Chapter Twelve

1. Chapter Twelve The Aggregate-Demand/Aggregate-Supply Model

2. Aggregate Demand & Aggregate Supply • A model of the overall economy that we can use to understand long-term output growth, business cycles, etc • Aggregate demand tells us the total amount of goods and services being purchased • Aggregate supply tells us the total amount of goods and services produced • Equilibrium is where aggregate demand = aggregate supply

3. Aggregate Demand • Aggregate demand is the total demand for goods and services by everyone in the economy • Consumption: demand by people for consumer goods • Investment: demand by business firms for equipment and buildings, and demand by people for housing • Net exports: demand by foreigners for our goods and services • Government spending: demand by the government for goods and services, as well as government investment spending

4. Consumption • Largest component of aggregate demand (about 2/3 of total) • Durable goods: autos, furniture, and major appliances • Nondurable goods: do not last as long as durables • Services: consumed immediately • Housing is not considered a durable good, but rather an investment good, which will be discussed later.

5. Consumption (cont’d) What affects consumption? • current income …Consumers buy more goods and services when they have more income • future income …If you expect a future income increase, you may spend more now • wealth …People with greater accumulated assets generally spend more • taxes…The more taxes consumer have to pay, the less disposable income they have to spend • the real interest rate …Higher real interest rates encourage consumers to save rather than spend

6. Investment • Investments in physical capital are about 1/6 of aggregate demand • Physical capital is the equipment and structures firms use in production and houses that people live in • The total amount of physical capital in an economy is its capital stock • Financial investment is NOT included; only investment in physical capital

7. Investment (cont’d) What affects business investment? • Size of existing capital stock compared to desired capital stock • Future consumption spending on the part of consumers (businesses want to anticipate consumer demand) • Firms’ ability to pay for the new capital • May use retained earnings in times of profit • Lower real interest rates stimulate investment as the opportunity cost of investing or holding cash goes down

8. Net Exports • International trade must be included when calculating aggregate demand • Americans import more than they export • Net exports = exports – imports • This is the only component of aggregate demand which may be negative • The level of net exports depends on • Current domestic income (-) • Domestic citizens import more from abroad if their incomes are higher • Current foreign income (+) • Domestic companies export more to foreigners if foreigners have higher income

9. Government Spending • Government spending accounts for about 1/6 of aggregate demand • Includes payments to government workers, government purchases of goods and services, gross government investment in physical capital • We assume government spending is chosen exogenously, and not explained by the AD-AS model

10. The Aggregate Demand Curve • Aggregate demand is the sum of all spending in the economy (consumption, investment, net exports, and government spending) • The aggregate-demand curve shows combinations of the price level and output that are consistent with equilibrium in the goods market and money market

11. The Aggregate Demand Curve (cont’d) • Goods market • Endogenous variables: current income, real interest rate • Exogenous variables: future income, wealth, taxes, future consumption, profits, business optimism, foreign income • Money market • Endogenous variables: price level, current income, nominal interest rate • Exogenous variables: quantity of money supplied, expected inflation rate • Relationship between them • Nominal interest rate = real interest rate + expected inflation rate

12. The Money Market After a Decline in the Price Level A decline in the price level decreases the demand for money, resulting in a lower nominal interest rate

13. The Aggregate Demand Curve • The price level is a key endogenous variable. • An inverse relationship exists between aggregate demand and the price level. • Any point along the AD curve is one for which both the goods and money markets are in equilibrium.

14. Aggregate Supply • Aggregate supplyis the economy’s total production of goods and services • Economists distinguish between short- and long-run aggregate supply • LRAS is fixed at full employment • In the short-run, output increases with the price level, as producers are incentivized to offer more for sale

15. Long-Run Aggregate Supply • Does the price level affect the amount produced in the long run? • Full employment: when capital and labor are fully utilized; the unemployment rate = the natural rate of unemployment (reflecting normal job turnover) • Full-employment output: the output produced when the economy is at full employment • Full-employment output is not affected by the price level, so the long-run aggregate supply curve is vertical

16. Short-Run Aggregate Supply • Does the price level affect the amount produced in the short run? • The amount of capital in the economy is fixed in the short run, so SRAS cannot be adjusted • Producers are reluctant to increase prices when demand increases, so higher demand leads to increased output • If prices throughout the economy rise (because of inflation), a firm might think increased demand for its product means demand for its product has increased, instead of realizing that it should raise its prices • The firm is fooled into producing too much

17. Aggregate Supply In the short run, the relationship between output and the price level is positive. In the long run, the economy is at full employment, so increases in the price level have no effect on output

18. Short-Run Aggregate Supply (cont’d) • The location of the SRAS curve depends on the expected inflation rate, since whether firms are fooled depends on the inflation rate they expect to prevail. When they are wrong, the economy may be located at a point on the SRAS curve, rather than the LRAS curve • As inflation expectations adjust, the SRAS curve shifts • Higher expected inflation causes the SRAS curve to shift to the left • For a given price level, higher inflation means lower relative prices, so firms produce less

