The Aggregate Demand Aggregate Supply Model

The Aggregate Demand Aggregate Supply Model

Chapter 19

THE AGGREGATE DEMAND – AGGREGATE SUPPLY MODEL.

Introduction.

  • The IS-LM-BP model was a very useful tool to study how fiscal and monetary policy could be used to promote growth and simultaneously balance the external sector.
  • The main shortcoming of that model was that it didn't give us any information about what was going on with the price level (inflation) while our policies were being implemented.
  • The AS-AD model will examine that phenomenon in closer detail, providing a more realistic representation of the economy under classical premises of price flexibility and instantaneous market clearing.
  • Both the IS-LM-BP model and the AS-AD framework produce similar answers to common questions but, at the same time, are comparable only to some extent.
  • This model represents the workings of the economy as the interaction between two curves:

-The AD curve, showing the relationship between the price level (P) and aggregate demand (AD), that is, real output (Y)

-The AS curve, showing the relationship between the price level (P) and aggregate supply (AS), that is, real output (Y)

-The components of the Balance of Payments will be included in the Aggregate Demand.

The Aggregate Supply and Aggregate Demand Model in an Open Economy.

The Aggregate Demand Curve

  • Recall that through the expenditure approach to GDP calculation we can figure out which were the uses given to all the goods and services produced during a year (that is, who demanded them). In an open economy:

Y = GDP = C + I + G + NX = AD

where:C = Consumption (expenditure by domestic households)

I = Investment (expenditure by firms), can be domestic or foreign.

G = Government Expenditure (you take a guess ;-)

NX = Net Exports (expenditure by the rest of the world) = X - M

AD = Aggregate Demand = Y = Real Output (recall circular flow diagram)

  • All the components of Aggregate Demand (except G) are inversely related to the price level:

-P reduces Consumption (C)

-P reduces Investment (I) because the nominal interest rate rises (i) (recall that i = r + )

-P reduces Net Exports (NX) because the price of X increase relative to the price of M

-Government Expenditure (G) does not depend on the price level

  • Therefore the Aggregate Demand curve is going to be a downward sloping line.

(See Aggregate Demand curve)

  • How different is this open-economy AD curve from the (mostly closed-economy) one that you saw in Principles or maybe in Intermediate Macro? They are almost identical:

In an open economy the AD curve is somehow flatter because a higher (lower) domestic price level (P) will have a larger repercussion on ADthrough lower (higher) X and KIN (foreign I)

In an economy with flexible ERs the AD curve will be flatter than in an economy with fixed ERs because a higher (lower) domesticprice level (P) increases (decreases) demand for imports M (M) and that in turn raises (lowers) demand for foreign currency and so ERs. In this case there is an even larger repercussion on ADthrough the Current Account (CA.)

  • Movements along the AD curve:

-We move up along the AD curve only if the price level increases: P Q of AD.

-We move down along the AD curve only if the price level decreases: P Q of AD.

  • Shifts in the AD curve:

-The AD curve shifts right if: Any of the AD components increases: C, I, G, X, M.

 Expansionary fiscal policy is applied: T, G.

 Expansionary monetary policy is applied: M i I

 The domestic currency depreciates: ERM X

-The AD curve shifts left if: Any of the AD components decreases: C, I, G, X, M.

 Contractionary fiscal policy is applied: T, G.

 Contractionary monetary policy is applied: M i I

 The domestic currency appreciates: ERX M

  • The AD curve is basically affected by monetary and fiscal policies ( in M, T, G) that are also known as demand policies (as opposed to supply policies.)

-Expansionary monetary or fiscal policies shift the AD line right

-Contractionary monetary or fiscal policies shift the AD line left

  • The AD curve is also affected by expenditure switching and direct control policies ( in Tariffs, Quotas, ERs, Capital Controls), directed towards the Balance of Payments.

The Aggregate Supply Curve

  • We will distinguish between:

-The Long-Run Aggregate Supply curve LRAS, that represents the relation between the price level (P) and the level of output (Y) produced by firms in the long-run.

  • Recall the concept of the production function from Principles or Intermediate Macro:

LRAS = Y = A . F (K, N)

  • Since the levels of physical capital (K), or labor (N), available in the long-run to any given country do not depend on the price level we can represent the LRAS as a vertical line.

(See Long-Run Aggregate Supply line)

  • Shifts in the LRAS curve:

-The LRAS curve shifts right if: Any of the factors of production increase: K, N.

 There is a technological improvement: A.

-The LRAS curve shifts left if: Any of the factors of production decrease: K, N.

 There is a reduction in technology: A.

-The Short-Run Aggregate Supply curve SRAS, that represents the relation between the price level (P) and the level of output (Y) produced by firms in the short-run.

