Aggregate Demand and Supply (1)

8/7/2019 Aggregate Demand and Supply (1)

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Aggregate Demand andSupply


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Aggregate Demand and Supply


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Aggregate Demand (AD)


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Defined: Amounts of Real Output Buyers Collectively Desire At Each Possible Price Level

AGGREGATE DEMAND

Aggregate Demand CurveDown Sloping Due To:

Real-Balances Effect Interest-Rate Effect Foreign Purchases Effect
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Aggregate Demand

The sum of all expenditure in the economy over aperiod of time

Macro concept WHOLE economy

Formula:AD = C+I+G+(X-M)

C = Consumption Spending I = Investment Spending G = Government Spending (X-M) = difference between spending on

imports and receipts from exports (Balanceof Payments)

Graphically


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AGGREGATE DEMAND CURVE

Price level

Real domestic output, GDP

AD


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Price level


CHANGES IN AGGREGATE DEMAND

AD1

AD2

Aggregate Demand

Can Increase


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Price level


CHANGES IN AGGREGATE DEMAND

AD1AD3

or Decrease

Aggregate Demand

Can Increase


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DETERMINANTS OF AGGREGATE DEMAND

Change in Consumer Spending

Consumer Wealth

Consumer Expectations Household Indebtedness


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Consumption Expenditure

Exogenous factors affecting consumption : Tax rates Incomes short term and expected income over lifetime

Wage increases Credit Interest rates Wealth

Property

Shares Savings Bonds


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Change in Investment Spending

Real Interest Rates Expected Returns

Expected Future Business Conditions Technology Degree of Excess Capacity Business Taxes


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Investment Expenditure

Spending on: Machinery Equipment

Buildings Infrastructure

Influenced by: Expected rates of return Interest rates Expectations of future sales Expectations of future inflation rates


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Government Spending

Defence Health Social Welfare

Education Foreign Aid Regions Industry Law and Order


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Net Export Spending

National Income Abroad Exchange Rates


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Aggregate Demand Curve Why does it slope down from left to right?

Assume RBI sets short term interest rates Assume a rise in the price level will be met

by a rise in interest rates Any increase in interest rates will raise the

cost of borrowing: Consumption spending will fall Investment will fall International competitiveness will decrease

exports fall, imports rise Therefore a rise in the price level leads to lower

levels of aggregate demand


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Aggregate Demand Curve

Inflation

Real National Income

AD

2.0%

Y1

At an inflation levelof 2%, the ADcurve gives a level

of output of Y1

This level of outputwill be associatedwith a particularlevel of

unemploymentwhich we will call U= 5%

U = 5%

3.0%

Y2

At a higher rate of inflation (3.0%)rising interest ratesmean that C, I and

(X-M) all havenegative effects onAD NY falls to Y2

U = 7%

The lower level of National Incomerequires fewer unitsof labour

unemployment risesto 7% shown by U =7%


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Shifts in the Aggregate DemandCurve

Inflation


AD

2.0%

Y1U = 5%

Shifts in AD will becaused by changes infactors affecting C, I,G and (X-M)(exogenous factors)e.g. increasing

income tax ratesaffect consumption

AD2

Y2U = 2%

Any exogenousfactor causing C,I or G to rise, ora trade surplus

causes a shift tothe right in AD

This would cause arise in nationalincome (economicgrowth) and leadto a fall inunemployment (U= 2%) (and viceversa)


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Import Spending (negative)

Goods and services bought from abroad representsan outflow of funds from the India (reduces AD)


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Export Earnings (Positive)

Goods and services sold abroad represents a flow of funds into India (raises AD)


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Key Variables


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Macroeconomic Policy


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Fiscal Policy

Government Income (taxes and borrowing) Government Spending


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Monetary Policy

Interest Rates (RBI)


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Aggregate Supply (AS)


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Capacity of the Economy

Costs of Production Technology Education and Training Incentives Tax regime Capital stock Productivity Labour Market


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AGGREGATE SUPPLYDefined:

Levels of Real Domestic Output At Each Possible Price Level Long-run Supply Curve

