Aggregate Demand, Aggregate Supply, and Modern Macroeconomics

1. Aggregate Demand, Aggregate Supply, and Modern Macroeconomics Chapter 9

2. Laugher Curve We adults do have something in common with today’s teenagers. They listen to rock groups and we listen to economists. None of us understands a word they’re saying. Jean Stapleton

3. Introduction Markets unleash individual initiative, increase supply, and bring about growth. But markets can create recessions too.

4. Introduction Macro intervention tools – monetary and fiscal policy – are tools governments use on the aggregate demand side of the economy.

5. Introduction Since politicians make policy, it is unlikely that they would do nothing in the face of a recession even if all economists agreed it was the right thing to do.

6. The Historical Development of Modern Macroeconomics The Great Depression of the 1930s was a defining event in society's view of markets, and in the thinking about government macro policy.

7. The Historical Development of Modern Macroeconomics During the Depression, output fell by 30 percent and unemployment rose to 25 percent.. People wanted to work but could not find jobs at any wage.

8. The Historical Development of Modern Macroeconomics Before the Depression, the prominent ideology was laissez-faire - keep the government out of the economy.

9. The Historical Development of Modern Macroeconomics After the Depression, most people believed government should have a role in regulating the economy.

10. From Classical to Keynesian Economics Pre-Depression economists focused on long-run issues such as growth. They were called Classical economists.

11. From Classical to Keynesian Economics Depression-era economists began to focus on short-run economic issues, especially the issue of how to dig out of the Depression.

12. From Classical to Keynesian Economics They were called Keynesians after economist John Maynard Keynes, author of The General Theory of Employment, Interest and Money, and the founder of modern macroeconomics.

13. Classical Economics The Classical economists' approach was laissez-faire (leave the market alone). They felt the market was self-adjusting, and they also concentrated on the long-run and largely ignored the short-run.

14. Classical Economics When the Great Depression hit with 25 percent unemployment, their response was to refer to supply and demand in the labor market.

15. Classical Economics Their solution to the high unemployment was to eliminate labor unions and government policies that kept wages too high.

16. The Layperson's Explanation for Unemployment The layperson's explanation for unemployment was different. They were not pleased with the classical argument but believed instead that the Depression was caused by an oversupply of goods that glutted the market.

17. The Layperson's Explanation for Unemployment Lay people advocated hiring people even if the work was not needed.

18. The Layperson's Explanation for Unemployment Classical economists opposed deficit spending, arguing that the money to create jobs had to come from somewhere.

19. The Layperson's Explanation for Unemployment Government demands for capital would crowd out private demands for money so everything would cancel out.

20. The Essence of Keynesian Economics The essence of Keynesian economics is stabilization through government efforts. Keynes said: "Let's forget about the long run and concentrate on the short run."

21. The Essence of Keynesian Economics By changing his focus, he created the macroeconomic framework that emphasizes stabilization policy.

22. The Essence of Keynesian Economics Keynes thought that the economy could get stuck in a rut as wages and price level adjusted to sudden changes in expenditures.

23. The Essence of Keynesian Economics The Keynesian linkage was: decrease in investment demand ? job layoffs ? fall in consumer demand ? firms decrease production ? more job layoffs ? further fall in consumer demand, and so forth

24. The Essence of Keynesian Economics Too little spending caused unemployment.

25. Equilibrium Income Fluctuates Income is not fixed at the economy's long-run potential income – it fluctuates. For Keynes there was a difference between equilibrium income and potential income.

26. Equilibrium Income Fluctuates Equilibrium income – the level toward which the economy gravitates in the short run because of these cumulative circles of declining or increasing production.

27. Equilibrium Income Fluctuates Potential income – the level of income that the economy technically is capable of producing without generating accelerating inflation.

28. Equilibrium Income Fluctuates Keynes felt that at certain times the economy needed help to reach its potential income.

29. Equilibrium Income Fluctuates Because short-run aggregate production decisions and expenditure decisions were interdependent, the downward spiral could start at any time.

30. The Paradox of Thrift The paradox of thrift is important to the Keynesian story. According to the paradox of thrift, an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.

31. The Paradox of Thrift Saving can be seen as something good, it leads to investments that leads to growth.

32. The Paradox of Thrift But if savings were not translated into investment as happened during the Great Depression total spending would fall and unemployment would rise.

