MacroEconomics
Ummad Mazhar, PhD
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Session 17: Course outline
Topics covered: Measuring macroeconomy; GDP and related concepts;
unemployment and its categories; price level, inflation (measurement), long run
growth; growth performance of Pakistan; Saving and investment spending;
loanable funds market; Multiplier; AD line. AS line in the short run and long run.
Topics for this session:
• How is the AD-AS model used to analyze economic
fluctuations?
• How the economy self-correct itself in the long run?
• How can fiscal policy stabilize the economy?
MECO121 [Dr. Ummad] 2
THE AD–AS MODEL
• The AD–AS model uses the aggregate supply curve and the aggregate
demand curve together to analyze economic fluctuations.
AD and AS supply shocks and short run equilibrium
• Macroeconomic equilibrium is affected by two main types of disturbances:
demand and supply.
• We can them AD shock and AS shock
• An AD shock shifts AD curve e.g., if AD shifts rightward, we call it positive
AD shock; if AD line shifts leftward we call it negative AD shock
• An event that affect supply side of the economy, shifts the SRAS curve
• A rightward shift in SRAS line is called positive supply shock
• A leftward shift in SRAS line is called negative supply shock
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Analyzing shocks to demand and supply
• FOUR STEPS TO ANALYZE THE MACROECONOMIC FLUCTUATIONS
1. Identify the shock
2. Direction of shift
3. Show through graph
4. Transition from short run to long run
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Negative demand shock
• Demand shocks shift AD,
moving the aggregate
price level and aggregate
output in the same
direction.
• A negative demand shock
shifts AD leftward from
AD1 to AD2, reducing the
price level and output.
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Positive demand shock
A positive demand shock shifts
AD rightward, increasing the
price level and output.
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Negative supply shock
Supply shocks shift SRAS, moving
the aggregate price level and
aggregate output in opposite
directions.
A negative supply shock shifts SRAS
leftward and causes stagflation—the
combination of inflation and falling
aggregate output.
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A positive supply shock
A positive supply shock shifts
SRAS rightward, generating higher
output and a lower price level.
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LONG-RUN MACROECONOMIC EQUILIBRIUM
• The economy is in long-run macroeconomic
equilibrium when the point of short-run
macroeconomic equilibrium is on the long-run
aggregate supply curve.
• Recessionary gap: when aggregate output is
below potential output
• Inflationary gap: when aggregate output is
above potential output
• Output gap: the percentage difference
between actual aggregate output and potential
output
Short run vs long run effect of negative AD shock…1
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Short run vs long run effect of negative AD shock…2
• In the long run the economy is self-correcting: demand shocks
have only a short-run effect on aggregate output.
• A negative demand shock shifts AD leftward, the economy moves
to E2 and a recessionary gap arises: the aggregate price level and
aggregate output both decline, and unemployment rises.
• But in the long run nominal wages fall in response to high
unemployment, and SRAS shifts rightward. Long-run
macroeconomic equilibrium is restored at E3.
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Short run vs
long run
effects of a
positive AD
shock
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Short run vs long run effects of a positive demand shock
• Starting at E1, a positive demand shock shifts AD rightward, and the
economy moves to E2 in the short run.
• This results in an inflationary gap as aggregate output and the
aggregate price level both rise, and unemployment falls.
• In the long run, nominal wages rise in response to low
unemployment, and SRAS1 shifts leftward. The economy returns to
long-run macroeconomic equilibrium.
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LEARN BY DOING QUESTION 1
• Suppose an economy is in short-run equilibrium but the level of
real GDP is less than potential output. Which of the following
statements is true?
a) In the long run, nominal wages will fall and the SRAS curve will
shift left, restoring the economy to potential output.
b) In the long run, nominal wages will fall and the SRAS curve will
shift right, restoring the economy to potential output.
c) In the long run, nominal wages will fall and the AD curve will shift
left, restoring the economy to potential output.
d) In the long run, nominal wages will fall and the AD curve will shift
right, restoring the economy to potential output.
