Chapter 29 Aggregate Demand and Aggregate Supply
Recall from previous chapters the following items:
1. business cycle – the movement of real GDP up and down along with the corresponding change in production, jobs, and other economic measures.
2. Recession – a drop in GDP for at least two quarters. This results in lower income, output, and employment.
A. Defining and Deriving AD
1. AD – Illustrates the equilibrium level of GDP at every price level. So, every point along the AD is SR equilibrium. It shows us the collective behavior of buyers in the marketplace. Essentially it is the demand for all G/S at each price level.
-reasons for downward slope
(a) real balances effect -as the value of the dollar goes up you want to purchase more. This occurs as we get an overall drop in price level.
(b) interest rate effect -as the p-level drops there is a smaller r which makes it cheaper to finance purchases
(c) net exports effect - relative prices of foreign goods now cheaper è as p-level goes up we purchase less domestic goods.
2. Deriving the AD:
**see previous notes for complete explanation on Money Supply and Money Demand.
a. Money Demand – MD - a demand curve that shows how people demand money at each interest rate. The curve is downward sloping b/c at higher rates we demand less money due to:
i. Cost of borrowing increasing
ii. OC of holding money goes up b/c it is forgone interest income
b. Money Supply – MS - the overall amount of money in the economy. It is a fixed value determined by The FED. That is why it is a vertical line.
Step 1: What we do is suppose a price level change from P1 to P2, where P2 > P1.
Step 2: If we have a change in P-level we know there is a shift in MD.
Step 3: A shift out (i.e. MD1 to MD2) in MD implies that we get an increase in r.
**When we get a change in r we get a change in GDP. We can see this effect in the
AE-Line.
Step 4: AE falls from AE 1 to AE 2
Step 5: We get a decrease in GDP from GDP1 to GDP2.
Now we have established a relationship between P-level and GDP. So we can graph this relationship in the following graph.
Aggregate Demand Curve:
Note: so we can see that we have established a negative relationship between price level and GDP. So as price level goes up we find that this corresponds to a lower output level.
3. Determinants of AD
a. Fiscal Policy – Changes in G or taxes
b. Monetary Policy – Changes in the MS that begin with the FED buying or selling bonds.
c. Changes in AE – NX, Investment Spending, or changes in autonomous
note: any changes in P-level or GDP holding all other variables constant will just be a movement along the existing curve (this is exactly how we discuss movers vs. shifters in general.
B. Aggregate Supply Curve
1. AS-illustrates the relationship between changes in output and the price levelè does so from a firms or production point of view. Measures the relative relationship of real GDP and what producers are willing and able to supply at different price level.
2. Basic Assumptions:
(a) Price is a function of costs: So we assume that price is just some percent of costs. We then realize that overall we could get some average measure of mark up costs in the economy and that this overall percent is slow to change.
So an example is P = 1.2C or price is 120% of costs
-if Price level ↑ è units costs ↑ (and vice versa)
(b) We then note that as output (GDP) increases then unit costs increase (due to the increase in demand for these goods; it can be thought of as a price of resources up)
- if GDP↑ è units costs ↑ (and vice versa)
Combining the two we note that: GDP↑ è units costs ↑ è P-level ↑
This gives is the relationship that we want for overall aggregate output and price level.
(c) Graphically:
Aggregate Supply Curve:
3. Changes in AS
-when we get things that change units costs other than output we get shifters in the AS è so changing output or price level with their corresponding changes in unit costs are movers.
Shifters:
(a) changes in oil prices
(b) changes in weather
(c) technology changes
(d) adjustments to LR of wages and other determinants of units costs that we defined earlier as slow to change
4. Ranges/Shape/Views of Aggregate Supply
a. Keynesian View – They believe in a horizontal AS curve b/c when the economy is below FE when AD shifts out the major effects are:
i. Increase in real GDP
ii. Unemployment drops
iii. Price level is constant
*so it means that Demand creates Supply
b. Classical View – In the LR the AS curve is vertical b/c the only effects of an increase in AD when we are already at FE are:
i. Increase in P-level
**This implies Supply creates its own Demand (Say’s Law)
Note: This is why Keynes model is generally used to explain SR dynamics in the economy and the Classical view is a better tool for the LR.
c. Intermediate Range – when the AS is in between the Keynesian and Classical range. When this occurs as AS shifts out, both GDP and price level increase.
Graphically:
C. Equilibrium
1. Def: this is where AD = AS. The price at which all suppliers want to supply at corresponds to the price level that demands are demanding at. It is equilibrium in price level and output.
At equilibrium we find the price level that AD = AS
Note:
(1)At GDP 1 this is not equilibrium because AD > AS. As this price level suppliers want to increase prices è reduce AD è get use back to Equilibrium.
(2) Equilibrium GDP might not be FE-GDP. This needs to be compared to FE levels.
(3) We can get macro shocks that take us away from levels that are already at FE levels.
Graphically:
Recall - changes in price level are also called inflation when they are calculated as rates of changes in price level from one year to the next.
