Unit 3 AS/AD model notes

AS/AD model

Full employment: equilibrium exist where AD intersects SRAS and LRAS at the same point. 

Recessionary Gap: occurs when equilibrium occurs below full employment output

Any time recession or recessionary gap AD is decreasing and shifts to the left

Inflationary Gap: exist when equilibrium occurs beyond full employment output

AD shifts to the right

Interest Rates and Investment demands

Investment: money spent or expenditures on: New plants (factories), Capital equipment (machinery), Technology (Hardware and software), New Homes, Inventories (goods sold by producers)

How business make decisions: Cost/ benefit analysis

How business determine the benefits: expected rate of return

How does business count the cost: Interest cost

How does business determine the amount of investment they undertake: Compare expected rate of return to interest cost. If expected return > interest cost then invest, If expected return < interest cost then don’t invest.

Real (r%) v. Nominal (i%)

Nominal is observable rate if interest. Real subtracts out inflation also known as ex post facto.

R%= i% - Pi%

Real interest rate determines investment decisions

Investment demand curve: it is downward sloping because when interest rate high, few investments are profitable, when they are low then more are profitable

Unit 3 AS notes

Aggregate supply

Long run v short run

Long run- period of time where input prices are completely flexible and adjust to changes in the price level: the level of real GDP supplied is independent from price level

Short run- period of time where input prices changes are sticky and do not adjust to changes in price level: the level of real GDP supplied is directly related to the price level

Long Run Aggregate Supply (LRAS) - marks the level of full employment in the economy (analogous to PPC)

Because input prices are completely flexible in the long-run, change in price level do not change firm’s real profits and therefore do not change firm’s level of output. This means LRAS is vertical at economy’s level of full employment.

 

SRAS- because input prices are sticky in the short run the SRAS is upward sloping.

Changes in SRAS- increase is shift to right, decrease is shift to left, key to understanding is per unit cost of production

Per- unit production cost= total input cost / total output

Determinants of SRAS:

                Input prices:

                                Domestic resource prices: wages (75% of business cost), cost of capital, raw materials

                                Foreign resource prices: Strong $= lower foreign resource prices

                                Market Power: monopolies and cartel that control resources control the price of those resources

                                Increase resource prices= SRAS shift to left

                                Decrease resource prices= SRAS shift to right

                Productivity:

                                Productivity= total output / total input

                                More productivity= lower unit production cost= SRAS right

                                Lower productivity= higher unit production cost= SRAS left

                Legal institutional environment:

                                Taxes and subsidies

                                                Taxes ($ to Gov’t) increase per unit price= SRAS left

                                                Subsidies ($ from Gov’t) decrease per unit price= SRAS right

                                Government Regulation

                                                Government regulation creates a cost of compliance= SRAS left

                                                Deregulation reduces compliance costs = SRAS right

Unit 3 AD notes

Aggregate Demand (AD) – shows the amount of real GDP that thee private, public, and foreign sector collectively desire to purchase at each possible price level. Relationship between price level and real GDP is inverse 

3 reasons AD is downward sloping: 

1.       Real-balances effect- when price level is high and businesses cant afford to purchase as much output. When price is low can purchase more output.
2.       Interest- rate effect- high price level increases interest rate decreases investment
3.       Foreign purchases effect- higher price level increases demand for relatively cheaper imports. Lower price-level increases the foreign demand for US exports

Shifts in AD

2 things: 

1.       change in C, Ig, G, and/or Xn
2.       multiplier effect that produces greater change that original change in  the 4 components

Increase= shift to right

Decrease= Shift to left

Determinants of AD:

                Consumption affected by:

                                Consumer Wealth: more wealth= more spending (AD shifts right) opposite also true

                                Consumer expectations: Positive expectations= more spending (AD shifts right) opposite also true

                                Household indebtedness: less debt= more spending (AD shift right) opposite also true

                                Taxes: Less taxes= more spending (AD shifts right) opposite also true

                Gross Private Domestic Investment:

                                Real interest rate: lower interest rate= more investment (AD right) opposite also true

                                Expected Returns: Higher expected returns= more investment (AD right) opposite also true. Expected returns influenced by: Expectations of future, Technology, Degree of excess capacity, business taxes.

               

                Government spending:

                                More government spending (AD right)

                                Less Government spending (AD left)

                Net exports:

                                Exchange rate: Strong $= more imports and less exports= (AD left) opposite also true

                                Relative income: Strong foreign economies= more exports= (AD right) opposite also true