Wages and Resource PricesMatch Price Level

Short-run Supply Curve Wages and Resource Prices

Do Not Match Price Level


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AGGREGATE SUPPLY

Price leve l

Real domestic output, GDPQ

P

Long Run

AS LR

Long-runAggregate

Supply

Q f

Full-Employment


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AGGREGATE SUPPLY

Price leve l


P

Short Run

ASAggregateSupply

Short-run

Q f

Full-Employment


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AGGREGATE SUPPLY

Price leve l


P AS 3AS 1

AS 2

Increase InAggregate

Supply

Decrease InAggregate

Supply

Changes in Aggregate Supply

DETERMINANTS OF AGGREGATE SUPPLY


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Input Prices

Domestic Resource Prices Labor

Land Capital

Prices of Imported GoodsMarket Power



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Productivity

Productivity =Total OutputTotal Inputs

Legal-InstitutionalEnvironment

Business Taxes andSubsidies Government Regulation


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Aggregate SupplyInflation


The shape of the AScurve is important indetermining theoutcome in theeconomy

AS

Yf

This shapereflects aKeynesian view

of the AS curve.

Yf represents FullEmployment Output at this point theeconomy is working tofull capacity andcannot produce anymore.

Y1

An output level of Y1would suggest theeconomy is workingbelow full capacityand there would bewidespreadunemployment.

Economy starts to overheat

Between Y1 and Yf,increases in capacityare possible but thenearer the economygets to Yf, the moreproblems areexperienced withacquiring resourcesto boost production(productionbottlenecks)especially labourskills shortages.


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Aggregate SupplyInflation


AS1 AS2

Yf1 Yf2

Increases incapacity canoccur as a

result of ashift in AS(akin to ashiftoutwards of the

ProductionPossibilityFrontier)(PPF)


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Aggregate Supply

Inflation


SRAS

Short runaggregate supply(SRAS) assumesfirms only able toincrease output athigher costs (e.g.

overtimepayments)thereby pushingup price level

SRAS 1

SRAS 2

SRAS assumescosts such asoverall wagerate remainfixed, changes

in such costscause a shiftin the SRAScurve(exogenousshocks inputcosts)


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Aggregate Supply

Inflation


LRAS Classicaleconomistsassume the longrun aggregatesupply curve(LRAS) is vertical(perfectlyinelastic).

This is becausethey believe thatin the long run,there will be nounemployment of resourcesbecause marketswill clear, thuswhatever therate of inflation,firms will supplythe maximumcapacity of theeconomy.

Yf


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Aggregate Supply

For our analysis,we will assumethe AS curvelooks like this!

Inflation


AS

EQUILIBRIUM AND CHANGES


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Price Level

Real Domestic Output, GDP

Q

PAS

AD

5 1 0 5 0 2

5 1 4

EQUILIBRIUM AND CHANGESIN EQUILIBRIUM

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100a b

EquilibriumReal Output

INCREASES IN AD
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Price Level


Q

PASAD1

INCREASES IN AD:DEMAND-PULL INFLATION

P 2

P 1

AD2

Q f Q1 Q2

DECREASES IN AD RECESSION


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Price Level


Q

PASAD1

DECREASES IN AD: RECESSION& CYCLICAL UNEMPLOYMENT

P 1

AD2

Q f Q1

a

c

b

DECREASES IN AD RECESSION


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Wage Contracts Morale, Effort, andProductivity

Efficiency Wages Minimum Wage Menu Costs Fear of Price Wars

DECREASES IN AD: RECESSION& CYCLICAL UNEMPLOYMENT

DECREASES IN AS
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Price Level


Q

PAS 1

AD1

DECREASES IN AS:COST-PUSH INFLATION

P 2

Q f Q1

a

b

AS 2

P 1

INCREASES IN AS


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Price Lev el


Q

P AS 1

AD1

INCREASES IN AS:FULL EMPLOYMENT

P 1

Q2Q1

a

b

AS 2

P 2

With Price-Level Stability

AD2

P 3

Q3


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REVISION


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The AD/AS Model

The AD/AS Model Explains short-run fluctuations in real GDP and

the Price level (inflation)


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Aggregate Demand

Aggregate demand is thetotal demand for goodsand services in theeconomy.

