AD/AS Model

9.1 Aggregate Demand

1. Definition: the total quantity of output all buyers want to but at a given price level
or total demand for an economy’s goods and services from domestic households,
firms, the government and foreigners.

2. AD = C+I+G+(X- M)

3. The downward sloping of AD curve (movement along the AD curve)

 High PL, AD for real output will be relatively low; low PL, AD will
relatively high, ceteris paribus à -ve correlation between AD and PL

o Why downward sloping?

o Income effect
 PL people’s real wealth/income will fall, people will feel less well
offà consume less goods and services à movement along the
curve from A to B
o Interest rate effect [bank]
 Increase in PL à rise in interest rate à opportunity of saving à

consumer spending ，investment à AD

o Net export effect
 Domestic PL , home produced goods will become more expansive
in other countriesà international competitive , D for export
à AD

o Non-price determinants of AD
o
o
o
o
o
4. Component affect AD:
Consumption
o Expectation of income/wealth

o ↑: spend more à C ↑àAD increase; ↓：spend lessàC↓àAD↓

o Interest rate
 Higher IR, opportunity cost of spending increaseà saving increaseà C
decrease
o Household debt (major part of consumer’s expenditure)
 Debt increase: C decrease
 Debt decrease: C increase
o Income tax rate
 Tax rate increaseà disposable income decrease, C decrease
 Vice versa

Investment
o Interest rate
 Higher IR, opportunity cost of borrowing increasesà I decrease
o Business confidence
 BI increase à I increase
 More confidence in expanding or product/tech innovations
o Corporate tax
 Tax increaseà less profit could be madeà invest lesser due to lack of
money
o Technology changes
 Better techà profit increaseà more money can be used on investmentà I

Government spending
o Spending on infrastructure, social services (merit goods)
o Fiscal policy
 Expansionary: G↑, tax↓
 Contractionary: G↓, tax↑

Net export(X-M)
o Exchange rate
 Appreciate: export become expansive à
 Depreciate: export become more competitive
o Trade barriers
 Tariff
 Quota
 Import duty
9.2 & 9.3 SRAS, LRAS, SR and LR equilibrium (Monetarist Model)
1. Definition:
 Short run: a period of time when prices of resources are inflexible
 Aggregate supply: the total quantity of goods and services produced in an
economy over a particular period of time at different price levels
 SRAS: the relationship between price level and the quantity of rGDP
produced by firms when the price of resources do not change
 Long run: a period of time when prices of resources are flexible, including
wages, change along with changes in the price level

2. Graph

why SRAS upward-sloping?

 When the price of resources unchanged, firm’s profit increaseà AR increase, AC
unchanged à firms become more profitableà increase the quantity of output
produced à +ve relationship between PL and rGDP

3. Movement along SRAS

 Causes of shifting
o Wages
 Increase in min wageà wages increase, if PL stays constant, firm’s
COPs increaseà SRAS decrease
o Raw materials
 Increase in price of raw materialsà SRAS decrease (shift to the left)
o Corporative tax
o Subsidies
o Supply shock
 Events that have a sudden & strong impact on SRAS
 E.g unfavourable weather conditions/ natural disasters
4. Types of equilibrium positions
 Recessionary gap

 Inflationary gap

 Full employment level of output


9.4 & 9.5 Aggregate supply and LR equilibrium (Keynesian Model)
1. Wage is downward stickyà getting stuck in the short run
 Keynesian economists argue that
o Situation 1: under conditions of an economy expansion and strong AD, with
unemployment lower than natural unemployment rate, wages quickly begin
to move upward
o Situation 2: in recession gap, AD is weak, the economy is in recession with
unemployment greater than NRU, wages do not fall easily as variety of
factors
 E.g. labour contract, min wage legislation, trade union

2. Keynesian model


 Recessionary gap

 Inflationary gap
 full employment equilibrium

3. Shifting AS in the long term

 Affecting factors
o Increase in quantities of FOPs
 LRAS(monetarist)/ Keynesian model AS shift to the right
 The economy is able to produce more rGDP
o Improvement in the quality of FOPs
 LRAS/AS curve shift to the right
 Higher level of education/skilled /healthy workers are able to produce
more output than the same number of unskilled/ less healthy workers
o Improvement in technology
 LRAS/AS curve shift to the right
 Firms are able to produce more output and increase in efficiency/ better
use of scarce resources

5. Differences between Monetarist Model and Keynesian Model

 Automatic self-correction
o Monetarist model
 Inflationary and recessionary gaps are automatically corrected in the
long run as long as resources, wages, prices are free t change as the PL
o Keynesian model
 The economy(inflationary/ recessionary gaps) will persist in the long run
due to downward sticky wage à insufficient AD

 Increase in AD may not cause an increase in PL

o Monetarist model
 SR: Increase in AD à increase in rGDP
 LR: increase in AD à increase in PL as in the long run, business cycle
fluctuated, inflationary/ recessionary gaps are eliminated (automatically
correction)
o Keynesian model
 Horizontal section: increase in AD à increase in rGDP without affecting
PL
 PL only changes when AS curve begins to slope upward, closing to full
 employment.
6. Keynesian multiplier
 Used to calculate the effect of changes in C, I, G, (X-M) expenditures on rGDP

change ∈rGDP
 Keynesian multiplier (k) =
initial change ∈expenditure
 Terminology:
o Marginal propensity to consume (MPC): additional income that households
spend on consumption of domestically produced goods and services
2
 E.g. MPC= à household spend two-thirds of their income on
3
domestic goods and services.
o Marginal propensity to save (MPS): additional income saved
o Marginal propensity to tax (MPT): additional income taxed
o Marginal propensity to import (MPM): additional income spend on imported
goods and services
1 1
 As MPC+ MPS+ MPT+ MPM = income à k= =
1−MPC MPS+ MPT + MPM