Aggregate Supply and Aggregate Demand

1
Aggregate Supply and Aggregate
Demand
11
CHAPTER
2
Aggregate Supply and Aggregate Demand

• Aggregate Demand
• Slope of the AD Curve
• Deriving AD from IS/LM
• Factors that Shift the AD Curve
• Aggregate Supply in the Short Run
• Slope of the AS Curve
• Factors that Shift the AS Curve
• Short-Run Equilibrium

3
Aggregate Supply and Aggregate Demand

• Long-Run Equilibrium
• Why Equilibrium Deviates from Potential
• Aggregate Demand Management in the AS/AD Model
• Inflation, Potential Output, and the Output Gap
• Importance of Expectations

4
Aggregate Demand

• The aggregate demand (AD) curve shows the
  combinations of price levels and income levels at
  which the goods and money market are both in
  equilibrium.
• The aggregate demand curve shows an inverse
  relationship between the price level and income
  levels because of the
• Interest rate effect
• International effect

5
The Interest Rate Effectcash balance approach
-- ignore
The price level increases
Real money balances decrease
People sell bonds to increase money balances
Bond prices fall and interest rates increase
Investment decreases, which decreases total
expenditures
6
Interest Rate Effecttransactions approach
r
r
LM1
LM2
M1/P1
M1/P2
r2
r1
Md(Y1)
Y1

Y
7
The International Effect
The price level increases
The real exchange rate rises
Exports become more expensive and decrease
Imports become cheaper and increase
Net exports decrease, which decreases total
expenditures
8
Interest Rate and International Effects
LM1 (PP1)
LM0 (PP0)
Real Interest Rate ()
B
C
A
IS0 (PP0)
IS1 (PP1)
Aggregate Output
Y2
Y1
Y0
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From IS/LM to AD
LM2 (PP2)
LM1 (PP1)
LM0 (PP0)
Real Interest Rate ()
B
C
A
IS0 (PP0)
IS1 (PP1)
IS2 (PP2)
Real Output, Income
Y2
Y1
Y0
C
P2
B
Price Level
P1
Aggregate Demand
A
P0
Real Output, Income
Y2
Y1
Y0
10
The Slope of AD

• The AD Curve is flatter if
• The interest rate effect is larger
• The international effect is larger
• The marginal propensity to consume and the
  multiplier are larger

11
Shifts in the AD Monetary Policy
LM0 (P0)
LM1 (P0)
A
Real Interest Rate ()
1. Expansionary monetary policy shifts the LM
curve to the right.
B
IS
Real Output, Income
Y0
Y1
2. Equilibrium income rises at every price
level. The AD curve shifts to the right, too.
Price Level
B
Aggregate Demand
P0
A
Real Output, Income
Y1
Y0
12
Shifts in the AD Fiscal Policy
LM0 (P0)
B
1. Expansionary fiscal policy shifts the IS
curve to the right.
Real Interest Rate ()
A
IS1(P0)
IS0(P0)
Real Output, Income
Y0
Y1
2. Equilibrium income rises at every price
level. The AD curve shifts to the right, too.
Price Level
B
Aggregate Demand
P0
A
Real Output, Income
Y1
Y0
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Aggregate Supply in the Short Run

• The aggregate supply (AS) curve shows how the
  price level responds to changes in aggregate
  output.
• AS is positively sloped because
• as firms produce more they demand more inputs
• the market supply of factors of production is
  positively sloped
• firms costs increase
• firms respond by raising prices resulting in an
  upward sloping AS

14
Factors that Shift the AS Curve

• Factors that reduce the costs of production,
  independent of demand, shift the AS to the right
• Increases in productivity tech. change
• Factors that increase the costs of production,
  independent of demand, will shift AS to the left
• Workers negotiate for higher wages because they
  expect increases in inflation
• Adverse supply shocks - natural disasters or oil
  supply disruptions, that increase costs of
  important inputs

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The AS Curve - Its Slope and Shifts
AS1
1. The AS curve shifts up when input costs
rise independently of demand.
2. Demand for inputs rises, increasing
their prices. As input prices rise, so do
product prices.
Aggregate Supply
AS0
Price Level
Price Level
AS2
P1
P0
2. The AS curve shifts down when worker
productivity rises.
1. As real output rises.
Real output, Income
Real output, Income
Y1
Y0
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Short Run Equilibrium AD Increases
1. The economy is in equilibrium at A and
expansionary monetary policy increases AD to AD1.
Aggregate Supply
Price Level
B
2. If prices are constant, income increases to
Y2.
P1
A
P0
AD1
3. With flexible prices, output increases only
to Y1.
AD0
Real output, Income
Y2
Y1
Y0
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Short Run Equilibrium AS Decreases
1. The economy is in equilibrium at A and a
significant portion of capital is damaged by an
earthquake.
AS1
AS0
Price Level
B
2. This increases production costs and shifts AS
to AS1.
P1
A
P0
3. The economy moves to B with higher prices and
lower output.
AD
Real output, Income
Y0
Y1
18
Long Run Equilibrium AD Increases
Potential Output
Price Level
C
P2
A
P0
AD1
AD0
Real output, Income
Y0
19
Long Run Equilibrium AS Decreases
AS1
AS0
Price Level
C
P2
B
P1
P0
AD
Y0
Real output, Income
Y1
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Alternative Adjustment to Long-Run Equilibrium
AS0
AS1
Price Level
P0
P1
A
B
P2
AD
Real output, Income
Y0
Y1
21
Alternative Adjustment to Long Run Equilibrium
Potential Output
Price Level
AS0
C
P0
P1
A
AD1
AD0
Y0
Y1
Real output, Income
22
Why Output Deviates From Potential and the AS is
Positively Sloped