The aggregate demand (AD) curve is a curvethat shows therelationship between theprice level and thequantity of real GDPdemanded by households,firms, and thegovernment.


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Deriving the Aggregate Demand Curve

The ADcurve is not amarket demand curve,and it is not the sumof all market demand

curves in theeconomy. It is amore complexconcept.

How are aggregate demand andaggregate expenditure related?

At every point along the aggregate demand curve,the aggregate quantity of output demanded isexactly equal to planned aggregate expenditure.


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Deriving the Aggregate DemandCurve

P M r I A E d Y

The Impact of an Increase in the Price Level on theEconomy Assuming No Changes in G, T , and M s


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Aggregate Demand Curve

Aggregate demand falls when the price levelincreases because the higher price levelcauses the demand for money to rise, which

causes the interest rate to rise. It is the higher interest rate that causesaggregate output to fall.

At all points along the AD curve, both thegoods market and the money market are inequilibrium.


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Reasons why AD is downward sloping

The consumption link: The decrease inconsumption brought about by an increase inthe interest rate contributes to the overall

decrease in output. The real wealth effect , or real balance , effect :

When the price level rises, there is adecrease in consumption brought about by achange in real wealth.


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Shifts in AD Changes in

GovernmentalPolicies

Changes in Monetary

Policy Changes in Expectationsof Households andFirms

Th A D d C


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The Aggregate Demand Curve:A Warning

A higher price level causes thedemand for money to rise,which causes the interest rateto rise.

Then, the higher interest ratecauses aggregate output tofall.

Th A D d C


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A higher price level causes thedemand for money to rise,which causes the interest rateto rise.

Then, the higher interest ratecauses aggregate output tofall.

Th A D d C


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At all points alongthe AD curve,both the goodsmarket and themoney marketare in equilibrium.

ther Reasons for a Downward-


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ther Reasons for a DownwardSloping Aggregate Demand

Curve The consumption link: The

decrease in consumption

brought about by anincrease in the interestrate contributes to theoverall decrease inoutput.

ther Reasons for a Downward-


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ther Reasons for a DownwardSloping Aggregate Demand

Curve The real wealth effect , or

real balance , effect is

the change inconsumption broughtabout by a change in realwealth that results from achange in the price level.

A E di


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Aggregate Expenditureand Aggregate Demand

At every point along theaggregate demand

curve, the aggregatequantity of outputdemanded is exactlyequal to plannedaggregate expenditure.Y = C + I + G

equilibrium condition

Shift f th A t D d


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Shifts of the Aggregate DemandCurve

An increase in thequantity of moneysupplied at agiven price levelshifts theaggregate

demand curve tothe right.

Shift f th A t D d


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An increase ingovernmentpurchases or adecrease in nettaxes shifts theaggregate

demand curve tothe right.

Shift f th A t D d


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Factors That Shift the Aggregate Demand CurveExpansionary monetary policy

M s AD curve shifts to the right

Contractionary monetary policy

M s AD curve shifts to the left

Expansionary fiscal policy

G AD curve shifts to the right

Contractionary fiscal policy

G AD curve shifts to the leftT AD curve shifts to the right T AD curve shifts to the left


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The Aggregate Supply Curve

Aggregate supply isthe total supply of

all goods andservices in theeconomy.


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The aggregate supply (AS ) curve is a graph

that shows therelationship between theaggregate quantity of output supplied by allfirms in an economy andthe overall price level.

The Aggregate S ppl C r e:


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The Aggregate Supply Curve:A Warning

The aggregate supplycurve is not a market

supply curve or the sumof all the individualsupply curves in theeconomy.

The Aggregate Supply Curve:


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Firms do not simply respond tomarket-determined prices, butthey actually set prices . Price-setting firms do not haveindividual supply curvesbecause these firms are

choosing both output andprice at the same time.



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When we draw a firms supplycurve, we assume that inputprices are constant. Inmacroeconomics, an increasein the overall price levelmeans that at least some

input prices will be rising aswell. The outputs of some firms are

the inputs of other firms.