  • Private firms increase their output level as the selling price of their goods increase (P) but they also take into consideration the production costs (P of inputs).

SRAS = Y = A . F (K, N) / P of inputs

  • We can then represent the SRAS as an upward sloping line.
  • Some authors, in order to simplify their analysis, may consider the aggregate level of output supplied in the short-run to be completely elastic with respect to the price level. In that case the SRASwill be represented with a horizontal line. The conclusions would be identical.

(See Short-Run Aggregate Supply line)

  • Movements along the SRAS curve:

-We move up along the SRAS curve only if the price level increases: P Q of SRAS.

-We move down along the SRAS curve only if the price level decreases: P Q of SRAS.

  • Shifts in the SRAS curve:

-The SRAS curve shifts right if: Any of the factors of production increase: K, N.

 There is a technological improvement: A.

 There is a decrease in production costs: P of inputs.

-The SRAS curve shifts left if: Any of the factors of production decrease: K, N.

 There is a reduction in technology: A.

 There is an increase in production costs: P of inputs.

  • Notice that fiscal nor monetary policies affect the supply side of the economy. Only long-run government policies (e.g: universal education, support of scientific enterprises) have an impact on aggregate supply.
  • How different is an open-economy SRAS curve from the (mostly closed-economy) one that you saw in Principles or maybe in Intermediate Macro? This is a very good question.

The study of the impact that free trade and free capital mobility has on the supply side of the economy is a fertile field of research in economics. What do we know so far?

Increased international competition by foreign firms forces most domestic firms to increase their productivity, reduce their price markups, and expand their scale of operations (allowing for increased returns to scale.) Some firms will have to shut-down, though.

Unfortunately, most of this analysis falls outside the material generally covered in undergraduate macroeconomics courses and will not be discussed in class.

Translated into the AS-AD model these conclusions can be represented with a somehow flatter SRAS curve, or even a LRAS curve that is further to the right of a closed economy situation.

Equilibrium

  • At any given moment in time the level of economic activity is going to be determined by the intersection of the aggregate demand and the aggregate supply curves.
  • The different phases of the business cycle can be described in terms of the AS-AD model

When the SRAS and AD curves intercept to the left of the LRAS curve the short-run level of output is below the full-employment level of output (Y*YE), creating what is known as a recessionary gap(uEu*).

When the SRAS and AD curves intercept to the right of the LRAS curve the short-run level of output is above the full-employment level of output (YEY*), creating what is known as an inflationary gap(u*uE).

When the SRAS and AD curves intercept over the LRAS curve the short-run level of output is the same as the full-employment level of output (Y*=YE), a situation known as a long-run equilibrium(u*=uE).

  • Keep in mind that neither fiscal nor monetary policies can promote long-run economic growth. Both of them are short-run demand-side policies, that don’t have an immediate, direct impact on the determinants of potential (full employment) GDP (i.e.: K, L, and A.)

An excessive growth of AD will create rapid growth (YEY*) but as the general price level rises, the cost of inputs increase and so the SRAS curve shifts left (so Y*=YE, with PEP*).

A depressed AD will create large unemployment (Y*YE) but as the general price level falls, the cost of inputs decrease and so the SRAS curve shifts right (so Y*=YE , with PEP*).

  • We can now use this model to analyze how the tools of macroeconomic policy can be used to achieve internal and external balance in a variety of scenarios.

Internal Macroeconomic Analysis with the AS-AD Model

  • The crossing of the AD and SRAS curves (YE) will represent the short-run equilibrium in the economy, defining the equilibrium price level (πE)
  • Whether or not that short-run equilibrium represents the full employment (Y*) of all factors of production (K and N) can be seen on the graph:

When YEY*, and therefore, uEu*, there is arecessionary gap.

When YEY*, and therefore, uEu*, there is an expansion, and an inflationary gap.

  • Two different types of economic policies can be applied to close a recessionary gap:

-Expansionary fiscal policy: T or G (at the new equilibrium Y but also P)

  • Gor Tmay cause some crowding out of private investment

-Expansionary monetary policy: M (at the new equilibrium Y but also P)

  • M may be ineffective if there is a liquidity trap or inflationary expectations by households.
  • Regardless of the economic policy employed, the general price level will be likely to rise.

Internal and External Balance in the Aggregate Demand – Aggregate Supply Model

  • If we put together the AD-SRAS curves we can determine how close the economy is to the goal of internal equilibrium (low unemployment) and study the economic policy options available to the government:

-Fiscal policy: changes in taxes (T) and/or the level of government expenditure (G)

-Monetary policy: changes in the level of the money supply (M)

  • A new battery of questions is thus presented to us:

-How are economic policies going to affect the achievement of domestic equilibrium?

-What are the repercussions to the external sector?

-How do external shocks affect the internal economy?