• Worker Misperception Model
• Workers supply more labor when nominal wages
  increase even if real wages have not
• Imperfect Information Model
• Firms respond to nominal price increases of their
  product by producing more even if its relative
  price is the same
• Sticky Wage and Price Model
• Firms have contractual relations with customers
  and do not raise prices, even if demand
  increases.

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Aggregate Demand Management

• Offsetting Aggregate Demand Shocks
• Offset negative shocks that push output below
  potential with expansionary monetary and fiscal
  policy
• Offset positive shocks that push output above
  potential with contractionary monetary and fiscal
  policy
• Offsetting Aggregate Supply Shocks
• Adverse AS shocks cause stagflation- simultaneous
  inflation and decreases in output
• Stagflation creates a policy dilemma, requiring a
  choice between more inflation or increasing output

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Adjustment After an Adverse Supply Shock
Potential Output
AS1
Price Level
AS0
P2
C
P1
B
P0
A
AD1
AD0
Y0
Y1
Real output, Income
25
Stagflation During the 1970s
Percent Change Percent Change in Real
Output in Inflation 1972 5.5 4.2 1973 5.8
5.6 1974 -0.6 8.9 1975
-0.4 9.4 1976 5.4 5.8 1977 4.7 6.5 197
8 5.4 7.3
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Real Business Cycle Theory

• Technology shocks are the source of output
  fluctuations in the economy.
• Fluctuations are not deviations of output from
  potential, but fluctuations of potential output.
• Policy should not be used to smooth out
  fluctuations since a change in output may be
  caused by a change in potential output or a shift
  in short-run AS or AD.

27
Inflation and the Output Gap
28
Actual and Potential Output
29
Expectations and the AS Curve
Potential Output
AS1
Price Level
AS0
P1
B
P0
A
AD1
AD0
Real output, Income
Y0
30
Reasonable Expectations

• Most people form reasonable expectations -
  expectations based on relevant information.
• People form expectations with a combination of
  extrapolations from the past and predictions of
  the future, based on theory.
• People will not make the same mistakes over and
  over again in forming their expectations.

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Rational Expectations

• Rational expectations are expectations based on
  the predictions of an economic model.
• The economic model distinguishes rational
  expectations from reasonable expectations.
• People figure out economic models an base their
  expectations on them.

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Policy and Expectations

• The more stable the economy and the more
  consistently policy impacts the economy, the more
  reasonable expectations become rational
  expectations.
• The distinction between rational and reasonable
  expectations is important in determining policy
  effects
• Rational expectations AD policy affects only
  the price level, not real output
• Reasonable expectations AD policy may work
  because the model changes

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An Unconventional View of Expectations and AD/AS

• Aggregate demand policy matters in both the short
  run and the long run.
• There are many levels of potential output which
  can be equilibrium, depending on aggregate
  demand.
• High aggregate demand can cause technological
  change which can increase potential output.

