Overview
This lecture covers the Aggregate Demand and Aggregate Supply model, differences between Keynesian and Neoclassical economics, their views on macroeconomic equilibrium, and fiscal policy tools.
Aggregate Demand and Aggregate Supply (AD/AS) Model
- Potential GDP is the maximum output at full employment, also called LRAS or Full Employment GDP.
- Aggregate Supply (AS) is total real GDP firms produce and sell at different price levels.
- The SRAS curve shows a positive short-run relationship between price level and real GDP, with input prices fixed.
- The LRAS curve is a vertical line at potential GDP, showing no long-run relationship between price level and output.
- Aggregate Demand (AD) is total spending on domestic goods and services at each price level.
- Components of AD: consumption, investment, government spending, and net exports.
Shifts in AD/AS Curves
- SRAS shifts left if wages/input prices increase, productivity falls, or adverse supply shocks occur; shifts right if the opposite happens.
- AD shifts right if consumption, investment, government purchases, or net exports increase; shifts left if any decrease.
Macroeconomic Equilibrium and Gaps
- Inflationary gap: equilibrium GDP is right of potential GDP, actual unemployment is below natural rate.
- Recessionary gap: equilibrium GDP is left of potential GDP, actual unemployment is above natural rate.
- Long-run equilibrium: actual and natural rates of unemployment are equal.
Keynesian Economics
- Focuses on short-run and aggregate demand, advocating government intervention to close output gaps.
- Recession explained by insufficient aggregate demand and slow adjustment due to sticky prices and wages.
- Expansionary fiscal policy: tax cuts or increased government spending to stimulate demand and end recession.
- Contractionary fiscal policy: tax hikes or spending cuts to reduce inflation.
- Expenditure multiplier: a change in spending has a more-than-proportional effect on GDP.
- Keynesian AS curve is horizontal below potential GDP and vertical at potential GDP.
- Keynesian Phillips Curve: high unemployment/low inflation, low unemployment/high inflation.
Neoclassical Economics
- Emphasizes long-run supply, potential GDP, and self-regulation via flexible wages and prices.
- In the long run, AD changes only affect price level, not output or unemployment.
- Economic growth is driven by increases in physical and human capital and technology.
- Laissez-faire: minimal government economic intervention.
- Adam Smith’s “invisible hand” describes market self-regulation.
Key Terms & Definitions
- Potential GDP — Maximum output at full employment; same as LRAS.
- Aggregate Demand (AD) — Total spending on domestic goods/services at each price level.
- Aggregate Supply (AS) — Total real GDP firms produce/sell at each price level.
- Short Run Aggregate Supply (SRAS) — Relationship between price level and output, with fixed input prices.
- Long Run Aggregate Supply (LRAS) — Vertical supply at potential GDP.
- Stagflation — Stagnant growth plus high inflation.
- Expansionary/Contractionary Fiscal Policy — Policy tools to increase/decrease AD.
- Sticky prices/wages — Prices/wages slow to adjust, causing slow macroeconomic adjustment.
Action Items / Next Steps
- Review examples of recessionary and inflationary gaps in AD/AS graphs.
- Study the shapes of Keynesian and Neoclassical AS curves.
- Prepare to identify and describe recessionary gaps in both models for the exam.