The AD-AS Model

• Short-run macroeconomic equilibrium occurs when the quantity of aggregate output supplied equals the quantity demand (AD = SRAS)

• Long-run macroeconomic equilibrium occurs when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve (AD = SRAS = LRAS)

• At the LRAS, the economy is functioning at the Potential Output, or Y_p

• If the aggregate output in the short-term is below the potential output, the economy faces a recessionary gap

• If the aggregate output in the short-term is above the potential output, the economy faces an inflationary gap

The Long-Run Approach

• In a recessionary gap, the following occurs

  • An initial negative demand shock (stock market crashes)

  • AD shifts to the left, and so the aggregate price level and aggregate output reduce, which leads to higher unemployment in the short-run

  • Eventually, a fall in nominal wages in the long run increases the SRAS and moves the economy back to potential output

  

• Expansionary Fiscal Policy

  • "In the long-run, we are all dead." John Maynard Keynes.

  • Use expansionary fiscal policy to boost aggregate demand in order to get the economy back to its potential output

    • Increase government spending (direct approach)

    • Decrease taxes

    • Increase in government transfers

  • Graph

  

• In a inflationary gap, the following occurs

  • An initial positive demand shock (real estate market booms)

  • AD shifts to the right, and so the aggregate price level and aggregate output increase, which leads to higher inflation in the short-run and reduces unemployment

  • Eventually, an increase in nominal wages in the long run decreases the SRAS and moves the economy back to potential output

  

• Contractionary Fiscal Policy

  • In 1968, President Lyndon Johnson imposed a temporary 10% hike on income taxes to stop inflation

  • Use contractionary fiscal policy to decrease aggregate demand in order to get the economy back to its potential output

    • Decrease government spending (direct impact)

    • Increase taxes

    • Decrease in government transfers

  • Graph

  

Stabilization Policy

• Use of government policy to reduce the severity of recessions and rein in excessively strong expansions

• Should the government use fiscal (or monetary) policy in order to reduce the severity of negative demand shocks?

• What should the government do in the face of a negative supply shock (or stagflation)

  • If you boost AD, you make inflation worse

  • If you decrease AD, you create more unemployment

• Examples

  • Assume the price of oil increases and the government attempts to combat this by lowering taxes and increasing government spending. What happens?

  

• Assume the price of oil increases and the government attempts to combat this by raising taxes and reducing government spending. What happens?