34
Inflation in the AS/AD Model
Potential Output
AS1
Price Level
AS0
P1
B
P2
C
AD1
A
P0
AD2
AD0
Real output, Income
Y0
Y1
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The U.S. Economy at the End of the 1990s
Potential Output
Potential Output
Price Level
Price Level
AS
AS
B
B
P1
P1
P0
P0
A
A
AD1
AD1
AD0
AD0
Y0
Y1
Y1
Y0
Real output, Income
Real output, Income
The Conventional View
The Unconventional View
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Short-Run Models and Theories
IS/LM
Summary A short-run model of real output. Real
output is determined by the level of expenditures
(aggregate demand). The two components are the
IS curve (goods market equilibrium) and the LM
curve (money market equilibrium).
Key Policy Implications Government can smooth
business cycles by using monetary and fiscal
policy.
Key Predictions Fiscal policy and monetary policy
can directly affect real output. Expansionary
fiscal policy leads to higher interest rates and
higher real output. Expansionary monetary policy
leads to lower interest rates and higher real
output. Crowding out can limit the effectiveness
of monetary policy. A liquidity trap cam limit
the effectiveness of monetary policy.
Key Assumptions The price level is
fixed. Equilibrium in the goods market is
determined by aggregate expenditures. Equilibrium
in the money market is determined by the demand
and supply of money.
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Short-Run Models and Theories
IS/LM/BP (Large Country)
Summary A short-run model of real output that
includes the international sector. The
upward-sloping BP curve shows where the balance
of payments is zero.
Key Assumptions The price level is fixed. Forces
constantly push the economy toward IS/LM
equilibrium and balance of payments equilibrium.
Key Policy Implications If exchange rates are
flexible, government need not worry about
maintaining balance of payments equilibrium. It
can focus on domestic goals. Government can
adjust exchange rates, import controls, export
drives, and capital controls to achieve domestic
goals.
Key Predictions If a country has flexible
exchange rates, the exchange rate adjusts to
domestic IS/LM equilibrium. A country with fixed
exchange rates may have difficulty achieving its
domestic goals.
38
Short-Run Models and Theories
Mundell-Fleming model
Summary An IS/LM/BP model for a small open
economy. The BP curve is horizontal at the world
interest rate.
Key Predictions If exchange rates are fixed,
expansionary fiscal policy must be accompanied by
expansionary monetary policy. If exchange rates
are fixed, expansionary monetary policy must be
accompanied by expansionary fiscal policy. If
exchange rates are flexible, expansionary fiscal
policy can affect the economy only if monetary
policy is also expansionary.
Key Policy Implications Government must accept
the world interest rate. To increase output an
economy should run expansionary fiscal policy and
monetary policies.
Key Assumptions The price level is
fixed. Capital will flow in an out of a country
to keep domestic interest rates at the world
interest rate.
39
Short-Run Models and Theories
AS/AD Model
Summary A model that integrates the long run and
the short run. The AD curve is downward sloping.
The AS model determines how changes in aggregate
expenditures are split between changes in output
and the price level.
Key Predictions Increases in aggregate demand
lead to increases in real output. Adverse
aggregate supply shocks lead to lower output and
higher prices. Changes in aggregate demand that
are perfectly anticipated have a smaller impact
on real output and a larger impact in the price
level compared to when the changes are
anticipated.
Key Policy Implications When the economy is below
potential output, it should run expansionary
monetary or fiscal policy to increase real
output. When the economy is above potential
output, it should run contractionary monetary or
fiscal policy to reduce real output and avoid
inflation. When the economy is at potential
output, policy should be neutral.
Key Assumptions Prices are flexible. A fall in
the price level leads to higher aggregate demand
because of the international and interest rate
effects. The more people expect a change in
aggregate demand, the less that change will
affect real output.
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Determinants of the Slope of AD

• The AD Curve is Flat if
• Investment is responsive to changes in the
  interest rate
• The multiplier is large
• The LM curve is highly responsive to changes in
  income
• The international effect is large

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A Flat IS Curve Means a Flat AD Curve
LM0
LM1
r0
Real Interest Rate ()
r1
IS
Real Output, Income
Y0
Y1
Price Level
Aggregate Demand
P0
P1
Real Output, Income
Y1
Y0
42
Income-Sensitive LM Means a Flat AD
LM0 (P0)
LM1 (P0)
Real Interest Rate ()
r0
IS
r1
Real Output, Income
Y0
Y1
Price Level
P0
Aggregate Demand
P1
Real Output, Income
Y1
Y0
43
Large International Effect Means Flat AD
LM0
LM1
Real Interest Rate ()
IS1
IS0
Real Output, Income
Y0
Y1
Price Level
P0
Aggregate Demand
P1
Real Output, Income
Y1
Y0
44
An Alternative AD/AS Model

• Criticisms of the AD/AS Model
• The curves are confusing because they are not
  micro supply and demand curves
• The model does not adequately explain how the
  economy reaches equilibrium
• The alternative AD/AS model develops the AS and
  AD curves with inflation and real output on the
  axes.

45
The Alternative AD Curve
Slope of the Alternative AD Curve
More inflation
Higher real interest rates
Lower quantity of aggregate expenditures
Downward sloping AD curve
Shifts in the AD Curve
Fiscal policy
Changes in the Feds policy rule
46
The Alternative AD/AS Model
Potential Output
Inflation
Short-run AS is horizontal because of inflation
inertia caused by slowly moving expectations of
inflation.
A
?0
AS
AD
Real output, Income
Y0
47
Adjustment to Long-Run Equilibrium
Potential Output
Potential Output
Inflation
Inflation
A
AS0
?0
D
B
AS1
AS1
?1
?1
C
?0
AS0
AD
AD
Y1
Y0
Y0
Y1
Real output, Income
Real output, Income
48
Expansionary Monetary Policy
Potential Output
Inflation
C
AS1
?1
A
B
?0
AS0
AD1
AD0
Real output, Income
Y0
Y1
49
Contractionary Fiscal Policy
Potential Output
Inflation
A
B
?0
AS0
C
?1
AS1
AD0
AD1
Real output, Income
Y0
Y1
50
An Adverse Supply Shock
Potential Output
Inflation
B
AS1
?1
A
?0
AS0
AD
Real output, Income
Y0
Y1