Chapter 12 – Aggregate Demand and Aggregate Supply (Part 2)
• Use of the AS-AD model to analyze economics fluctuations in both short run and long run.
• Discuss how stabilization policies can be used to smooth out business cycles.
MGEA06 Week 7 (Recorded Lecture) Iris Au 1
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The AS-AD Model
Recap what we learned from Week 61:
• The AD curve is downward sloping. We derive the AD curve by tracing all
the combinations Y and P such that Y = AEPlanned(P). The AD equation: Y = ( 1 ) AE0 − ( ) P or, P = AE0 – (1 – MPC)Y
1−MPC 1−MPC
where AE0 = AC + AI + G + X0 – IM0 + MPC × TR0 – MPC × T0 – d × i
Changes in AE0 will shift the AD curve.
• The SRAS curve is upward sloping. The SRAS equation:
P = (𝑎 + 𝑏𝑌) (𝑊), ̅
Changes in producers’ per-unit profit other than output prices (P) will shift the SRAS curve.
• The LRAS curve is vertical. The LRAS equation is: YP = YFE = A × F(K, L, H)
Changes in the (long-run) production function will shift the LRAS curve.
• The short-run equilibrium refers to the situation in which the AD intersects
• The long-run equilibrium refers to the situation in which the short-run
equilibrium is on the LRAS curve
• If YSR YFE, then the economy has an output gap.
1 We assume interest rate is held fixed; taxes, transfer payments, exports & imports are constant terms and are determined autonomously.
MGEA06 Week 7 (Recorded Lecture) Iris Au 2
Shifts of Aggregate Demand
Example: Suppose households decide to save more:
MGEA06 Week 7 (Recorded Lecture)
Shifts of the Short-Run Aggregate Supply
Example: Suppose the price of oil increases:
MGEA06 Week 7 (Recorded Lecture)
Simultaneous Shifts of the Short-Run & Long-Run Aggregate Supply
Example: Suppose the level of total factor productivity increases: P LRAS0
MGEA06 Week 7 (Recorded Lecture)
Macroeconomic Policy
• Fiscal policy – the government’s choice regarding levels of spending, taxes, and transfer payments.
• Monetary policy – the central bank’s choice regarding the level of money supply. A change in money supply causes interest rate to change, which will lead to a change in autonomous expenditure (because it affects the costs of planned investment and current consumption) – Chapters 10 & 15.
• Both fiscal and monetary policies are, sometimes, referred as stabilization policy – public policies aimed at reducing the fluctuations in output in the short run, i.e., keeping Y close to YFE in the short run.
MGEA06 Week 7 (Recorded Lecture) Iris Au 6
Policy in the Face of Demand Shocks
Suppose autonomous consumption : ACAE0 .
AD shifts to the left to AD1.
Point B is the SR equilibrium:
Y to Y1 P to P1
Option 1 – Maintain the Status Quo (i.e., the Long Run Adjustment Mechanism)
Option 2 – Run Counter-Cyclical Stabilization Policy in the Short Run
MGEA06 Week 7 (Recorded Lecture) Iris Au 7
Response to (Short-Run) Supply Shocks
LRAS SRAS1
SRAS0 Suppose oil price increases: Oil price per-unit
production cost .
Per-unit profit SRAS
shifts to the left to SRAS1.
Point B is the SR equilibrium:
Y to Y1 P to P1
Option 1 – Maintain the Status Quo (i.e., the Long Run Adjustment Mechanism)
Option 2 – Run Counter-Cyclical Stabilization Policy in the Short Run
MGEA06 Week 7 (Recorded Lecture) Iris Au 8
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