<3.2: AD/AS>

REFERRING TO THE 'IMPACTS ON HOUSEHOLD DEMAND' ABOVE, AND YOUR KNOWLEDGE ABOUT 'DEMAND SHIFTS', COMPLETE THIS TABLE, WITH FULL EXPLANATIONS.

REFERRING TO THE 'IMPACTS ON FIRM'S DEMAND' ABOVE, AND YOUR KNOWLEDGE ABOUT 'DEMAND SHIFTS', COMPLETE THIS TABLE, WITH FULL EXPLANATIONS.

REFERRING TO THE 'IMPACTS ON GOVT'S DEMAND' ABOVE, AND YOUR KNOWLEDGE ABOUT 'DEMAND SHIFTS', COMPLETE THIS TABLE, WITH FULL EXPLANATIONS.

REFERRING TO THE 'IMPACTS ON FORIGN DEMAND' ABOVE, AND YOUR KNOWLEDGE ABOUT 'DEMAND SHIFTS', COMPLETE THIS TABLE, WITH FULL EXPLANATIONS.

• If we imagine the economy is at its potential output level and (at full employment with say an NRU of 3%), and then it enters an EXPANSIONARY PHASE with high demand, causing the average price level to start rising, how will producers react? 

  • • • They will initially think that the price increases are specific to their industry and try to make more profits by asking existing staff (who are also oblivious to the rising average prices) to work overtime, also they may well be able to tempt some of the naturally unemployed 3%, (those between jobs) to help out by offering slightly higher wages (though not by much), in this case, the unemployment rate will be below the NRU. 

      • So, we can say that in the SR as the APL rises following an increase in AD, so too does the quantity supplied, moving from the 'full employment level of Real GDP, 'Yfe' to level 'Y1', this deviation beyond 'Yfe' is referred to as an 'INFLATIONARY GAP'

      • But this scenario won't last forever why?

• It takes time for people to realise that the cost of living has increased, but eventually in the long-run this loss of purchasing power is fully recognised and factor prices (wages) are renegotiated back to their real values, which increases the costs of production for the firms (Shifting the supply curve to the left), meaning the original profit incentive (available with fixed factor prices) has gone and so they reduce output and make the extra workers redundant as well as eliminate overtime hours reverting back to the original potential output and NRU levels of 3%.

• So we can say that in the long run, factor prices adjust to the change in prices back to their real values and output returns to the full-employment level, so a movement from 'B' to 'C'.

• If we imagine the economy is at its potential output level and (at full employment with say an NRU of 3%), and then it enters a CONTRACTIONARY PHASE with low demand, causing the average price level to fall, how will producers react? 

  • • • They will initially think that the price decreases are specific to their industry and given that factor costs are all fixed, they will need to reduce their staff in order to cut costs and reduce the quantity they supply.

      • So, we can say that in the SR as the APL FALLS so too does the quantity supplied, with the equilibrium moving from 'A' to 'B', hence the slope of the SRAS.

      • Furthermore, we can say that in the SR as the APL falls following a decrease in AD, so too does the quantity supplied, moving from the 'full employment level of Real GDP, 'Yfe' to level 'Y1', this deviation below 'Yfe' is referred to as a 'DEFLATIONARY GAP'

      • But this scenario won't last forever?

• As mentioned above, the quantity supplied decreases as factor payments are fixed and therefore the real costs of the firm has increased, while the price it can sell at has fallen hence they produce less and make staff redundant meaning they are above the NRU.

• However in the long-run this gain of purchasing power is fully recognised and factor prices (wages) are renegotiated downwards to their real values, workers who don't accept will be replaced by those who were made redundant before (Don't forget the real wage has returned to normal now, just at a lower nominal rate) which decreases the costs of production for the firms, so they revert back to the original potential output level and the NRU returns to 3%.

• So we can say that in the long run, factor prices adjust to the change in prices back to their real values, and output returns to the full-employment level at an NRU of 3%.

• If we look at the two diagrams below, what can you infer about where the level of output lies once the factor prices adjust? That's right, it always returns to the full-employment level of output, and the only thing that changes is the price level.

So, if we were to draw the long-run level of output we would end up with a vertical line stationed at the full employment level of output.

So far we know this...

• The LRAS curve represents the level of REAL GDP at full employment.at any one moment in time.

• The Long term trendline in the business cycle represents the level of REAL GDP at full employment over time.

• Therefore, the level of REAL GDP at the LRAS curve = a point on the Long term trendline

Therefore...

• The INFLATIONARY/EXPANSIONRY GAP on the ADAS diagram caused by either a rise in demand or supply corresponds to expansionary periods of time on the business cycle when actual GDP is MORE THAN potential GDP.

• The DEFLATIONARY/STAGFLATIONARY GAP on the ADAS diagram can be caused by either a fall in demand or supply and corresponds to contractionary periods of time on the business cycle when actual GDP is LESS THAN potential GDP.

• When there is NO GAP on the ADAS diagram it corresponds to a period of time on the business cycle when actual GDP EQUALS potential GDP.

We can see from the diagrams below that in the Keynesian diagram when AD falls from AD1 to AD2 prices do not fall and readjust like in the classical diagram. Therefore, the economy gets stuck at point 'd', in the SR and hence is 'Unable to move into the LR'.

The KEYNESIAN AS curve consists of three separate sections, which illustrate the relationship between output and price level as before, approaching and at the full employment level of output.

• SECTION 1: CHANGE IN OUTPUT & NO CHANGE IN PRICE. Within this range of output, there exists an abundance of 'Spare capacity' in terms of unemployed factor resources therefore as output rises, there is no upward pressure on factor costs.

