3.

2 AD-AS Model
The paramount macroeconomics model
Aggregate Supply
  Explain the monetarist/new
classical perspective on the long-
run aggregate supply curve
 Explain that when the economy
is at a long-run equilibrium,
Learning unemployment is equal to the
Outcomes natual rate of unemployment
 Explain inflationary and
deflationary (recessionary) gaps
 Explain how in the monetarist/new
classical perspective the economy
automatically adjusts to full
employment output
 03
LRAS
The monetarist/new classical
model (19th) century
 Aggregate Supply

Why the LRAS curve is

vertical?
 Aggregate Supply

Why the LRAS curve is

vertical?
• In the long run, wages and other input prices are
fully flexible. Any changes in the aggregate price
level will be accompanied by equal proportional
changes in all input prices, including nominal
wages.

• Therefore, as the price level increases or decreases,

with constant real costs, firms’ profits are also
constant, and firms no longer have any incentive to
increase or decrease their output levels.
 Long-Run Aggregate Supply
In long run, price level increases but GDP doesn’t.

LRAS
Price
level
We assume that in Full-Employment
the long-run the (Maximum sustainable
economy will be capacity)
producing at full
employment.
Economy resources
can be used fully and
efficiently
Real GDP
Long-Run Equilibrium when AD curve and SRAS
curve intersect at a point on the LRAS curve

Price LRAS
Level AS

PLe

AD
Yp RealGDP
Long-Run Equilibrium and Full Employment
Output
 Determinants of LRAS

• Quality of Factors of Production

• Quantity of Factors of Production
• Technology
• Infrastructure

It is reasonable to link LRAS with PPC, for both

curves indicate the potential output of a nation
 Practice: Assume the government increases
spending. What happens to PL and Output?
Price LRAS
Level SRAS

PL1 PL and Y will

Increase
PLe

AD1
AD
YP Y1 Real GDP
Inflationary Gap (Positive Output Gap)
Output is high and unemployment is less than NRU.
Price LRAS
Level SRAS

• Real GDP is greater

than potential GDP
PL1 • Too much total demand
in the economy!

AD1

YP Y1 Real GDP
Practice: Assume consumer spending falls.
What happens to PL and Output?
Price LRAS
Level SRAS

PL and Y will
PLe decrease
PL1

AD1 AD
Y1 YP Real GDP
Recessionary Gap (Negative Output Gap)
Output low and unemployment is greater than NRU
Price LRAS
Level SRAS

• Real GDP below

potential GDP
• There is not enough
demand in the economy!
PL1

AD1
Y1 YP Real GDP
Practice: If there is a negative “supply shock”
of oil. What happens to PL and Output?
Price LRAS SRAS1
Level SRAS

PL1 Stagflation
Stagnant Economy
PLe + Inflation

AD
Y1 YP Real GDP
Deflationary (recessionary) and
inflationary gaps in relation to
potential output
Correspondence of AD/AS Model with Business Cycle
Model
Example: Deflationary gap
Correspondence of AD/AS Model with Business Cycle
Model
Example: Deflationary gap
 04

Long-Run Self-Adjustment
#1 Assume there is an increase in consumer spending.
What happens to PL and Output in the short-run?

Price LRAS
Level SRAS

PL1
PL and Y will
Increase
PLe

AD1
AD
YP Y1 Real GDP 20
#2. If consumer spending increases, what happens
to price level and output in the long-run?

Price LRAS SRAS1

Level SRAS
PL2 Price level
increases and
PL1
output stays the
PLe same

AD1
AD
YP Y1 Real GDP 21
If consumer spending increases, what will happen
in the short-run and in the long-run?
In the long-run, wages and costs increase.
LRAS SRAS
Price 1

Level

SRAS
PL2

PL1
PLe

AD AD1
YP Y1 Real GDP
 If consumer spending decreases, what
happens to PL and Output in the short-run ?