  • The answers to these questions depend on the type of ER system (fixed or flexible) that the country adopts:

Fixed ERs, Imperfect Capital Mobility: Reducing Unemployment and Keeping BP=0

The case of Argentina in late 2001.

  • Expansionary monetary policy does not achieve internal balance because the resulting low domestic interest rate will promote large capital outflows that will in turn reduce the domestic money supply and so return the AD curve to its initial position.
  • Expansionary fiscal policy can achieve internal balance because the resulting higher domestic interest rate will attract large capital inflows that will in turn increase the domestic money supply and so shift the AD curve farther to the right.

Monetary policy is ineffective in this scenario and will place devaluating pressure on the fixed ERs. Only fiscal policy is available. Prices rise and domestic exports are reduced.

(The parity with the US dollar served to control inflation but made monetary policy unavailable. Besides, the government can not run larger budget deficits anymore.)

Fixed ERs, Perfect Capital Mobility: Reducing Unemployment and Keeping BP=0

The case of the European Monetary System in 1992.

  • Expansionary monetary policy does not achieve internal balance because the resulting low domestic interest rate will promote large capital outflows that will in turn reduce the domestic money supply and so return the AD curve to its initial position.
  • Expansionary fiscal policy can achieve internal balance because the resulting higher domestic interest rate will attract large capital inflows that will in turn increase the domestic money supply and so shift the AD curve farther to the right.

Higher domestic interest rates attract capital flows from other partners in the EMS and so reduce their money supplies, imposing recessionary forces on their economies.

(Coordination of macroeconomic policies among economic union members is required in order to promote general economic growth and to maintain the fixed ER arrangement.)

Fixed ERs, Imperfect Capital Mobility: External shocks and internal effects

Speculation against fixed ERs: EMS (1992), Mexico (1994), Thailand (1997).

  • Foreign investors liquidate their assets denominated in the domestic currency and transfer them out of the country (I)by first purchasing a foreign currency. This places devaluating pressures on the fixed ER. The domestic Central Bank will try to fight them.
  • When reserves are exhausted in the defense of the fixed ER the CB must choose between rising domestic interest rates (AD shifts left), or devaluating (AD shifts right in the long-run.)

Extending the defense with higher interest rates or giving up the defense and devaluating are both costly decisions for the country.

(Fixed ERs, that are expected to promote international trade and capital flows, expose the domestic economy to costly external shocks.)

Flexible ERs, Imperfect Capital Mobility: External shocks and internal effects

Speculation against flexible ERs: developed industrial economies.

  • Foreign investors liquidate their assets denominated in the domestic currency and transfer them out of the country(I)by first purchasing a foreign currency. This places depreciating pressures on the flexible ER. The domestic Central Bank does not need to fight them.
  • A depreciated domestic currency promotes exports and reduces imports. The AD shifts right. The capital outflow reduces the domestic money supply and puts pressure on interest rates to rise. Foreign capital flows back into the country. The ERfalls.AD returns to initial point.

The AD curve adjusts itself (through the changes in the ERand π) and the Central Bank does not need to intervene at all.

(Flexible ERs, very volatile due to the large number of factors that affect them, simultaneously protect the domestic economy from costly external shocks.)

Flexible ERs, Imperfect Capital Mobility: Reducing Unemployment and Keeping BP=0

Mexican macroeconomic policies after 1994.

  • Expansionary fiscal policy does not achieve internal balance:the resulting higher price levels lower NX (AD shifts left.)Although initiallyY, the AD curve returns to its initial position.
  • Expansionary monetary policy can achieve internal balance because the resulting low domestic interest rate will promote large capital outflows that will raise the ER, promoting X and lowering M. The AD curve, then, shifts to the right.

Fiscal policy is ineffective in this scenario because it will place revaluating pressure on the flexible ERs. Only monetary policy is available. Prices rise and domestic exports are reduced.

(Mexico has to exercise precise fiscal discipline in order to avoid pressures on ERs that will cause a domestic recession. Only fine-tuning with monetary policy is possible.)

Flexible ERs, Perfect Capital Mobility: Reducing Unemployment and Keeping BP=0

The case of the USA and Canada.

  • Expansionary fiscal policy does not achieve internal balance: the resulting higher price levels lower NX (AD shifts left.) Although initially Y, the AD curve returns to its initial position.
  • Expansionary monetary policy can achieve internal balance because the resulting low domestic interest rate will promote large capital outflows that will raise the ER, promoting X and lowering M. The AD curve, then, shifts to the right.

Lower domestic interest rates re-direct capital flows towards this NAFTA partner and so increase its money supply. Inflation is likely to build up in the Canadian economy.

(Coordination of macroeconomic policies is required in order to avoid a situation where USA exports overrun Canadian goods, or the USA “exports” inflation to Canada.)

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