useful to analyze inflation, but cannot explain unemployment.
The positively sloped short run AS curve assumes that wages are fixed, so it cannot be applied to the long run, but it helps to explain short-run fluctuations in output.
Classical and Keynesian Perspectives
P
YN
RGDP
AS
AD1
AD2
P1
P2
P
SRAS
AD2
AD1
P0
YN
Y1
Y2
LAS
RGDP
Classical Theory
Keynesian Theory
Real wage
DL
Employment
NN
w1/p1 = w2/p2
SL
w1/p2
Real Wage
Employment
DL
SL
w0/p0
N2
NN
K
| Classical Theory | Keynesian Theory |
| Market clears at the full-employment level of output | Market clears at any level of output |
| Supply determines output, demand sets price Supply-side model | Demand determines output Demand-side model |
| Prices and wages are completely flexible ensuring a return to full-employment equilibrium | Prices and wages are rigid and the economy will not automatically return to full-employment equilibrium |
| Government intervention not required as the economy is self-correcting | Government intervention is required because of various market failures |
| Unemployment exists due to the maintenance of wage rates above market clearing levels | Unemployment exists due to a deficiency of aggregate demand |
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