LEARN BY DOING QUESTION 1
(Answer)
• Suppose an economy is in short-run equilibrium but the level of real
GDP is less than potential output. Which of the following
statements is true?
a) In the long run, nominal wages will fall and the SRAS curve will
shift left, restoring the economy to potential output.
b) In the long run, nominal wages will fall and the SRAS curve
will shift right, restoring the economy to potential output.
(correct answer)
c) In the long run, nominal wages will fall and the AD curve will
shift left, restoring the economy to potential output.
d) In the long run, nominal wages will fall and the AD curve will
shift right, restoring the economy to potential output.
LEARN BY DOING QUESTION 2
• Suppose short-run equilibrium real GDP for an economy is greater
than potential output. This implies that:
a) nominal wages will have to adjust upward as the economy
moves from the short run to the long run.
b) the level of unemployment is very low.
c) jobs are plentiful.
d) to reach long-run equilibrium, the SRAS curve will shift to the
left, resulting in a higher aggregate price level.
e) Answers (a), (b), (c), and (d) are all correct.
LEARN BY DOING QUESTION 2
(Answer)
• Suppose short-run equilibrium real GDP for an economy is greater
than potential output. This implies that:
a) nominal wages will have to adjust upward as the economy
moves from the short run to the long run.
b) the level of unemployment is very low.
c) jobs are plentiful.
d) to reach long-run equilibrium, the SRAS curve will shift to the
left, resulting in a higher aggregate price level.
e) Answers (a), (b), (c), and (d) are all correct. (correct answer)
Fiscal Policy and AD management
• Fiscal policy: the setting of the level of government spending and
taxation by government policymakers
• Motivation:
• “But this long run is a misleading guide to current affairs. In the
long run we are all dead. Economists set themselves too easy,
too useless a task if in tempestuous seasons they can only tell
us that when the storm is long past the ocean is flat again.”
—J. M. Keynes in The General Theory of Employment, Interest, and Money.
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Fiscal policy tools: Expenditures and taxes
Government Revenues Government Spending
Tax Revenues Current expenditures
Non-Tax Revenues Running of govt. department;
organizations
Borrowing (bank, non- Defense
bank)
Privatization proceeds Fund for emergencies
External receipts Development expenditures
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Affect of government policy on the economy
Government spending or tax
Direct effect of spending Indirect effect of taxes
Taxes or subsidies
AD Transfers
Because Autonomous part of Autonomous consumption Autonomous investment (
C+I+G consumption Disposable income tax concessions)
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Fiscal policy and aggregate demand in the short run
• Change in government purchases directly effect AD
•Y = C + I + G
• Change in government tax indirectly effect AD e.g., via
change in disposal income (i.e., C)
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Expansionary fiscal policy
• Fiscal policy that increases aggregate demand is called expansionary fiscal
policy
• An increase in government purchases of goods and services
• A cut in taxes
• An increase in government transfers
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Expansionary fiscal policy closes a recessionary gap
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Contractionary fiscal policy
• Fiscal policy that reduces aggregate demand is called contractionary fiscal
policy
• A reduction in government purchases of goods and services
• An increase in taxes
• A reduction in government transfers
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Contractionary fiscal policy can close inflationary gap
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Effectiveness of fiscal policy
• Some people are skeptical of the use of fiscal policy in managing economy\
• There are three arguments against the use of fiscal policy:
1. Government spending crowd out private spending
2. Government borrowing increases interest rate and crowd out private
investment
3. Costs of government deficits
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Summary
• Due to AD shock both price level and output move in the same
direction
• Due to AS shock price level and output move in the opposite
direction
• In the long run economy can self-correct itself and track its
way back to full employment equilibrium
• Fiscal policy can be used to manage AD in the short run.
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Relevant Exercises/Problems
• Pages 309-311: Problems 4, 5, 14, and 15
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See you next time
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