Description                                  
In this presentation, the narrator illustrates the impact economic policy has on the macroeconomy in terms of the AD - AS model. 

Wilbur White: 
All the President ever talks about is jobs, jobs, jobs. Well... what about inflation? The consumer price index has risen 5% in the past year. Your dollars are worth less than they were a year ago. If you adjust the GDP for inflation, the economy isn't growing at all. I say reduce taxes and cut expensive government programs. Let the free market decide where the jobs come from. 

Narrator: 
Inflation... employment... GDP... With so many variables and influences shaping our economy, is it possible for the President to implement policies that will effect these important economic variables? 

Narrator: 
The aggregate demand -- aggregate supply model provides useful insights into macroeconomic fluctuations as well as the impact of economic policy on the general state of the macroeconomy. 

Narrator: 
The short-run macroeconomic equilibrium is represented by the intersection of the aggregate demand and short-run aggregate supply curves. While the long-run macroeconomic equilibrium occurs at the intersection of these two curves and the long-run aggregate supply curve. At this point, we have full employment. The goods market and the money market are in equilibrium and all costs such as wage rates and other input costs are fully adjusted to price changes. 

Narrator: 
To see how government policy can effect the macroeconomy, suppose the current short-run equilibrium level of income occurs below the full employment level of income. The distance between the full employment income and the current short-run equilibrium income level is known as a recessionary gap. 

Narrator: 
With a recessionary gap the average price level tends to fall because the short-run equilibrium level of income is lower than the full employment income level. Monetary or fiscal policy can be useful here in helping to eliminate the recessionary gap and restoring the full employment equilibrium. 

Narrator: 
An increase in government spending, a decrease in taxes, or an increase in the supply of money could all move the aggregate demand curve to the right in an attempt to restore the economy to its full employment output level. 

Narrator: 
Conversely, suppose the short-run equilibrium occurs above the full employment output level. In this case, the distance between the full employment output level and the short-run equilibrium output is known as an expansionary gap. 

Narrator: 
With an expansionary gap the average price level tends to rise because the short-run equilibrium level of income is above the income level of full employment. Here again, monetary and fiscal policy can be useful in eliminating the expansionary gap. 

Narrator: 
A reduction in government spending, an increase in taxes, or a decrease in the supply of money can all lead to a reduction in aggregate demand and the elimination of the expansionary gap. 

Narrator: 
Notice that monetary and fiscal policy can only effect the aggregate demand side of the model. An obvious question arises about the aggregate supply side... Do changes in economic activity effect the aggregate supply side? 

Narrator: 
The aggregate supply side of the economy is an area where economists often disagree. Certainly, changes in the short-run aggregate supply curve can occur when there are changes in costs. A good example is the oil price changes of the 1970's. An increase in the price of oil, an intermediate good in most production processes, caused the short-run aggregate supply curve to shift to the left. This shift caused prices to rise and at the same time output moved to the left of the full employment level. This process is known as stagflation. 

Narrator: 
Stagflation creates a no-win situation for policy makers. An increase in aggregate demand could restore full employment output but it will also create a higher price level. 

Narrator: 
Conversely, if no action is taken, the economy stagnates below full employment equilibrium causing an increase in unemployment. Clearly, policy makers must make a tough choice. 

Narrator: 
Now that we've examined some of the reasons for shifts in aggregate demand and short-run aggregate supply, it's easy to see why macroeconomic equilibrium is almost always a short-lived phenomenon. 

Narrator: 
But what happens when there are shifts in long-run aggregate supply? And how do we account for various rates of change in the short-term that occur simultaneously with long-term trends? These are not simple questions and economists spend entire careers inventing and adjusting models in an effort to explain and predict macroeconomic behavior. Various macroeconomic paradigms differentiate themselves in their assumptions about rates of change in the AS - AD model. 

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