Question

Part A. Using the New Classical Model with rational expectations, examine the effect of a tax increase. Look at the case where it is expected and where it is unexpected. Use graphs for AS-AD and Labor market. For each case, what is the impact on labor, output, and prices?

Part B. Within the simple real business cycle model, analyze the effect of a negative shock to technology (a negative shock toz) that lasts for one period. What is effect when the shock persists for multiple periods?

Part C. Suppose there was a change in preferences in a real business cycle model such that the representative agent valued leisure more and consumption goods less. How would output and employment be affected by the change?

Answer 1

• The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.

• We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram.

• Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP.

• The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram.

• Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

The AD/AS model allows economists to analyze multiple economic factors.

Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts including the three macroeconomic goals of growth, low inflation, and low unemployment; the elements of aggregate demand; aggregate supply; and a wide array of economic events and policy decisions.

The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing these factors together in one diagram. In addition, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach—focusing on aggregate demand and the short run—while also including the Say’s law approach—focusing on aggregate supply and the long run.

Growth and recession in the AD/AS model

We can examine both long-term and short-term changes in gross domestic product, or GDP, using the AD/AS model. In an AD/AS diagram, long-run economic growth due to productivity increases over time is represented by a gradual rightward shift of aggregate supply. The vertical line representing potential GDP—the full-employment level of gross domestic product—gradually shifts to the right over time as well. You can see this effect in AD/AS diagram A below, which shows a pattern of economic growth over three years.

However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in an AD/AS diagram.

AD/AS diagram A, on the left, shows how productivity increases will shift aggregate supply to the right

In the short run, GDP, falls and rises in every economy as the economy dips into recession or expands out of recession. When an AD/AS diagram shows an equilibrium level of real GDP substantially below potential GDP—as is shown in the diagram below at equilibrium point \text{E0}E0start text, E, 0, end text—it indicates a recession. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP—as it is at equilibrium point \text{E1}E1start text, E, 1, end text.

The higher of the two aggregate demand curves in this AD/AS diagram is closer to the vertical potential GDP line and hence represents an economy with a low unemployment. In contrast, the lower aggregate demand curve is much farther from the potential GDP line and hence represents an economy that may be struggling with a recession.

Unemployment in the AD/AS diagram

We can examine two different types of unemployment using an AD/AS diagram—cyclical unemployment and the natural rate of unemployment. Cyclical unemployment bounces up and down according to the short-run movements of GDP. The long-term, baseline level of unemployment that occurs year in and year out, however, is called the natural rate of unemployment.

The natural rate of unemployment is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.

In an AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full-employment level of GDP. Take another look at the AD/AS diagram above. Relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as at the equilibrium point \text{E1}E1start text, E, 1, end text. On the other hand, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point \text{E0}E0start text, E, 0, end text.

The factors that determine the natural rate of unemployment are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP, or full-employment GDP, in a given economy.

Inflationary pressures in the AD/AS diagram

Inflation fluctuates in the short run, and higher inflation rates typically occur either during or just after economic booms. For example, the biggest spurts of inflation in the US economy during the 20th century followed the wartime booms of World War I and World War II. On the other hand, rates of inflation generally decline during recessions.

The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the aggregate supply curve. Let's look at diagram A, on the left below. In this diagram, you'll see a shift of aggregate demand to the right. The new equilibrium \text{E1}E1start text, E, 1, end text is at a higher price level than the original equilibrium \text{E0}E0start text, E, 0, end text. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.

The two graphs show how a shift in aggregate demand or supply can cause inflationary pressure. The graph on the left shows two aggregate demand curves to represent a shift to the right. The graph on the right shows two aggregate supply curves to represent a shift to the Incorporates Growth, Unemployment, and Inflation" by OpenStaxCollege, CC BY 4.0

Another source of inflationary pressures is a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor. This situation can cause the aggregate supply curve to shift back to the left. In diagram B above, the shift of the SRAS curve to the left also increases the price level from \text{P0}P0start text, P, 0, end text at the original equilibrium \text{E0}E0start text, E, 0, end text to a higher price level of \text{P1}P1start text, P, 1, end text at the new equilibrium \text{E1}E1start text, E, 1, end text. In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.

An AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years.