33. The Paradox of Thrift These concerns led to the development of the aggregate demand/aggregate supply model.

34. The Paradox of Thrift It is this model that most economists use to discuss short-term fluctuations in output and unemployment.

35. The AS/AD Model The AS/AD model consists of three curves: the aggregate supply curve, the aggregate demand curve, and the potential output curve.

36. The AS/AD Model The aggregate supply curve – the curve describing the supply side of the aggregate economy.

37. The AS/AD Model The aggregate demand curve – the curve describing the demand side of the aggregate economy.

38. The AS/AD Model The potential output curve – the curve describing the highest sustainable level of output.

39. The AS/AD Model The AS/AD model is fundamentally different from the microeconomic supply/demand model.

40. The AS/AD Model In the microeconomic supply/demand model the price of a single good is on the vertical axis and the quantity of a single good on the horizontal axis.

41. The AS/AD Model In the AS/AD model the price of everything is on the vertical axis and aggregate output is on the horizontal axis.

42. The AS/AD Model The AS/AD model is an historical model that starts at a point in time and says what will happen when changes affect the economy.

43. The Aggregate Demand Curve The aggregate demand (AD) curve shows how a change in the price level changes aggregate expenditures on all goods and services in an economy. The AD curve is more an equilibrium curve.

44. The Slope of the AD Curve The AD is a downward sloping curve. Aggregate demand is composed of the sum of aggregate expenditures. Expenditures = C + I + G +(X - M)

45. The Slope of the AD Curve The slope of the curve depends on how these components respond to changes in the price level.

46. The Wealth Effect The wealth effect tells us that as the price level falls, the value of cash rises so that those who hold money and other financial assets get richer, so they buy more.

47. The Wealth Effect While economists accept the logic of the argument, they do not see the wealth effect as strong.

48. The Interest Rate Effect The interest rate effect is the effect a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates.

49. The Interest Rate Effect The linkage is: a decrease in the price level ? increase of real cash ? interest rates fall ? banks have more money to lend ? investment expenditures increase ? jobs are created ? consumer expenditures increase

50. The International Effect The international effect tells us that as the price level falls (assuming the exchange rate does not change), net exports will rise.

51. The International Effect The linkage is: a decrease in the price level in the U.S. ? the fall in price of U.S. goods relative to foreign goods ? U.S. goods become more competitive internationally ? U.S. exports rise and U.S. imports fall.

52. The Multiplier Effect A change in quantity demanded has repercussions on production (supply decisions) and subsequently on income and expenditures (demand decisions). These repercussions are called multiplier effects.

53. The Multiplier Effect As the price level falls, the initial changes due to the wealth, interest rate, and international effects set in motion a process in the economy that amplifies the initial effects.

54. The Multiplier Effect The multiplier effect is the amplification of initial changes in expenditures.

55. The AD Curve

56. Shifts in the AD Curve Except for a change in the price level, anything that changes aggregate expenditures shifts the AD curve.

57. Shifts in the AD Curve The main shift factors of aggregate demand are foreign income, expectations about future output or prices, exchange rate fluctuations, the distribution of income, and government policies.

58. Foreign Income When U.S. trading partners go into a recession, the demand for U.S. goods (exports) will fall, causing the U.S. AD curve to shift to the left. A rise in foreign income leads to an increase in U.S. exports and a rightward shift of the U.S. AD curve.

59. Exchange Rates When a currency loses value relative to other currencies, export goods produced in that country become less expensive and imports into that country become more expensive.

60. Exchange Rates Foreign demand for its goods increases and its demand for foreign goods decreases as individuals do their spending at home.

61. Expectations About Future Output If businesses expect demand to be high in the future, they will want to increase their capacity to produce. Their demand for investment, a component of aggregate equilibrium demand will increase as well. The AD curve will shift to the right.

62. Expectations About Future Output When consumers expect the economy to do well in the future, they will spend more now.

63. Expectations of Future Prices If one expects the prices of goods to rise in the future while the current price remains constant, it pays to buy goods now before the prices rise. The AD curve will shift to the right. The is most acutely felt in a hyperinflation.

64. Expectations of Future Prices It is difficult to specify the exact reason why expectations will cause a shift in the AED curve because of the interrelatedness of various types of expectations.

65. Distribution of Income People tend to spend a greater percentage of their wage income as compared to their profit income.

