AD-AS Model

Part III:

Putting it all together

Stick Wages

Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages.

Nominal wages cannot be sticky forever. The length of their stickyness is the difference in the short and long run

3 Ranges of the Segmented AS Curve

1. Keynesian

2. Intermediate

3. Classical

PL AS

(3)

(2)(1)

RGDP

Long Run Aggregate Supply

Prices are relative. If your pay is cut by 50% but all prices drop by 50% your income has the same value

LR Aggregate SupplyThe upward slope of the

SRAS is due to sticky wages / other prices, BUT wages always adjust / are renegotiated in the LR

LR -- ALL inputs are flexible & PL has NO effect on quantity of output supplied

LR Aggregate Supplyo LRAS’s position on the

horizontal axis represents the speed limit or potential (non-inflationary) level of output (i.e. full employment)

LR Aggregate Supply Actual RGDP is

almost always above or below FE (Full Employment) [i.e. at a SR equilibrium]

Potential output for the U.S. has grown steadily over time

LR Aggregate Supply

Shifts in LRAS due to:

11 in labor force

11 in physical capital

11 in natural resources

14 in human capital

15 in technology

Same reasons the PPC shifts

Moving from the SR to the LR

If the economy is almost always on its SRAS, why is LRAS relevant?

Over time, the SRAS will shift to restore the LR equilibrium

Actual output will eventually reach potential output

Putting AS & AD Together Movement along a curve occurs because the

other curve has shifted. To understand the economy, you need both curves (and LRAS).

PL SRAS

AD0

AD1

RGDP

SR Macroeconomic EquilibriumThe intersection of SRAS &

AD is equilibrium: quantity of total output supplied = Q demanded by C + I + G + (X - M).

It shows PL & RGDPBelow equilibrium, PL will

rise because there is a shortage.

Above equilibrium, PL will fall because there is a surplus.

PLSRAS

AD

RGDP

P*

Y*

Negative Supply Shock

Darth Vader attacks Dathomir.

Shifts in SRAS (Supply Shocks)1. Negative Supply Shock --Some 1 in production costs

(e.g. increasing commodity prices, increasing nominal wages, decline in productivity)

--Shifts SRAS to the left-- PL 1 (inflation up)-- RGDP 1 (unemployment

up)

PL

LRASSRAS1

SRAS0

AD

RGDPFEY1

P*

P1

Negative SRAS Shock: Phillips Connection

Result: stagflation (means stagflation + inflation)

= worst of all possible worlds

= right shift of SR Phillips Curve (cost-push inflation)

What should we try to fix first?

Inflation

Unemployment

SRPC0

SRPC1

Positive Supply Shock

Luke Skywalker comes and saves the day

Shifts in SRAS (Supply Shocks)2. Positive Supply Shock

--Some 1 in production costs (e.g. decreasing input prices, increase in productivity)

--Shifts SRAS to the right-- PL 1 (inflation down)-- RGDP 1 (unemployment down)

Result: best of all possible worlds

Full employment & disinflation creates waves of national optimism

PL

LRASSRAS0

SRAS1

AD

RGDPFE Y1

P1

P*

Negative SRAS Shock: Phillips Connection

2. Positive Supply Shock

The Short Run Phillips Curve shifts LEFT

Improved menu of tradeoffs

How can we keep this going?

inflation

unemployment

SRPC0

SRPC1

Shifts in AD: Demand Shocks

1. Negative Demand Shock:

Recession caused by a leftward shift in AD

(e.g. a 1 in wealth, oversupply of stock of capital, contractionary fiscal or monetary policy)

This dude is literally tightening his belt.

This was actually a movie

Shifts in AD: SR Demand Shocks

When AD shifts left…

Result: Recession

PL 1 (disinflation or deflation)

RGDP 1 (unemployment 1 )

Ex. 2001 Recession & Great Depression

LRASSRAS

PL

RGDP

AD1AD0

P*

P1

Y1 FE

Negative AD Shock: Phillips Connection

Left Shift in Aggregate Demand corresponds to…

Movement downward along the Phillips Curve

Tradeoff between inflation and unemployment

inflation

unemployment

SRPC

Shifts in AD: SR Demand Shocks

2. Positive Demand Shock

-- demand-pull boom caused by a right shift in AD

(e.g. an 1 in wealth, undersupply of stock of capital, expansionary fiscal or monetary policy

Shifts in AD: SR Demand Shocks

AD shifts right…Result: Inflationary

BoomPL 1 (demand-pull

inflation)RGDP 1 (unemployment

1 )Ex. Spending on WWII

& Great Society

LRAS SRAS

PL

P1

P*

FE Y1 RGDP

AD0

AD1

Positive AD Shock: Phillips Connection

Right shift in AD corresponds to…

Movement upward along the Phillips Curve

Tradeoff between unemployment and inflation

inflation

unemployment

SRPC

In the LR the economy self-corrects Negative D shock 1 PL &

RGDP AD moves 1 SRAS b/c sticky

wages are not falling as fast as product market prices (businesses lay off workers or shut down b/c of 1 profitability)

1 unemployment 1 bargaining power of workers; nominal wages 1

1 in cost of production shifts SRAS to the right until FE equilibrium (LRAS equilibrium) is restored

Net result: same FE level (RGDP) at a lower PL

PL LRAS SRAS0

SRAS1

AD1AD0

RGDPRecessionary Gap

1

2

While this explanation makes waiting for the LR adjustment look quite desirable, SR recessions can be very disruptive to

the population.

Positive Ag. Demand Shock 1 PL & RGDP AD moves 1 SRAS b/c sticky

wages are not rising as fast as product market prices (firms ratchet up production, hire more workers, & add shifts b/c of 1 profitability)

Tight labor market 1 bargaining power of firms; nominal wages 1

1 in cost of production shifts SRAS to the left until FE equilibrium (LRAS equilibrium) is restored

Net result: same FE level (RGDP) at a higher PL

PL LRAS SRAS1

SRAS0

AD0AD1

RGDPInflationary Gap

From LR to SRHow long does it take to move from SR to LR?

*answer depends on whether you believe in Adaptive or Rational Expectations

Adaptive Expectations Rational Expectations

Adaptive Expectations

The economy moves from the short run to the long run slowly because individuals respond to events as / after they happen

People are largely reactive to events “on the ground”

Rational Expectations The economy moves from SR to LR

quite quickly b/c people have an intuitive understanding of the economic forces at work & react immediately to where the economy is going.

They make decisions optimally, using all available information.

e.g. if a union is negotiating a contract during a period of current & past low inflation and announced gov’t policy indicates that the G will be trying to trade a 1 PL for 1 unemployment, then the union will put that future inflation into the new contract, sabotaging G efforts to move up the SRAS -- instead go straight to same RGDP at a higher PL.

Implications: LR or “Extended” Phillips Curve

3 Generalizations

1. Under normal circumstances there is a SR tradeoff between the rate of inflation & the rate of unemployment

2. Aggregate supply shocks can cause both 1 rates of inflation & 1 rates of unemployment

3. There is no significant tradeoff between inflation & unemployment over long periods of time

Inflation

Unemployment

SRPC0

SRPC1

LRPC