Chapter 12 Homework Srascurve Would Shift Down Restoring Long run Equilibrium

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Chapter 12: The Aggregate-Demand/Aggregate-Supply Model 126

CHAPTER 12

The Aggregate-Demand/Aggregate-Supply Model

TEACHING OBJECTIVES

Goals of Chapter 12

A. See how the AD-AS model is built up from dividing the economy’s

spending into a number of different categories, depending on who

buys which goods and services.

B. Examine how government policy works in the AD-AS model.

C. Look at the large, structural macroeconomic models of the 1960s

and how they were used for forecasting and analyzing changes in

government policy.

D. Examine the differences between Keynesian and classical views of

the economy.

E. Discuss whether the large, structural macroeconomic models

contributed to the poor performance of the economy in the 1970s.

TEACHING NOTES

A. Introduction

1. The complexity of the economy requires economists to produce

simpler models for understanding how the economy works

2. The aggregate-demand/aggregate-supply model divides

spending into different categories, depending on who buys what

3. Government policy influence aggregate demand and aggregate

supply

B. A Model of Aggregate Demand and Aggregate Supply

1. Aggregate demand: the total demand for goods and services

a) Consumption

(1)Consumer spending on durables, nondurables, and

services

(2)Affected by current income, future income, wealth, taxes,

and real interest rate; use Data Bank: Is Consumer

confidence a Good Indicator of Future Consumer Spending?

b) Investment

(1)Consider only investment in physical capital (equipment

and structures used by businesses and houses that people

live in) not financial investment (stocks and bonds)

(2)Capital stock equals total amount of physical capital

(3)Investment depends on future consumption, wealth, taxes,

real interest rate, profit, and current and future income

Chapter 12: The Aggregate-Demand/Aggregate-Supply Model 127

c) Net exports

(1)Net exports equal exports minus imports

(2)Net exports depend on domestic income and foreign

income

d) Government spending

(1)Government spending is assumed to be exogenous

e) The aggregate-demand curve: a curve that shows

combinations of the price level and output that are consistent

2. Aggregate Supply

a) Aggregate supply is the economy’s total production of

goods and services

b) The aggregate-supply curve shows the combination of the

price level and output that is consistent with firms’ production

decisions

c) Full employment is the situation when all capital and labor

d) In the short run, an upward-sloping aggregate supply (SRAS)

curve shows that a higher price level leads to increased

output

e) In the long run the economy is at full employment and the

unemployment rate equals the natural rate of unemployment,

so the long-run aggregate supply (LRAS) curve is a vertical

line at full-employment output (Figure 12.3)

3. Putting Aggregate Demand and Aggregate Supply Together

a) In the short run, equilibrium occurs where the SRAS and AD

curves intersect; see Figure 12.4a

b) In the long run, equilibrium occurs where the LRAS and AD

curves intersect; see Figure 12.4b

4. From the Short Run to the Long Run

a) The short-run equilibrium differs from the long-run equilibrium

because wages and prices do not adjust immediately to clear

Chapter 12: The Aggregate-Demand/Aggregate-Supply Model 128

5. How Shifts in Exogenous Variables Affect Aggregate Demand and

Aggregate Supply

a) The aggregate demand curve shifts to the right because of

changes in the market for goods and services, including

increases in future income, wealth, future consumption,

pro9ts, business optimism, and foreign income; or decreases

in taxes or the real interest rate

b) The aggregate demand curves shifts to the right because of

changes in the market for money, including a decrease in the

costs of using ATMs or other variables that cause money

6. An Example: A Drop in Business Optimism

a) A sudden decline in business optimism would not affect the

aggregate supply curves, but would shift the aggregate

demand curve to the left

7. Adjustment from the Short Run to the Long Run

a) The SRAS curve adjusts to restore long-run equilibrium at the

C. Data Bank: Is Consumer Con9dence a Good Indicator of Future

Consumer Spending?

1. There is a strong correlation between consumer confidence and

consumer spending

Chapter 12: The Aggregate-Demand/Aggregate-Supply Model 129

2. The author’s research shows that the consumer confidence

indexes are not helpful at all for forecasting future consumption

D. Data Bank: Investment Shocks and the Business Cycle

1. The shocks that cause recessions are often shocks to investment

E. Analyzing Policy Using the AD-AS Model

1. Monetary Policy

a) Monetary policy can be used to manipulate the AD curve to

restore long-run equilibrium more quickly than the slow

adjustment of prices, wages, and price expectations

2. Effects of Fiscal Policy

a) Fiscal policy can also be used to shift the AD curve in the

same way as monetary policy is used

b) The main difference between using 9scal policy and monetary

policy is in their effect on the real interest rate; use Figure

12.10 and Table 12.4

F. Large, Structural Macroeconomic Models

1. Large computer models, based on the basic structure of the

AD–AS model, have been developed since the 1950s to help

economists forecast the economy and understand the impact of

monetary and 9scal policies

2. These models are called large, structural macroeconomic

models because they consist of hundreds of equations

describing the structure of the economy

3. Keynesian economists were the main force behind the

development of the models, which were the state of the art for

many years

4. But inconsistencies in the structure of the models and their

forecasting failures in the 1970s led many economists to

question their value

Chapter 12: The Aggregate-Demand/Aggregate-Supply Model 130

tools. Classicals, on the other hand, think that the

price-adjustment process is fairly quick, so government policy is

not needed to restore equilibrium

3. In the AD-AS model, effective use of policy requires knowledge

about the location of the LRAS curve. Keynesians are con9dent

about the knowledge that policymakers possess about the

location of the LRAS curve and the state of the economy, to use

policy effectively, whereas classical economists are skeptical in

this case

classicals believed that supply shocks caused recession

H. Policy Perspective: Did Large Macro Models Mislead Policymakers in

the 1970s?

1. In the early 1970s, Keynesian macroeconomists using large,

structural macroeconomic models thought they had solved the

business cycle and that macroeconomics was obsolete as a field

of study

2. A tradeoff between inflation and unemployment was a key part

of Keynesian theory

3. But in the 1970s, in3ation and unemployment both rose sharply,

contrary to the theory and to the forecasts from the large,

structural macroeconomic models

4. The theory of rational expectations was able to explain the

failures of Keynesian theory; the lack of a tradeoff between

inflation and unemployment; and the failure of the large,

structural macroeconomic models