ECON1102 Lecture Notes - Lecture 7: Ceteris Paribus, Real Interest Rate, Aggregate Supply
TOPIC 7A THE AD-AS MODEL
AD-AS
- We have considered a long-run model of the macroeconomy, namely the Solow-Swan growth model.
Now we must build a comparable model for the macroeconomy in the short-ru. •
- The Aggregate Demand and Aggregate Supply (AD-AS) model examines how short-run fluctuations in
real GDP and the price level occur and how they affect total output.
- The basic idea: Real GDP and the price level are determined in the short run by the intersection of the
shortrun Aggregate Demand (AD) curve and the short-run Aggregate Supply (AS) curves.
AD AND AS CURVES
- Aggregate demand (AD) curve: A curve that shows the relationship between the price level (or
inflation rate as an alternative but equivalent specification) and the quantity of real GDP demanded by
households, firms and the government, i.e. the whole economy. We derived this curve last time from
the AE model.
- Aggregate supply (AS) curve: In this case we have two versions: Short-run aggregate supply (SRAS)
curve: A curve that shows the relationship in the short run between the price level and the quantity of
real GDP supplied; Long-run aggregate supply (LRAS) curve: a similar curve for the long-run. Unless
explicitly noted reference to an AS curve can be assumed to be short-run.
- I the log ru e hae a lassial dihoto. “‘ doest hold ad hae upard slopig suppl ure.
AD CURVE V MARKET DEMAND CURVES
- Remember that the AD curve is fundamentally different than the microeconomic market demand
curve.
- An AD curve is built up from the demand expenditures side of the whole economy – C+I+G+NX – and in
this sense represents a short-run balance across these components across all micro-markets for goods
and services. It shows total AD (or AE) associated with different price level.
- A market demand curve is, by contrast, the sum of willingness to-pay for a given good at various prices
across all potential buyers of that good. Both D curves slope downward but the reason for a negatively
sloped market demand curve is due to the fact consumers are generally willing to buy less of a good
the more its price increases. (The AS curve is also different from the market S curve – more on that
later)
AGGREGATE DEMAND (AD) SLOPE SIGN
- Why is the aggregate demand curve downward sloping (i.e. the sign of the slope is negative)? Since AD
is derived from AE, we know the major reasons for this:
1. The wealth effect
- A change in the price level affects real wealth and hence consumption.
2. The interest-rate effect
- A change in the price level affects real interest rate and hence investment (primarily).
3. The international-trade effect
- A change in the price level affects relative real price of foreign and domestic goods and also
international exchange rates and hence net exports.
AGGREGATE DEMAND (AD) SLOPE MAGNITUDE
- The AD curve shows the relationship between the price level and the quantity of real GDP demanded,
holding everything else constant. Changes in the price level are depicted as movements up or down a
stationary aggregate demand curve. So the relationships of C, I, G and NX to AD given changes in price
level are all inverse, i.e. price level increases reduce one or more of these components and make the
sign of the slope negative.
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- The strength of the various effects makes the curve shallower or steeper, ceteris paribus (i.e. changes
the magnitude of the slope). Thus, if I, say, is very sensitive to real interest rate changes as affected by
price level, then the AD curve will be steeper than when I is not very sensitive to such changes
- Here is an example of two different AD curves. AD1 is flatter than AD2, which means that the
elastiit resposieess of ‘eal GDP ith respet to the prie leel is uh greater tha that of the
steeper AD2.
- So we can see that a change in the price level in either direction changes Real GDP much more for AD1
tha for AD hih is relatiel ielasti.
- What determines AD elasticity?
- Recall that the AD curve shows the relationship between different price levels and different real GDP
levels and is drawn from the AE curve consisting of C+I+G+NX.
- Also recall that each one of these expenditure categories has functions behind them (e.g. the
consumption function).
- It is through these functions that we can determine responsiveness of real GDP to nominal price
changes.
A CONCEPTUAL EXAMPLE
- Suppose we have two different economies (or the same economy but in two different years). Call them
Economy 1 and Economy 2. (If we were looking at the same economy but at different times we could
say Economy 1 t and Economy 1t+5 to indicate, for example, time t and then time t+5, e.g. 5 years later
for Economy 1)
- Both economies have the same expenditure functions except that 1 has an investment function (I)
where investors are much more responsive to changes in short-run real interest rates than with 2.
- Which economy has a flatter AD curve?
ANSWER
- First e hae to thik of hat flatter eas. It eas that a hage i the prie leel ill ield a
greater hage i ‘eal GDP, eteris parius. I other ords, a flatter ure ill e ore elasti or
responsive.
- Conceptually it should then be clear that 1 will have a flatter (more responsive) curve than 2 because
the economies (or more precisely their AE curves) are entirely identical except for their I functions,
which is more responsive to real interest rate changes in 1 than in 2.
- Intuitively what is happening is that I in 1 will shift much more in response to a given a change in
nominal interest rates in the short-run than in 2 as price level changes in 1 will, by changing the real
interest rate, up or down, yield a greater change in I in that economy than in 1.
AGGREGATE DEMAND (AD) SHIFTS
- Slope refers to movements along the curve. But the AD curve may shift left or right as well. This would
e the ase he a eogeous shok ours.
- Variables that shift the aggregate demand curve include:
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1. Changes in government policies.
- Examples: taxes; government purchases.
2. Changes in the expectations of households and firms.
3. Changes in foreign variables in economies outside the domestic economy, e.g. relative income
levels between countries.
A NOTE ON “HIFT“ VE‘“U“ MOVEMENT“ ALONG
- We must make sure to be very clear on the economic differences between shifts and movements along
a curve. In a movement along a curve everything is held constant and we are looking at a line that
shows what real GDP will be, given different possible price levels as this affects the components of AE,
ceteris paribus. In shifts of the curve there is an exogenous shock that changes our overall structure
somehow, e.g. a shift in the entire structure of interest rates and its effect on the whole economy.
- So if price level changes but nothing else does, we have a movement along the AD curve (i.e.
everything else in the economy, including the functions behind C, I, G and NX, are fixed and we are just
looking at the set trade-off between total real GDP and changes in price levels). If there as a change to
the parameters, e.g. a rise in interest rates because of changes in the loanable funds market, then
there is a shift in AD.
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Document Summary
We have considered a long-run model of the macroeconomy, namely the solow-swan growth model. Now we must build a comparable model for the macroeconomy in the short-ru(cid:374). The aggregate demand and aggregate supply (ad-as) model examines how short-run fluctuations in real gdp and the price level occur and how they affect total output. The basic idea: real gdp and the price level are determined in the short run by the intersection of the shortrun aggregate demand (ad) curve and the short-run aggregate supply (as) curves. We derived this curve last time from the ae model. Unless explicitly noted reference to an as curve can be assumed to be short-run. I(cid:374) the lo(cid:374)g ru(cid:374) (cid:449)e ha(cid:448)e a (cid:272)lassi(cid:272)al di(cid:272)hoto(cid:373)(cid:455). Does(cid:374)(cid:859)t hold a(cid:374)d ha(cid:448)e up(cid:449)ard slopi(cid:374)g suppl(cid:455) (cid:272)ur(cid:448)e. Remember that the ad curve is fundamentally different than the microeconomic market demand curve.
