ECS 1601

Learning Unit 8
More on macroeconomic
theory and policy

Remember, the
Thisway
is the
best
to first
learn
learning
of
is to takeunit
notes
the
third
last
and
ASKand
if you
part
ECS 1601.
dontofunderstand.

Take out your text book. Keep

it next to you!
If the slide has a red
speech bubble that says
READ section so-and-so, hit
pause, read the section
and watch the slide
thereafter!

Content
In this learning unit, you will learn
more about:
The aggregate demand and
aggregate supply model
The monetary transmission
mechanism
Monetary and fiscal policy
in the AD-AS framework

Read section
19.1 in
textbook
pp 360-367

8.1 The AD-AS model

Study box
19.1 in
textbook
p 360

Recall the demand and

supply models from
microeconomics
(ECS 1501).
The aggregate demand
(AD) and aggregate
supply (AS) model are
similar, but the AD-AS
model is a macroeconomic model, so we
have to change a couple
of things:

Price (P)

D
0
Quantity (Q)

It is not the supply of one

1
good or service.
but the supply of all goods
and services, which is
called aggregate supply
(AS).
2 It is not the demand for
one good or service
but the demand for all
goods and services, which
is called aggregate
demand (AD).

AS
S

Price (P)

8.1 The AD-AS model

D
AD
0
Quantity (Q)

It is not the quantity of one

3
good or service.
but the quantity of all
goods and services, which
is the same as total
production or income.
It is not the price for one
4
good or service
but the prices for all goods
and services, which the
same as the general price
level.

AS

Price (P)
Price level

8.1 The AD-AS model

AD
0
Total production,
income
Quantity
(Q)

8.1 Aggregate Demand (AD)

AD = C + I + G + NX
(just like the expenditure line in the
Keynesian model)

Slope of the AD curve

Reasons why a fall in the price level tends to raise the quantity of
goods and services demanded
in the economy.
Consumers
become wealthier, which
Wealth effect
stimulates the demand for
consumer goods and services C .
Interest rate
effect
International
trade effect

Interest rates fall, which stimulates

the demand for investment goods I.
The currency depreciates, which
stimulates demand for net exports
(X-Z).

8.1 Aggregate Demand (AD)

Lets explain how each of these effects influence
aggregate demand (the arrows indicate direction of
change):

Wealth effect

Change in
real wealth

Change in
price level

Interest rate
effect
Change in
price
level

Change in
interest rates

Change in
aggregate
spending

Change in
consumption
spending

Change in
aggregate
spending

Change in
investment
spending

International trade effect

Change in
price level

Change in
interest
rates

Change in prices of
domestic goods relative
to foreign goods

Change in
exchange
rate

Change in
net exports

Change in
aggregate
spending

8.1 Changes to AD

Remember: an
increase or
decrease in
the price level
will only cause
a movement
along the AD
curve

Price level

Study table
19.1 in
textbook
pp 363

Increase in P
causes a
leftward move
along the AD
curve
Decrease in P
causes a
rightward move
along the AD
curve

P
P
P

AD
Y

Total production, income

8.1 Changes to AD

What will cause

the AD curve to
shift to the right?

G
T
NX

Price level

Study table
19.1 in
textbook
p 363

AD1

AD
0
Total production, income

What will cause the

AD curve to shift to
the left?

I
G
T
NX

Price level

8.1 Changes to AD

AD2

AD

Total production, income

8.1 Changes to AD

Lets put the AS curve back.

Show where the equilibrium is
and what the equilibrium price
level and total production are.
The economy will be in
equilibrium where the AS and
AD curve intersects, i.e. at
price level PE and income
level YE
Suppose there is an increase in
AD.
Where is the new equilibrium
and what was the impact on
the equilibrium price level and
the equilibrium total
production?

AS
Price level

Refer to
Changes in
AD on pp
365-366

E1
P1
PE

AD1

AD
0

YE

Y1

Total production, income

8.1 Changes in AD
AS
Price level

Lets see what happens

when the AS curve is
steeper, such as AS
Suppose there is now an
increase in AD.
Equilibrium is now at E2.
Compare E1 and E2.
Because the AS curve is
steeper than before, the
increase in the price
level is larger and the
increase in the income
level is smaller than for
the flatter AS curve.

AS
E
P2
P1

E1

PE

AD1

AD
0
0

YE Y2 Y1

Total production, income

8.1 Aggregate Supply (AS)

In the short run, the AS curve slopes

upward from left to right.
Why does the AS curve slope
upward?
The AS curve is primarily focused on
the cost of production.
At any time there is a certain level
of nominal wages in the economy.
An increase in prices from P1 to P2
results in a decrease in real wages
(remember nominal wages are set).
Therefore, producers will now
employ more labourers and
increase production from Y1 to Y2.
A higher level of prices is associated
with a higher level of production,
and the AS curve slopes upward.

AS

Price level

Refer to
The slope
of the
short-run
AS curve
p 364

P2

P1

If you dont
understand
how an
increase in
prices results
in a decrease
in real wages,
Y2
ask yourY1etutor.
Total production, income

8.1 The long-run AS curve

(LRAS)

In the long run, the AS curve is

vertical (independent of the price
level).
Total production in the long run
depends on the quantity and
quality of the available factors of
production.
The long run level of output is also
called:
potential output
full-employment output
the natural rate of output
Changes in the availability and
productivity of the factors of
production will give rise to shifts of
the LRAS curve:
To the right if their quantity or
productivity increases
To the left if their quantity or
productivity decreases

LRA
S

Price level

Read in
textbook
pp 364365

Y
Total production,
f
income

8.1 Changes to AS

Remember, an
increase or
decrease in
the price level
will only cause
a movement
along the AS
curve.

