Chapter 5Aggregate Supply and Demand

5-*IntroductionPrevious lectures: models of long run economic growth Now turn to short run fluctuations in the economy the business cycleBusiness cycles: deviations from trend growth of the economy Recessions and recoveriesCan be large: cumulative US contraction during the Great Depression of 30%Swings in inflation and unemployment can be similarly large

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5-*IntroductionAS/AD model: basic macroeconomic tool for studying output fluctuations and the determination of the price level and the inflation rateExplains how the economy deviates from a path of smooth growth over timeExplores the consequences of government policies intended to reduce unemployment and output fluctuations and maintain stable prices

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5-*AS and ADAggregate supply curve describes, for each given price level, the quantity of output firms are willing to supplyUpward sloping: firms supply more output at higher pricesAggregate demand curve shows the combinations of the price level and the level of output at which the goods and money markets are simultaneously in equilibriumDownward sloping: higher prices reduce the value of the money supply, which reduces the demand for outputIntersection of AS and AD curves determines the equilibrium level of output and price levelHow does the AS/AD work?

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5-*AS, AD, and EquilibriumAS and AD intersect at point E in Figure 5-1

Equilibrium: AS = ADEquilibrium output is Y0 Equilibrium price level is P0

[Insert Figure 5-1 here]

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5-*AS, AD, and EquilibriumShifts in either the AS or AD schedule change in the equilibrium level of prices and output

[Insert Figure 5-2 here]Figure 5-2 illustrates an increase in AD resulting from an increasein money supply.

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5-*AS, AD, and EquilibriumThe amount of the increase/decrease in P and Y after a shift in either aggregate supply or aggregate demand depends on:

The slope of the AS curveThe slope of the AD curveThe extent of the shift of AS/AD What is the slope of the AS curve?

[Insert Figure 5-3 here]Figure 5-3 shows the result of anadverse AS shock: AS Y, P

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5-*Classical AS CurveThe classical AS curve is vertical: the same amount of goods will be supplied, regardless of price [Figure 5-4 (b)]Assumption: the labor market is in equilibrium with full employment of the labor forceThe level of output corresponding to full employment of the labor force = potential GDP, Y*

[Insert Figure 5-4 here]

Long run version of the AS curve

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5-*Classical Supply CurveY* grows over time as the economy accumulates resources and technology improves AS curve moves to the right The growth theory models described in earlier chapters explain the level of Y* in a particular periodY* is exogenous with respect to the price level

illustrated as a vertical line since graphed in terms of the price level[Insert Figure 5-5 here]

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5-*Keynesian Supply CurveThe Keynesian AS curve is horizontal: firms will supply whatever amount of goods is demanded at the existing price level [Figure 5-4 (a)]Assumption: unemployment exists firms can obtain any amount of labor at the going wage rate Prices sticky in the short run: firms reluctant to change prices and wages when demand shiftsIntellectual origins: Great Depression

[Insert Figure 5-4 here, again]Short run version of the AS curve

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5-*Frictional Unemployment and the Natural Rate of UnemploymentTaken literally, the classical model implies that there is no involuntary unemployment everyone who wants to work is employedIn reality there is some unemployment due to frictions in the labor market (e.g. workers who are moving, looking for a new jobs, entrants to the job market, etc.)The unemployment rate associated with the full employment level of output is the natural rate of unemploymentNatural rate of unemployment is the rate of unemployment arising from normal labor market frictions that exist when the labor market is in equilibrium

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5-*AS and the Price Adjustment MechanismAS curve describes the price adjustment mechanism within the economyFigure 5-6 shows the SRAS curve in black and the LRAS in purple, and the adjustment from the SR to the LRThe AS curve is defined by the equation: (1) where Pt-1 is the price level next period Pt is the price level todayY* is potential outputY- Y* is the output gap

[Insert Figure 5-6 here]

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5-*AS and the Price Adjustment Mechanism

(1)

If output is above potential (Y>Y*), prices will increase and be higher next periodIf output is below potential (Y

5-*AS and the Price Adjustment Mechanism (1)The upward shifting horizontal lines in Figure 5-6 (b) correspond to successive snapshots of equation (1)The speed of the price adjustment mechanism is controlled by If is large, AS rotates quickly If is small, prices adjust slowly is of importance to policy makers: If is large, the AS mechanism will return the economy to Y* relatively quicklyIf is small, might want to use AD policy to speed up the adjustment process