66. Distribution of Income As real wages increase, while total income remains constant, it is likely that the AD curve will shift to the right.

67. Monetary and Fiscal Policy Activist macro policy makers think they can control the AD curve to some extent. Macro policy is the deliberate shifting of the AD curve to influence the level of income in the economy.

68. Monetary and Fiscal Policy If the federal government spends lots of money or lowers taxes, it shifts the AD curve to the right.

69. Monetary and Fiscal Policy When the Fed expands the money supply, it can often lower interest rates and thereby shift the AD curve to the right.

70. Monetary and Fiscal Policy Expansionary macro policy shifts the AD curve to the right.

71. Multiplier Effects of Shift Factors An AD curve cannot be treated like a demand curve. When a shift factor of the AD curve causes it to move, it moves by more than the initial shift factor because of the multiplier effect.

72. Effect of a Shift Factor on the AD Curve

73. The Aggregate Supply Curve The aggregate supply (AS) curve specifies how a shift in the aggregate demand curve affects the price level and real output.

74. The Aggregate Supply Curve

75. The Slope of the AS Curve The AS curve is a horizontal line. This is to simplify the explanation. It fits reality reasonably well in recent times.

76. The Slope of the AS Curve The horizontal AS curve tells us that a large majority of U.S. goods markets are quantity adjusting markets.

77. The Slope of the AS Curve Quantity adjusting markets – markets in which firms respond to changes in demand primarily by modifying their output instead of changing their prices.

78. Shifts in the AS Curve When a significant number of firms adjust their prices, the AS curve shifts. When prices are raised, the curve shifts up; when prices are lowered, the curve shifts down.

79. Shifts in the AS Curve There are two factors that shift the AS curve:

80. Shifts in the AS Curve Specifically: % change in the price level = % change in wages – % change in productivity

81. Shifts in the AS Curve An increase in factor prices increases the costs of production and shifts the AS curve up.

82. Shifts in the AS Curve An increase in productivity reduces the cost of production and shifts the AS curve down.

83. Shifts in the AS Curve

84. The Potential Output Curve The final curve that makes up the AD/AS model is the potential output curve. The potential output curve shows the amount of goods and services an economy can produce when both labor and capital are fully employed.

85. The Potential Output Curve It is vertical since at potential output, a rise in the price level means that all prices, including input prices rise.

86. The Potential Output Curve

87. Equilibrium in the Aggregate Economy Changes in the aggregate supply, aggregate demand, and potential output curves affect short-run and long-run equilibrium.

88. Short-Run Equilibrium Short-run equilibrium is where the AS and AD curves intersect. In the short run the price level is fixed and the output is variable. Increases (decreases) in aggregate demand lead to higher (lower) output.

89. Short-Run Equilibrium:Shift in Aggregate Demand

90. Short-Run Equilibrium:Shift in Aggregate Supply

91. Long-Run Equilibrium Long-run equilibrium is where the AD and potential output curves intersect. In the long run, output is fixed and the price level is variable.

92. Long-Run Equilibrium Aggregate demand determines the price level.

93. Long-Run Equilibrium:Shift in Aggregate Demand

94. Integrating the Short-Run and Long-Run Frameworks The potential output curve integrates the short-run and long-run frameworks.

95. Integrating the Short-Run and Long-Run Frameworks The economy is in both short-run and long-run equilibrium when all three curves intersect in the same location.

96. Integrating the Short-Run and Long-Run Frameworks The ideal situation is for aggregate demand to grow at the same rate as aggregate supply and potential output.

97. Short-Run and Long-Run Equilibrium

98. Recessionary and Inflationary Gaps When the economy is in short-run equilibrium but not in long-run equilibrium, the position of the AS curve is determined by the relationship between output and potential output.

99. Recessionary and Inflationary Gaps If output is below potential, the AS is pulled down by falling input prices.

100. The Recessionary Gap When aggregate demand is below potential, the economy is below potential output and all of the resources in the economy are not being fully realized.

101. The Recessionary Gap A recessionary gap is the amount by which equilibrium output is below potential output.

102. The Recessionary Gap If the economy remains at this level of output for a long time, costs and wages would tend to fall because there would be an excess supply of factors of production.

103. The Recessionary Gap Factor prices will fall causing the AS curve to shift down to eliminate the recessionary gap.

104. The Recessionary Gap

105. The Inflationary Gap The inflationary gap occurs when the economy is above potential that exists at the current price level. If the economy is in a situation where short-run equilibrium is at a higher price level than the economy's potential output curve, we have inflation.