Price level

Study Table
19.2 in
textbook
pp 364

Decrease in P
results in a
leftward move
along the AS
curve

Increase in P
results in a
rightward move
along the AS
curve

P
P

Total production, income

8.1 Changes to AS

What will cause the

AS curve to shift to the
left?
Wages
Price of
The same
intermediary goods
amount of
production
Price of imported
Y1 can now
goods
only be
Productivityproduced at
a higher
Deteriorating price
weather
level.
conditions (for
example, floods or
earthquakes that
destroy infrastructure)

AS1

AS

P2
Price level

Study Table
19.2 in
textbook
pp 364

P1

Y1
Total production, income

8.1 Changes to AS

What will cause the

AS curve to shift to the
right?
Wages
Price of
The same
intermediary goods
amount of
production
Price of imported
Y1 can now
goods
be produced
Productivityat a lower
Good weatherprice level.
conditions (sunshine
and good rain
improve harvest)

Price level

Study Table
19.2 in
textbook
p 364

AS
AS2
P2

P1

Y1
Total production, income

8.1 Changes in AS

Lets put the AD curve back.

The economy will be in
equilibrium where the AS and
AD curve intersects, i.e. at
price level PE and income
level YE.
Suppose there is an upward
shift of the AS curve (e.g. due
to a supply shock).
Where is the new equilibrium
and what was the impact on
the equilibrium price level and
the equilibrium total
production?
Production decreased AND the
price level increased. This is
called stagflation.

AS1

AS

Price level

Refer to
Changes in
AS on pp
366-367

E1
P1
E

PE

AD
0

Y1

YE

Total production, income

 What happens when the SARB

changes the repo rate (assuming
prices and wages are fixed)?
When the SARB decreases the repo
rate, the general interest rate level
will decrease.
What will the effect of a decrease in
the interest rate be on investment
spending? Go back to chapter 17,
figure 17-3, if you cannot recall.
If investment spending increases,
what will the effect be on aggregate
spending?
Aggregate spending increases due to
the increase in investment spending.
But remember, due to the multiplier,
a small change in aggregate
spending has a larger effect on total
production and income.

Interest rate (i)

8.2 The monetary

transmission mechanism

Do not study
Other links
between
interest rate
and the rest of
the economy.

i
i
I
l

Aggregate spending (A)

Read section
19.2 in
textbook
pp 367-370.

lInvestment spending (I)

A2
A1

Y
Y
Total production, income (Y)

Lets see what happens when prices and wages are not fixed anymore in the
AD-AS model..
There is an increase in aggregate spending due to the increase in investment AS
spending.
It is illustrated by a rightward shift of the AD curve, prices and total production
Thus: The monetary transmissions
mechanism
A
P2
Asays:

Price level

Aggregate spending (A)

8.2 The monetary

transmission mechanism

P1

AD
AD
Y

Total production, income (Y)

Y1

Y2

Total production, income

Read section
19.3 in
textbook
pp 372-375

8.3 Monetary policy

in the AD-AS framework

Expansionar
y monetary
policy

Contraction
ary
monetary
policy

It is implemented when
the central bank (e.g. the
SARB) reduces the repo
rate at which it provides
credit to the banks. The
general interest rate
level in the economy
decreases.
It is implemented when
the central bank
increases the interest
rate. The general interest
rate level in the economy
increases.

Investment
increases. The AD
curve shifts to the
right.

Investment
decreases. The AD
curve shifts to the
left.

8.3 Fiscal policy

in the AD-AS framework
Expansionar
y fiscal
policy

Contraction
ary fiscal
policy

Government
expenditure (G)
increases
Taxes (T) decrease,
which increases
consumption (C)
Government
expenditure (G)
decreases
Taxes (T) increase,
which decreases
consumption (C)

The AD curve shifts

to the right.

The AD curve shifts

to the left.

8.3 Monetary and fiscal policy lags

There are different monetary and fiscal lags.
The recognition lag
(The time it takes government/SARB to see something is
wrong)
The decision lag
(The time it takes government/SARB to decided what to do
about the problem)
The implementation lag
(The time it takes government/SARB to organize everything
so that the decision can be implemented)
The impact lag
(The time it takes for the policy to have an
impact in the economy)

8.3 Relative effectiveness

Fiscal policy is generally more effective to
stimulate a depressed economy.
Monetary policy is generally more effective to
dampen an overheated economy.
Apart from the lags previously named, there
are institutional features of these policies that
also have to be taken into account:
Fiscal policy has to be approved in parliament.
Monetary policy is directed by the SARB and it has more
freedom.

Different governmental bodies should therefore

synchronise

8.3 Policy dilemma

What happens to net exports if
income increases?
How much power do fiscal and
monetary policies have in an open
economy?
Read sub-section policy dilemma
in an open economy
carefully and discuss it
with your e-tutor.

Are you able to?

List the basic assumptions of the AD-AS model?

Define the AD curve?
Define the AS curve?
Define stagflation?
Define a supply shock?
Define demand management?
Define contractionary fiscal/monetary policy? And explain it with or without
the aid of a graph?
Define expansionary fiscal/monetary policy? And explain it with or without
the aid of a graph?
Define the trade-off principle?
Define the transmission mechanism? And explain it with or without the aid of
a graph?
Explain the implications of assumptions of the AD-AS model?
Distinguish between fiscal and monetary policy?
Discuss the lags associated with fiscal and monetary policy?
Show with and without a graph :
the impact of key changes on the AD and AS curves?
the policy dilemma in an open economy

That wasnt
so bad!
Keep up the
hard
work.

That is the end of learning unit 8

A quiz on this work will be
available soon; make sure you
do it and discuss it
with your e-tutor!