[Insert Figure 5-6 here]

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5-*AD Curve and Shifts in ADAD shows the combination of the price level and level of output at which the goods and money markets are simultaneously in equilibriumShifts in AD due to:

Policy measures: Changes in G, T, and MSConsumer and investor confidence[Insert Figure 5-8 here]

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5-*AD Relationship Between Output and PricesKey to the AD relationship between output and prices is the dependency of AD on real money supplyReal money supply = value of money provided by the central bank and the banking systemReal money supply is written as , where is the nominal money supply, and P is the price level AND For a given level of , high prices result in low (high prices purchasing power of the available cash is low) so that thus a high P low level of AD

AD curve is downward sloping

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5-*AD and the Money MarketFor the moment, ignore the goods market and focus on the money market and the determination of ADThe quantity theory of money offers a simple explanation of the link between the money market and ADThe total number of dollars spent in a year, NGDP, is P*YThe total number of times the average dollar changes hands in a year is the velocity of money, VThe central bank provides M dollars

The fundamental equation underlying the quantity theory of money is the quantity equation: (2)

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5-*AD and the Money Market (2)If the velocity of money is assumed constant, equation (2) becomes an equation for the AD curveFor a given level of M, an increase in Y must be offset by a decrease in P, and vice versaInverse relationship between Y and P as illustrated by downward sloping AD curveAn increase in M shifts the AD curve upward for any value of YIllustrated in Figure 5-8

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5-*Changes in the Money Stock and ADAn increase in the nominal money stock shifts the AD schedule up in exact proportion to the increase in nominal moneySuppose corresponds to AD and the economy is operating at P0 and Y0If money stock increases by 10% to , AD shifts to AD Because must hold, the value of P corresponding to Y0 must be P = 1.1P0Therefore real

money balances and Y are unchanged [Insert Figure 5-8 here, again]

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5-*AD policy and the Keynesian Supply CurveFigure 5-9 shows the AD schedule and the Keynesian AS curveInitial equilibrium is at point E (AS = AD)Sticky pricesSuppose an aggregate demand policy increases AD

to ADThe new equilibrium point, E, corresponds to the same price level, and a higher level of output (employment is also likely to increase)

[Insert Figure 5-9 here]

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5-*AD policy and the Classical Supply CurveIn the classical case, AS schedule is vertical at potential level of outputUnlike the Keynesian case, the price level is not given, but depends upon the interaction between AS and ADSuppose AD increases to AD:At the original price level, spending would increase to E BUT firms can not obtain the N required to meet the increased demandAs firms seek to hire more workers, wages and costs of production increase, and firms must charge higher priceMove up AS and AD curves to E

[Insert Figure 5-10 here]RESULT: Increase in AD resultsin higher prices, but not output

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5-*Supply Side EconomicsSupply side economics focuses on AS as the driver in the economySupply side policies are those that encourage growth in potential output shift AS to rightSuch policy measures include: Removing unnecessary regulationMaintaining efficient legal systemEncouraging technological progressPoliticians also use the term supply side economics in reference to the idea that cutting taxes will increase AS enough that tax collections will actually increase, rather than fall

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5-*Supply Side EconomicsCutting tax rates has an impact on both AS and ADAD shifts to AD due to increase in disposable income (relatively large compared to that of the AS)AS shifts to AS as the incentive to work increasesIn short run, economy moves from E to E: GDP increases, tax revenues fall proportionately less than tax cutIn the LR, economy moves to E as AS curve shifts to right: GDP is higher, but by a small amount, Tax collection falls and deficit risesSupply side effective if tax cuts accompanies by spending cuts

[Insert Figure 5-11 here]

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5-*AS and AD in the Long RunIn the LR, AS curve moves to the right at a slow, but steady paceMovements in AD over long periods can be large or small, depending largely on movements in money supplyFigure 5-12 shows a set of AS and AD curves for the period 1970-2000Movements in AS slightly higher after 1990Big shifts in AD between 1970 and 1980Prices increase when AD moves out more than ASOutput determined by AS, while prices determined by the relative shifts in AS and AD

[Insert Figure 5-12 here]

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