• SECTION 2: CHANGE IN OUTPUT & CHANGE IN PRICE. Within this range of output, the availability of resources is running out and firms need to compete for these scarce factors by offering higher payments, which inevitably means they will charge higher prices.

• SECTION 3: NO CHANGE IN OUTPUT & CHANGE IN PRICE. Within this range of output level, the economy has reached full employment, and beyond to a level of output that represents an NRU of 0%. as such only prices can rise while output is fixed.

• We can use the Keynesian model to show basically the same scenarios as in the classical model, however, the main differences are as follows: 

  • • • Factor costs won't automatically adjust downwards, and the economy can become stuck in a recessionary stage. 

      • Unlike in the classical model, increases in AD will not always raise prices when in section 1.

The LRAS curve is stationed at a level of REAL GDP that is termed the 'full employment level of output', and this level is just a single point on the long-term trend on the business cycle, which as we know is upward sloping over time. This suggests that the LRAS curve regularly SHIFTS to the RIGHT, but what would cause this to happen? To answer this we need to consider those factors which 'PERMANENTLY' impact the productive capacity of the economy.

• Increases in the QUANTITY of the factors of production: For example a growing population, Increases in net migration, the discovery of new mineral reserves, all increase the level of resources available.

• Increases in the QUALITY of the factor of production: For example Improvements in education and training, a healthier workforce, all lead to greater productivity and output.

• Improved TECHNOLOGY => PRODUCTIVITY of production: For example, workers who work with improved machines and equipment that have been produced as a result of technological innovations will be able to produce more output in the same amount of time.

• Increases in EFFICIENCY: When an economy increases its efficiency in production, it makes better use of its scarce resources, and can as a result produce a greater quantity of output. Therefore, potential output increases, and the AS curves shift to the right. (Decreases in efficiency would shift the LRAS and AS curves to the left.)

• INSTITUTIONAL changes: This point is related to efficiency in resource use because changes in institutions can sometimes have important effects on how efficiently scarce resources are used, and therefore on the quantity of output produced. For example, the degree of private ownership as opposed to public ownership of resources, the degree of competition in the economy, the degree and quality of government regulation of private sector activities, and the amount of bureaucracy can each affect the quantity of output produced.

• Reductions in the NRU: If it decreases, (E.g reduce the time it takes for people between jobs to find new jobs) the economy is making better use of its resources, and can therefore produce a larger quantity of output. Therefore, potential output increases, and the AS curves shift to the right. (An increase in the natural rate of unemployment would result in a leftward shift in the LRAS and Keynesian AS curves.)

• SHIFTS IN LRAS WILL ALSO SHIFT THE SRAS: Any permanent increase in the productive capacity of the economy will also help firms in the SR to lower the cost of production, hence the SRAS will shift with any changes in LRAS.

• NOT ALL SHIFTS IN SRAS WILL SHIFT THE LRAS: As already shown changes in the costs of production such as wages have only a temporary impact on output in the SR, but not in the LR.

• SHIFTS IN LRAS WILL ALSO SHIFT AD: As we know output = income = spending, therefore we can assume that with greater output comes greater spending and aggregate demand, for example a larger labour force will make more goods and equally demand more goods. 

• Every AD curve is based on a level of SPENDING GROWTH that is consistent along the entire curve, for example, say the amount of spending in $-terms increased by 5%.

• But what did this extra 5% spending go on? Is it the purchasing of greater amounts of output (SPENDING GROWTH = REAL GDP GROWTH), is it simply the same quantity of goods with higher prices (SPENDING GROWTH = PRICE LEVEL GROWTH) or is it a combination of both (SPENDING GROWTH = REAL GDP GROWTH + PRICE LEVEL GROWTH)?

• For example, with a SPENDING GROWTH of 5% we could have any of the following REAL GDP GROWTH & PRICE LEVEL GROWTH rate combinations

• Therefore we can say THE AD CURVE REPRESENTS THE COMBINATIONS OF OUTPUT & PRICE LEVEL GROWTH ASSOCIATED WITH A CERTAIN LEVEL OF SPENDING GROWTH.

• Obviously when spending growth rises the AD curve shifts right and vice versa.

• As mentioned above the level of aggregate demand corresponds to the LEVEL OF SPENDING in the economy. This level of spending is directly correlated to the average price level:

  • • THE WEALTH EFFECT wealth effect (wealth = value of all assets owned, including property, savings, stocks, bonds, etc); If the price level increases then the real value of wealth falls and people feel poorer and thus spend less. 

    • THE INTEREST RATE EFFECT If the price level increases then consumers and firms need more money for their transactions =? demand for money 1l' =? interest rate 1l' =} cost of borrowing 1l' =? consumer and firm spending U due to lower borrowing =? there is an upward movement along the AD curve, from a to b on AD,

    • THE INTERNATIONAL TRADE EFFECT trade effect If the price level increases=} exports become more expensive to foreigners =? quantity of exports (X) demanded by foreigners U. Also imports (M) become relatively cheaper to domestic residents =? quantity of imports 1l' =? (X - M) U =? there is an upward movement along the AD curve, from a to b on AD,

• Therefore we can say THE AD CURVE REPRESENTS THE COMBINATIONS OF OUTPUT & PRICE LEVEL GROWTH ASSOCIATED WITH A CERTAIN LEVEL OF SPENDING GROWTH.

• Obviously when spending growth rises the AD curve shifts right and vice versa.