LRAS SRAS
Price
Level

PLe
PL1

AD2 AD
Y1 YP Real GDP
 If consumer spending decreases, what will
happen in the short-run and in the long-run?
In the long-run, wages & costs eventually decrease.
LRAS SRAS
Price
Level

SRAS2
PLe
PL1

PL2

AD2 AD
Y1 YP Real GDP
 The rest of the world has just experienced a great
recession due to the Covid-19. What happens to price
level and output for our economy in the long-run?
Price LRAS
Level SRAS

SRAS1

Price Level
PLe decreases and
PL1
output stays the
PL2 same
AD
AD1
Y1 Yp Real GDP
If investment increases, what happens in the
short-run and long-run?
Capital Stock- Machinery and tools purchased by
businesses that increase their output.
Price
Level LRAS LRAS1 The PPC shifts outward since
producers can make more.

Capital Goods
AS

PL1
PLe

AD AD1
QY Q1 QY1 GDPR Consumer Goods 26
Video Task

TASK: https://www.bilibili.co
m/video/BV1Ua4y1F7
1. Use the AD-AS diagram 2E/?spm_id_from=333
.1007.top_right_bar_w
to explain the video. indow_history.content
.click&vd_source=589
c22722f2486d1f6215
21335ea125c
One more video
https:/ /w ww.bilibili.com/ video/BV
1VX4y 1m 7 p5 / ? spm_ id_ from=3 3 3.
999.0.0 &vd_ source =d9 fb39 1 2 3 5 3
262067 2 8 e6 cf97 9 8 6 1 70 6
 04

Keynesian AS
 Keynesian AS

• Keynes questioned the classical economists’

view of the economic system as a harmonious
system that automatically tends towards full
employment.

• It is possible for the economy to get stuck in the

short-run recession for longer periods of time.
 Keynesian AS
Getting stuck in the short
run:
Wage and price downward inflexibility
• During economic expansion and strong
aggregate demand, the price level rises, and the
wages quickly begin to move upward.

• In a recessionary gap, where aggregate demand

is weak and the economy is in recession, wages
do not fall easily, even over longer periods of
time.

• Not only wages but also product prices do not

fall easily when the economy is in a recessionary
 Keynesian AS

Why are wages inflexible?

1. Wage contract
2. Minimum wages
3. Unpopularity of wage cuts
4. Labour union power
 Keynesian AS
Getting stuck in the short
run:
The inability of the economy to move into the long
run
Spare capacity
 Keynesian AS
Getting stuck in the short
run:
The inability of the economy to move into the long
run

• Keynesians would not suggest that wages and prices

can never fall. They would agree that if a recession
or depression contiunues for a long enough time,
wages and prices would eventually fall. But it will be
very costly in terms of unemployment, low incomes
and lost output.
 The shape of the Keynesian AS curve

3 sections Price
1. The horizontal section occurs because
level
of: Keynesian
a) Wage-price downward inflexibility AS
b) Spare capacity when the economy is in Vertical
recession

2. The upward sloping section occurs

becauce of resource bottlenecks Upward
(shortages) appear as output increases sloping

and approaches Yp, causing resource

Horizontal
prices to increase.

3. The vertical sections occurs because

maximum capacity output is reached. Yp Ym Real GDP
3 sections of the Keynesian AS curve
 Three Equilibrium States of the
economy in the Keynesian model
 Three Equilibrium States of the
economy in the Keynesian model
 Keynesian Model: Conclusions

• The economy in Keynesian model can remain

indefinitely stuck in a deflationary gap, unlike in the
monetary/new classical model where the economy
automatically returns to full empolyment equilibrium

• Increases in aggregate demand in Keynesian model

need not necessarily result in increases in the price
level, unlike in the monetarist/new classical model
where increases in aggregate demand always results
in a higher price level.
 05

Shifting aggregate supply

curve over the long term
 Shift in aggregate supply in the
long run and economic growth
 In the long run the LRAS and the Keynesian AS curves
can shift, both curves shift to the right or to the left in
response to factors that change potential output.