2. Disequilibria:
GDP1: This is not equilibrium because at this level of GDP consumers would be willing to pay a higher price and there would be a drop in inventories. So, there would be an increase in output and an increase in price level to PE.
GDP2: This is not equilibrium because at this level of GDP consumers would not be willing to pay a higher price and there would be an increase in inventories. Suppliers would be charging to high of a price overall in the economy. So, there would be a decrease in output and a decrease in price level until we go to PE.
3. Shifts of AD or AS
a. Shifts in AD – Recall that to get a change in AD we would need something to change spending holding price level constant. Our examples before were monetary and fiscal policy and other AE spending changes.
Consider an increase in AD
Graphically:
-We can see that if AD shifts out we get an increase in GDP, but we also get an increase in P-level. This is inflationary. So we see that to get growth through an increase in spending results in inflation. This is why the FED closely monitors inflation upon engaging in its policy or when it notices that there have been unusually high spending levels in the economy. They want to make sure that there is controlled/contained growth.
Note: that the opposite results hold. So if we had AD ↓ à P –Level ↓ & GDP ↓
b. Shifts in AS or Supply Shocks. Recall that for supply to change we get change in things that affect unit costs overall in the economy without really affecting GDP. Many of these items (weather, technology, war, price of oil, etc...) are not something that can be predicted or controlled. So, they are called shocks. If we get a (-) change in AS the results are as follows:
Graphically:
-so we can see here that a negative supply shock results in a drop in GDP and an increase in price level. These are two bad effects in the economy overall. So when we had a natural disaster like hurricane Katrina, steps were taken in order to minimize these effects. Two things that can be done are:
(1) FED – engage in expansionary policy (increase money supply) in order to help GDP get back to previous levels and probably increase.
(2) Federal Government – engage in expansionary fiscal policy by increasing G or decreasing taxes. By doing this spending should increase which would also help GDP grow.
Both of these types of policy measures will generally help GDP grow again, but even if that occurs the price level in the economy is most likely going to rise due to the supply shock. We can see this in the graph below.
Graphically:
-we can see that with AD shifting from AD1 to AD2 with either monetary or fiscal policy (or both working in tandem) that the economy does get back to GDPE1, but it is at the expense of a higher price level.
D. Synopsis of A-C and Explanation of Business Cycle and AD/AS (29.4)
Topic 1: Aggregate Supply and Aggregate Demand at Equilibrium
1. Recall from before how we defined and derived our AD/AS curves. Both show us a relationship between P-level and Real GDP.
(a) AD Shifts:
Overall Effect: AD↑ à P-level↑ Real GDP↑
Recall that our shifters which cause this are:
i) Wealth
ii) Expectations (of future income or prices)
iii)Taxes or G à Fiscal Policy
iv) Monetary Policy à Changes in interest rate
v) Any changes in spending (IP or NX)
* opposite cases are true
(b) Changes in AS:
Overall Effect: AS↑ à P-level↓ Real GDP↑
Recall that our shifters which cause this are all essentially temporary things or shocks. For this reason we will assume that for the most part that we cannot control the shifts of AS.
-note that we get an upward sloping line to due wage stickiness. If the wages were completely flexible then unit costs would change more readily. We will illustrate this in our comparison with SR vs. LR.
i) Wages
ii) Price of non-labor inputs
iii)Productivity changes à Changes in K or Technology
iv) Supply Shocks such as weather, natural disasters, and wars
v) Subsidies or government regulation that a affects business environment
* opposite cases are true
(c) LRAS or Potential GDP
For the long run we assume that there is perfect wage flexibility and that our economy has moved to its LR levels in all relevant markets. We also assume that the economy in terms of production and consumption moves to levels that are consistent with the levels that are currently possible in the economy w/o over consuming or producing in the SR.
It is sometimes called the natural rate (NR) or full-employment (FE) levels in the economy.
Graph 1:
Note: The economy is in LR equilibrium when the AD and LRAS curve intersect. At this time we say that we are operating at FE or natural rate in the economy. It is not always the case that this occurs. Consider the two cases below when we have instances where the economy is operating above or below the NR.
Classical View: The view that our economy should be in the LR equilibrium at all times if the government doesn’t interrupt the private market is called the classical view. They propose that the economy self-corrects (which will be shown to be true) so it is best to leave the markets alone. This might be the case in the LR, but in the meantime when there is unemployment or inflation we as a society want to use corrective measures to assist the overall macroeconomy.
The reason we get this in the economy is called.
Say’s Law- Supply creates its own demand. Because this is the case, if we get that all funds are eventually spent and all G/S are eventually purchased, we should have an efficiently operating economy that has no excess inventories or shortage of inventories.
This implies that our production, or GDP, should be at efficient levels.
Note: The Great Depression dispelled this notion that we should just let our economy operate with no intermediation. This is called Laissez-Faire or hands off approach when monitoring the economy
Case 1: Operating above the FE in the SR – Inflationary Gap
In this instance we can see that GDP-SR > GDP-FE. This means the economy is in a surplus. So we will have inflation because the price level will rise and employment level will decrease as we move back to our FE level of GDP.
Case 2: Operating below FE in the SR – Recessionary Gap