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Rather than an aggregatesupply curve, what does existis a price/output responsecurve a curve that tracesout the price and outputdecisions of all the markets

and firms in the economyunder a given set of circumstances.

Aggregate Supply in the Short


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Aggregate Supply in the ShortRun

In the short run, theaggregate supplycurve (theprice/outputresponse curve)has a positive

slope.



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At low levels of aggregate output,the curve is fairlyflat. As theeconomyapproachescapacity, the

curve becomesnearly vertical. Atcapacity, thecurve is vertical.



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Macroeconomists focus onwhether or not the economyas a whole is operating at fullcapacity.

As the economy approachesmaximum capacity, firms

respond to further increases indemand only by raising prices.

Output Levels and


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Output Levels andPrice/Output Responses

When the economy is operating at lowlevels of output, an increase inaggregate demand is likely to result in

an increase in output with little or noincrease in the overall price level.

The Response of Input Prices to


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p pChanges in the Overall Price

Level There must be a lag

between changes in

input prices and changesin output prices,otherwise the aggregatesupply (price/outputresponse) curve wouldbe vertical.

The Response of Input Prices to


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p pChanges in the Overall Price

Level Wage rates may increase

at exactly the same rate

as the overall price levelif the price-level increaseis fully anticipated. Mostinput prices, however,tend to lag increases inoutput prices.

Shifts of the Short Run


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Shifts of the Short-RunAggregate Supply Curve A cost shock , or supply shock , is a

change in costs that shifts the aggregatesupply ( AS ) curve.


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that shows therelationship between theaggregate quantity of output supplied by allfirms in an economy andthe overall price level.


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Aggregate Supply

Aggregate supply is the total supply of allgoods and services in the economy.


that shows the relationship between theaggregate quantity of output supplied by allfirms in an economy and the overall pricelevel.


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Aggregate Supply Curve

The aggregate supply curve is not a marketsupply curve and it is not the simple sum of all the individual supply curves in the

economy. One reason is that firms do not simply respond

to market-determined prices, but they actuallyset prices . Price-setting firms do not have

individual supply curves because these firmsare choosing both output and price at thesame time. We can add something that doesnot exist!


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Another reason is that when we draw a firmssupply curve, we assume that input prices areconstant. If the overall price level is rising,there will be an increase in at least some inputprices.

The outputs of some firms are the inputs of other firms.

As wage rates and other input prices rise, the

firms individual supply curves are shifting, sowe can not sum them to get an aggregatesupply curve.


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Aggregate Supply

In the short run, theaggregate supply curve(the price/output responsecurve) has a positiveslope.

At low levels of aggregateoutput, the curve is fairlyflat. As the economyapproaches capacity, the

curve becomes nearlyvertical. At capacity, thecurve is vertical.

AS

Real GDPY

Price Level


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Shifts in the Short-run AS Curve

A leftward shift of theAS curve could becaused by costshocks.

A decrease in costs,A decrease in costs,economic growth, or economic growth, or public policy, canpublic policy, cancause a rightwardcause a rightwardshift of theshift of the AS AS curvecurve ..


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Factors that shift the Aggregate Supply Curve

deregulation

Bad weather, naturaldisasters,destruction b/ wars

Good weather

Public policyPublic policy waste andinefficiency

supply-side policies over-regulation tax cuts

Capital deterioration more capital more labor

higher input prices lower input prices higher wage rates lower wage rates

Factors That Shift the Aggregate Supply Curve

Shifts to the LeftDecreases in Aggregate Supply

Shifts to the RightIncreases in Aggregate Supply

technological change

StagnationEconomic growth

Higher costsLower costs


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The Equilibrium Price Level

The equilibriumprice level is thepoint at which theaggregate demandand aggregatesupply curves

intersect.


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Equilibrium in AD/AS

P P 0 and0 and Y Y 0 correspond to0 correspond toequilibrium in theequilibrium in thegoods market and thegoods market and themoney market and amoney market and aset of price/outputset of price/outputdecisions on the partdecisions on the partof all the firms in theof all the firms in theeconomy.economy.

