The Aggregate Demand Aggregate Supply Model

1
The Aggregate Demand -- Aggregate Supply Model

• Fundamental inflexibility assumptions
• W -- inflexible (short-run)
• -- flexible (long-run)
• P -- flexible
• i -- flexible.
• Overriding theme -- policies affect the price
  level as well as real GDP.

2
Properties of Aggregate Demand (AD) Curve

• Downward sloping.
• Expansionary shifts in the IS or LM curves shift
  the AD curve rightward (fiscal or monetary
  policy).
• Contractionary shifts in the IS or LM curves
  shift the AD curve leftward (fiscal or monetary
  policy).

3
Properties of the Short-Run Aggregate Supply Curve

• Upward sloping (w inflexible)
• P? ? (W/P)? ? L? ? Y?
• Variables that enhance production shift the SAS
  curve rightward.
• Variables that hinder production shift the SAS
  curve leftward.

4
Shift variables -- SAS Curve

• Nominal Wage Rate (w)
• Capital Stock
• Labor Productivity
• Price of Energy

5
Properties of the Long-Run Aggregate Supply Curve

• Vertical (w flexible) at Y YN.
• P? ? (W/P) returns to equilibrium
• ? L unchanged
• ? Y unchanged
• Variables that enhance production shift the LAS
  curve rightward.
• Variables that hinder production shift the LAS
  curve leftward.

6
Shift Variables -- LAS Curve (Variables That
Change YN)

• Capital Stock
• Labor Productivity
• (output)/(labor hours)
• Price of Energy
• Labor Force
• Household Attitudes Toward Work
• Transfer Payments

7
Lengthening the Short-Run (Demand Policy)

• Encourage long-term, non-indexed nominal wage
  contracts.
• Keep inflation expectations down.
• -- seek gradual policy changes
• (soft landing)
• -- verbal reassurances on inflation

8
Rational Expectations

• Rational Expectations -- People form expectations
  using all available information in the most
  efficient way.
• Truly the best guess.
• Errors between actual expected variables are
  totally unpredictable, and independent from the
  set of available information.

9
Rational Expectations, Continued

• Corresponds to fundamental assumption on human
  behavior, rationality (according to the economic
  definition).
• Application -- efficient markets (Finance), and
  predicting movements in stock prices.

10
Goals for Economic Policy

• Fluctuations -- accept YN, seek to get Y as
  close to YN as possible (examples, standard
  fiscal and monetary policy) ? shift AD curve.
• Economic Growth -- seek to simultaneously
  increase Y and YN ? shift LAS curve.

11
Possibilities -- Accelerating YN Growth

• Capital Stock?
• Labor Productivity?
• Price of Energy ?
• Labor Force?
• Household Attitudes Toward Work?
• Transfer Payments?

12
Trying to Increase Labor Productivity

• Promote Investment (plant and equipment)!!!
• Incorporates new technology.
• Also expands the capital stock.

13
Promoting Investment

• Tax Cut for Investment
• -- investment tax credit
• -- accelerated depreciation
• Increase Business Confidence
• Strive for Lower Interest Rates
• -- Keep Federal Budget in line
• (G?, maybe T? for consumers)
• -- Promote Greater Saving