 An increase in potential output signifies economic

growth over the long term; a decrease signifies
negative growth.
Shift in aggregate supply in the
long run and economic growth
 Factors that change aggregate
supply over the long term

1. Increases in quantity and quality of factors of

production
( An increase in the quantity of phisical capital...)
( Greater levels of education, skills or health lead to an
improvement in the quality of labour resources...)
( More highly skilled and educated workers or healthier
workers can produce more output...)
 Factors that change aggregate
supply over the long term

2. Improvements in technology
(Workers who work with improved machines and
equipment that have been produced as a result of
technological innovations will be able to produce more
output in the same amount of time...)
 Factors that change aggregate
supply over the long term

3. Increases in efficiency
(When an economy increases its efficiency in production,
it makes better use of its scarce resources, and can as a
result produces a greater quantity of output...)
 Factors that change aggregate
supply over the long term

4. Institutional changes
(The degree of competition in the economy and the
amount of bureaucracy can affect the quantity of output
produced...)
 Factors that change aggregate
supply over the long term

5. Reductions in the natural rate of unemployment

(When it decreases, the economy is making better use
of its resources, and can therefore produce a larger
quantity of output...)
The relationship between the SRAS and
LRAS curves in the monetarist/new
classical model
• If an economy is experiencing long-term economic
growth, its LRAS curve will be shifting rightward,
indicating increases in potential output.

• SRAS curve will be shifting rightward as well. Any

factor that shifts the LRAS curve must, over the long
term, also shift the SRAS curve.
The relationship between the SRAS and
LRAS curves in the monetarist/new
classical model
• There are certain events with only a temporary effect
on aggregate supply, and these can shift the SRAS
curve for a short while, leaving the LRAS curve
unchanged.

• For example, bad weather conditions that cause a

drop in agricultural output. The SRAS curve shifts to
the left for that reason, but then moves back to
normal patterns; the LRAS curve remains unchanged.
 06
Implications of the Keynesian model and the
monetarist/new classical model
 Automatic Self-correction V.S.
Persistence of Deflationary Gaps
Monetarist/new classical economics:
recessionary gaps are automatically corrected
Keynesian economics:
recessionary gaps can persist over long
periods of time
Increases in aggregate demand
need not cause increases in the
price level
 TOK

Why does the debate between monetarist/new

classical economics V.S. Keynesian economics
persist?

Read the comments made by Mark Blaug and

Robert Solow, discuss the view that ideology
and value inflence economists’ research.
Mark Blaug
Robert Solow
Great
Depression
Government
Relief
 The Keynesian revolution
• From Keynesian view, government should
intervene to promote total demand of an
economy.
• Two distinctions of Keynesian economics from
Neoclassical economics
• Although market can eventually
automatically correct itself, government
must intervene to shorten this painful
period.
• Government can spend more than it has:
running into a budget deficit ( 财政赤字 ). John Maynard Keynes

(budget deficit spending)

• Worked well until 1970s.
 A more detailed elaboration of John
Keynes’s work

• Between 1945 and 1981, 27 out of 36 years were time when

government ran into budget-deficit.
• Government targeted at a specific inflation rate to ensure
unemployment, yet its excessive interventions causing volatile
fluctuations, eventually leading to over-supply of money. In fact,
average inflation rate was over 10% for 13 years before 1982.
The Critique of Keynesian theory

1. What is the economic problem that the Keynesian theory

cannot explain and solve?
--- Stagflation ( 滞涨 )

2. Which theory mainly explains the failure of Keynesian

theory?
--- Rational expectation ( 理性预期理论 )
So what caused the crisis of Keynesian
economics?
• Keynesian Assumption:
• When money supply increases, firms would believe
that this rise in price level is profitable, thus willing to
increase their production. The same works for
consumers receiving higher income.
• Rational expectation
• Firms will expect inflation when price increases, so a
higher equilibrium price will not motivate them to
produce more.
• Consumers will expect that their higher wage is a
result of inflation, so they will not spend more.
 Monetarist/New classical school of
economists
• Monetarism, attributed to the New classical economics,
Nobel Prize winning economist associated partly with
another Nobel Prize winning
Milton Friedman (1912-2006),
economist Robert Lucas
emphasizes the role of money in (born 1937) emphasizes the
• the economy.
Monetarists importance of individual's
believe the central 'rational expectations' of
bank should inflation and government
increase the policy actions.
money supply, but
by a strictly
controlled steady
amount consistent
with the rate of
growth of national
Monetarist/New classical school of
economists
• Though they are quite different from each other, we are
considering them together because they share a unifying
principle regarding to the role of markets in bringing the
economy back to a situation where there is full
employment without any government intervention.
In 1980s
Ronald Reagen Margaret Hilda Thatcher

Market-based supply side policies