AS

AD

Real GDP Y

Price Level

P0

Y0


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Long-Run AS Curve

LRAS- is a curve thatshows therelationship in thelong-run between the

price level and thequantity of real GDPsupplied.

Changes in the pricelevel do not affect thelevel of aggregatesupply in the long-run. Therefore it isvertical.

Remember in the longrun capital is notfixed.

LRAS representspotential GDP (whatthe economy could bedoing if all resourcesare being usedefficiently, & theeconomy isexperience fullemployment.


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Graphical Presentation of LRAS

LRAS

Real GDP

Price L evel

Increase

LRAS

Decrease

The Long-Run


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The Long RunAggregate Supply Curve

Costs lag behindprice-levelchanges in theshort run, resultingin an upward-sloping AS curve. Costs and the price level

move in tandem in thelong run, and the AS curve is vertical.


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The AS/AD Model Together


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The Long-Run


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When output is pushedabove potential, there isupward pressure oncosts, and this causesthe short-run AS curve tothe left.

Costs ultimately increase by the samepercentage as the price level, andthe quantity supplied ends up backat Y

0.

The Long-Run


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Y 0 represents thelevel of output thatcan be sustained inthe long runwithout inflation. Itis also called

potential output or potential GDP .

Aggregate Demand, AggregateS l d M d Fi l


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Supply, and Monetary and FiscalPolicy

Expansionary policy works

well when the economy ison the flat portion of theAS curve, causing littlechange in P relative to theoutput increase.

AD can shift to the right for a number of reasons, including an increase in themoney supply, a tax cut, or anincrease in government spending.

Aggregate Demand, AggregateS l d M d Fi l


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When the economy isoperating near fullcapacity, an increase inAD will result in anincrease in the price levelwith little increase inoutput.

On the steep portion of the AS curve,expansionary policy does not workwell. The multiplier is close to zero.

Supply, and Monetary and FiscalPolicy

Long-Run Aggregate


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g gg gSupply and Policy Effects

If the AS curve is vertical inthe long run, neither monetary policy nor fiscalpolicy has any effect onaggregate output.

In the long run, the multiplier effect of achange in government spending or taxes on aggregate output is zero.

The Simple Keynesian


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The output of the economycannot exceed themaximum output of Y F .

The difference betweenplanned aggregateexpenditure and aggregateoutput at full capacity issometimes referred to as

an inflationary gap .

C f I fl ti


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Causes of Inflation

Inflation is an increase inthe overall price level.

Sustained inflation occurswhen the overall pricelevel continues to riseover some fairly longperiod of time.

C f I fl ti


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Causes of Inflation

Demand-pull inflation isinflation initiated by anincrease in aggregatedemand.

Cost-push, or supply-side,inflation is inflation caused by anincrease in costs.

Cost-Push, or Supply-Side


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, pp yInflation

Stagflation occurs whenoutput is falling at thesame time that prices

are rising. One possible cause of

stagflation is anincrease in costs.

Cost-Push, or Supply-Side


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, pp yInflation

Cost shocks are badnews for policymakers. The onlyway to counter theoutput loss is byhaving the price

level increaseeven more than itwould without thepolicy action.

E t ti d I fl ti


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Expectations and Inflation

If every firm expects every other firm to raise prices by 10%,every firm will raise prices byabout 10%. This is howexpectations can get built intothe system. In terms of the AD/AS diagram, an

increase in inflationary expectationsshifts the AS curve to the left.

Mone and Inflation


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Money and Inflation

Hyperinflation is aperiod of veryrapid increases inthe price level.

Money and Inflation


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Money and Inflation

An increase in G withthe money supplyconstant shifts the AD

curve from AD0 toAD1. This leads to anincrease in the interestrate and crowding out

of planned investment.

Money and Inflation


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Money and Inflation

If the Fed tries to preventcrowding, it will increasethe money supply and

the ADcurve will shiftfarther and farther to theright. The result is asustained inflation,

perhaps hyperinflation.

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Aggregate Demand and Supply (1)