LEARNING UNIT 8

CHAPTER 19

MORE ON
MACROECONOMIC
THEORY AND POLICY
2
Theme 1: The Aggregate
Demand-Aggregate Supply Model

 Learning Outcomes:
• Use the AD-AS model to analyse
L the impact of a change in economic
variables on the achievement of
O macroeconomic objectives.

1
3 AD/AS Graph

Pe E (Macro – economic equilibrium)

Ye
(Y)
 4 THE AD-AS MODEL
 What are the labels on the
axes
 General price level (P)(vertical)
 National income / GDP (Y)
(horizontal)
 What does AD stand for?
 Aggregate Demand
 What does AS stand for?
 Aggregate Supply
5
THE AD CURVE
 There is an negative or inverse relationship between the
general price level (P) and the level of output/income (Y).

 The movement along the AD curve is a result of the

change in the price level. This is made up of three parts:
 Wealth effect
 When prices fall, the real value of incomes increase and
there is a movement along the AD curve.
 Interest rate effect
 When prices fall, interest rates are also likely to fall. Again,
there will be a downward movement along the AD curve.
 International trade effect
 Decrease in prices leads to a depreciation of the rand which
in turn can lead to an increase in the quantity demanded of
domestic goods.
6 SHIFTING THE AD CURVE
 Factors that affect the Aggregate Demand curve are
the same as those that affected the Aggregate
Spending (A) in the Keynesian model and more:

G T
FISCAL
C I POLICY

i MONETAR
Y POLICY
X-
Z
7 Aggregate Demand increases
↑C or ↑I or ↑G or ↑(X-Z) or ↓T
or ↓i
Price level AD1
AD
NOTICE THAT
AS BOTH THE
P1 GENERAL
PRICE LEVEL
AND OUTPUT
P
LEVEL
INCREASE

Y Y1 Aggregate Income (Y)

8 Aggregate Demand decreases
↓C or ↓ I or ↓ G or ↓(X-Z) or ↑T
or ↑i
Price level

NOTICE THAT
AS THE GENERAL
PRICE LEVEL
DECREASES
P and THE
P1 OUTPUT LEVEL
ALSO
DECREASES
AD
AD1
Y1 Y Aggregate Income (Y)
9
Movie time!
10 Recap: The AD - curve
11 LU8: Slopes of the AS
curve
 The AS curve can have different
slopes.
 The Short-run AS curve is mainly determined
by the costs of production in the economy and it
slopes upwards indicating a positive relationship
between the price level and the level of output.
 The Long-run AS curve is a vertical line
indicating that the LR level of output is not
affected by the price level.
12
 SRAS & LRAS
13
14 Long-run AS vs Short-run AS

LRAS
SRAS
Price level

Price level
SRAS

Income Income
(Y) (Y)
 SHIFTING THE SRAS CURVE
STUDY TABLE 19-
15 2
 The factors that affect aggregate supply:
 Price of factors of production
 Increase Firms produce less and AS decreases (shifts left)

 Decrease Firms produce more and AS increases (shifts

right)

 Price of imported capital and intermediate

goods AS decreases (shifts left)
 Increase
 Decrease AS increases (shifts right)

 Productivity Workers produce more, AS increases (shifts

right)
 Increases
Workers produce less, AS decreases (shifts left)
 Decreases

 Weather conditions?
16 LU8: AD-AS Model
 Aggregate Supply decreases

Price level AS1 THE GENERAL

AD PRICE LEVEL
INCREASES but
AS THE OUTPUT
E1
P1 LEVEL
DECREASES
P E
SUPPLY
SHOCK
STAGFLATIO
N

Y1 Y (Y)
17 LU8: AD-AS Model
 Aggregate Supply increases

Price level AS
AD
AS1 NOTICE THAT
THE GENERAL
PRICE LEVEL
P
DECREASES
P1 while THE
OUTPUT LEVEL
INCREASES

Y Y1 National Income (Y)

18
Simultaneous changes in AD-AS Model

Price level AD1 AS1

AD IN THIS CASE
P1 AS PRICE WILL
CERTAINLY
INCREASE
BUT THE
P EFFECT ON
THE LEVEL OF
OUTPUT IS
UNCERTAIN

Y National Income (Y)

19 Theme 2: The Monetary
Transmission Mechanism
 Learning Outcomes:
• Explain the
L monetary
O transmission
2 mechanism
20 Movie time!!!
Monetary Transmission Mechanism
21
22 Monetary Transmission Mechanism

 Definition of Monetary Transmission

Mechanism
 The way in which changes in the
monetary sector are transmitted to the
rest of the economy.
 The transmission mechanism starts with a
change of the interest rate in the FINANCIAL
SECTOR.
 i ↓→
23
↑I
24

Keynesian
model
i ↓→ ↑ I
→↑A→↑Y
 25

AD/AS Model ↑
i ↓→ ↑ I →↑A P
→↑AD ↑
Y
26
27 TRANSMISSION

MECHANISM
A change in the interest rate leads to change in the level of
autonomous investment in the economy.
 This, in turn, causes a change in aggregate spending (A). In the
Keynesian model this change in A will lead directly to a change in
output (Y).
Δi → ΔI → ΔA →
ΔY

 In the AD-AS model this ΔA leads to a change in aggregate demand

which then causes a change in the price level and the level of output
(Y) in the economy. Use the following identity:

ΔY
Δi → ΔI → ΔA → ΔAD
ΔP
28 Theme 3: Monetary and Fiscal
Policy in the AD-AS Framework
 Learning Outcomes:
• Explain monetary and
L fiscal policy in the AD-AS
O framework
3
• Policy lags associated
L with fiscal & monetary
O policies
4
• Explain “supply-side”
L economics
5
Fiscal & Monetary Policy
in AD/AS Analysis
 Expansionary Policies – AD increases
30
Fiscal
policy

Price level AD1

AD ↑G
↓ T /t
AS
P1 E1 ↓ i%

P E
Monetary
policy

Y Y1 Y
 Contractionary Policies – AD decreases
31
Fiscal
policy

Price level
↓G
↑ T /t
AS
↑ i%
P
P1
Monetary
policy
AD
AD1
Y1 Y National Income (Y)
32 POLICY LAGS
 FISCAL and MONETARY policy (Table 19-3):


The same for fiscal and
RECOGNITION LAG
monetary
Long for fiscal and Short for
 DECISION LAG monetary

 IMPLEMENTATION LAGLong for fiscal and extremely

Short for monetary
Longer for monetary than for
 IMPACT LAG
fiscal
33 LU8: Supply-side
economics
 Key elements:
 Supply-siders believe government
spending is too high.
 Argue for less intervention in the
economy.
 Believe taxes are too high (want lower
taxes).
 SO, they recommend:
 cuts in G;
 deregulation and tax cuts.
34