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1 ECMA06 – The AS-AD Model (continued) The AS-AD Model (continued) Outline The derivation of the aggregate supply (AS) curve. The adjustment mechanism of the AS-AD model. Consider the effect of a disturbance in the AS-AD model and its implications on government policy. Aggregate Demand - Review Recap, what do we learn about the AD? The AD curve indicates the equilibrium level of output on the demand side. The AD curve shows the combinations of Y and P such that Y = AE = C + I + G + X – IM. Any factor that affects autonomous expenditure other than Y and P will shift the AD curve.

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2 Derivation of the Aggregate Supply (AS) To complete the model, we need to derive the aggregate supply curve. The aggregate supply (AS) curve represents the amount of output that firms in the economy are willing to produce at each price level . Question: What we learned about marginal cost (MC) in micro suggests that AS should be upward sloping. Does it hold true for the economy as a whole? Answer: Probably not! Once again we are looking at the entire economy not just one industry, the big picture matters!
3 ECMA06 – The AS-AD Model (continued) Slope of the AS Curve Case 1: If There is a Lot of Unemployment, This means Y* is much lower than Y FE (Y* < Y FE ). If this is the case, we might expect that firms will be willing to supply more even if price does not increase much. The AS curve will be relatively flat (i.e., elastic) . Since there are quite a large number of unemployed workers, firms would find it easy to hire workers if they want to expand. Besides, firms probably have unused facilities.

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4 Case 2: If There is a Not Much Unemployment, This means Y* is bigger than Y FE (Y* > Y FE ). If this is the case, we might expect that firms will be hard- pressed to supply much more even if price increases. The AS curve will be
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