19. Equilibrium in the AD-AS Model Short-run equilibrium Intersection of the AD and SRAS curves. Determination of output and price level in the short run; output may differ from full-employment output

20. Equilibrium in the AD-AS Model Short-run equilibrium Intersection of the AD and LRAS curves. Determination of output and price level in the long run; output must equal full-employment output

21. Equilibrium in the AD-AS Model (cont’d) • How does the economy adjust to move from the short run to the long run? • Adjustment does not occur immediately • Producers may be fooled and cannot distinguish changes in overall prices from changes in their own prices • Wages and prices may be slow to adjust; for example, wages may be negotiated and firms may hesitate to change menus or catalogs • Adjustment occurs gradually over time as the SRAS curve shifts until it crosses the intersection of LRAS and AD

22. AD-AS Model Shifters An increase inCauses this curve to shiftIn this direction Future income AD Right Wealth AD Right Taxes AD Left Real interest rate AD Left Future consumption AD Right Profits AD Right

23. AD-AS Model Shifters (cont’d) An increase inCauses this curve to shiftIn this direction Business optimism AD Right Foreign income AD Right Government spending AD Right ATM costs or other Variables that increase money demand AD Left Money supply AD Right

24. AD-AS Model Shifters (cont’d) An increase inCauses this curve to shiftIn this direction Productivity LRAS Right SRAS Right Capital stock LRAS Right SRAS Right Labor force LRAS Right SRAS Right Expected price level SRAS Left Costs of producing OutputSRAS Left

25. Example: A Drop in Business Optimism • If business firms lose confidence, they may become pessimistic about the future and decline to invest in new capital • The AD curve would shift to the left • In the short run, the price level decreases and output as businesses produce fewer goods • In the long run, the SRAS curve shifts to the right. Restoring equilibrium • Long-run equilibrium has the same full-employment output and a higher price level

26. Example: A Drop in Business Optimism The initial effect is a decrease in AD. Eventually, SRAS shifts right and restores equilibrium.

27. Equilibrium in the AD-AS Model What if exogenous variables shift? • Determine which curve (SRAS, LRAS, AD) is affected and in which direction each curve shifts • Find the new short-run equilibrium (price level and output) • Determine how the SRAS curve must shift to restore equilibrium • Find the new long-run equilibrium

28. Monetary Policy & the AD-AS Model • Monetary policy refers to the Fed’s decisions about the size of the money supply • An increase in the money supply shifts AD right; a decrease in money supply shifts AD left • If the economy is in a recession, the Fed can shift the AD curve to the right by increasing the money supply, restoring full-employment equilibrium with a higher price level

29. Monetary Policy & the AD-AS Model (cont’d) The economy is in recession when AD intersects SRAS at less than full employment. An increase in the money supply starts the process back toward long-run equilibrium.

30. Monetary Policy & the AD-AS Model (cont’d) If the Fed uses expansionary policy when the economy is at full employment, the result is temporarily higher output and much higher prices

31. Fiscal Policy & the AD-AS Model • Fiscal policy refers to the government’s decisions regarding levels of taxation and government spending • The government can increase aggregate demand by reducing taxes or increasing government spending, and vice-versa • If in recession, the government might cut taxes or increase government spending to attempt to restore full employment

32. Fiscal Policy & the AD-AS Model (cont’d) When the economy is in recession, government might try to shift back toward long-run equilibrium though the manipulation of aggregate demand

33. Large, Structural Macroeconomic Models • Large, structural macroeconomic models are models with many equations that describe the economy in great detail and are based on the assumption that their equations do not change over time • Their development was led by the Keynesians, focusing on how government could shock aggregate demand to temper the business cycle • Policymakers use the models to analyze historical events and to guide future policy decisions • Eventually, equations began to break down and economists became skeptical of the model’s efficacy

34. Large Macro Models & Their Performance in the 1970s • In the early 1970s, macroeconomics as a field was considered to be solved. Economists believed • Large macro models provided good forecasts • Policy control of economy could eliminate the business cycle • Policymakers needed to decide on the desired trade-off between unemployment and inflation • The stagflation of the 70s seemed to disprove the models

35. Rational Expectations Theory • Introduced by skeptics of Keynesian theory • Rational expectations theory means that people use all available information in making economic decisions • Large macro models assume people do not have rational expectations; treat expected inflation as exogenous, based on past data • Under rational expectations, expected inflation becomes an endogenous variable to which people can respond in a future-oriented manner

36. Rational Expectations Theory • The argument that the macro models are fundamentally flawed is known as the Lucas critique, which argues • A change in policy will alter the structure of large macro models • The large macro models are flawed, because they treat some coefficients as constant; under rational expectations theory, those coefficients will change as policy changes • Models must consider people’s expectations about policy to gage their reactions to it