106. The Inflationary Gap

107. The Inflationary Gap

108. The Economy Beyond Potential How can the economy operate beyond potential? It is possible to overutilize resources beyond their potential for a brief time.

109. The Economy Beyond Potential When a firm is below potential, firms can hire additional factors of production to increase production without increasing production costs.

110. The Economy Beyond Potential Once the economy reaches its potential output that is no longer possible.

111. The Economy Beyond Potential As firms compete for resources, costs rise beyond productivity increases.

112. The Economy Beyond Potential At this point the economy will slow down by itself or the government will step in with a policy to contract output and eliminate the inflationary gap.

113. Some Additional Policy Examples If politicians suddenly raise government expenditures when the economy is well below potential output, output rises while the price level remains unchanged.

114. Some Additional Policy Examples If consumer optimism leads to an increase in expenditures when the economy is at the target rate of unemployment, the price level rises while output remains unchanged.

115. Increase in AD at Less than Potential Output

116. Increase in AD at Target Rate of Unemployment

117. Macro Policy Is More Complicated Than It Looks The problem in the AS/AD model is that we have no way of knowing the level of potential output. As a result, it is difficult to predict whether the AS curve will be shifting up when aggregate demand increases.

118. Three Policy Ranges An economy has three policy ranges: The Keynesian range. The Classical range. The intermediate range.

119. Three Policy Ranges The Keynesian range – when the economy is far from potential income, and there is little fear that an increase in aggregate demand will cause the AS curve to shift up.

120. Three Policy Ranges In the Keynesian range an increase in aggregate demand will increase income and have no effect on the price level.

121. Three Policy Ranges The Keynesian range corresponds to the recessionary gap and it is because of this that Keynesian economics is sometimes called depression or recession economics.

122. Three Policy Ranges The Classical range –the economy is above the level of potential output there so that any increase in aggregate demand will increase factor prices.

123. Three Policy Ranges In the Classical range, an increase in aggregate demand will push up the price level and not affect real output.

124. Three Policy Ranges The Classical range corresponds to the inflationary gap.

125. Three Policy Ranges The intermediate range – when the economy is between the two ranges, the AS curve will shift up some and real output will increase some.

126. Three Policy Ranges In the intermediate range, the price/output path of the economy is upward sloping.

127. Three Ranges of the Economy

128. The Problem of Estimating Potential Output A key to policy is determining which range we are in which requires us to determine the level of potential output. Estimating potential output is difficult.

129. The Problem of Estimating Potential Output One way of estimating potential output is to estimate the rate of unemployment below which inflation has begun to accelerate in the past.

130. The Problem of Estimating Potential Output One can then calculate output at the target rate of unemployment, adjust for productivity growth, and estimate potential output.

131. The Problem of Estimating Potential Output Unfortunately, the target rate of unemployment fluctuates and is difficult to predict.

132. The Problem of Estimating Potential Output Another way gives us a very rough estimate of potential output.

133. The Problem of Estimating Potential Output Estimating potential income from past growth rates can by iffy if such shift factors as regulations, technology, expectations, etc. are changing quickly or dramatically.

134. Some Real-World Examples The United States in the mid-1990s: The economy was expanding slowly albeit accompanied with major structural changes. As firms expanded, they often laid off workers simultaneously. These structurally unemployed workers needed retraining which needed time.

135. Some Real-World Examples The United States in the mid-1990s:

136. Some Real-World Examples Canada in the mid-1990s:

137. Some Real-World Examples Canada in the mid-1990s:

138. Some Real-World Examples Japan in the late 1990s:

139. Some Real-World Examples The European Union in the mid-1990s:

140. Some Real-World Examples The European Union in the mid-1990s:

141. Some Real-World Examples The formerly socialist countries: Structural change in these nations is especially critical. Output has fallen by 40 to 50 percent. As they struggle to create new institutional structures, past data are meaningless.

142. Debates About Potential Output Knowing potential output is crucial in knowing what policy to advocate. According to real business cycle economists, the best estimate of potential output is the actual income in the economy.

143. Debates About Potential Output Their Classical supply-side explanation is called real business cycle theory. Classicals Believe:

144. Aggregate Demand, Aggregate Supply, and Modern Macroeconomics End of Chapter 9