Aggregate Demand Aggregate Demand and Aggregate Supply:and Aggregate Supply:
Explaining economic fluctuationsExplaining economic fluctuations--
Revision of main conceptsRevision of main concepts
Francesco DaveriFrancesco Daveri
Two key facts on fluctuations
1. Economic fluctuations occur systematically, but they are irregular, for their timing and duration is unpredictable
• Macroeconomic variables behave as random variables
2. Most aggregate variables fluctuate together: macro-economic variables are closely related
• Yet: even if most variables move together, their volatility differs across variables
Growth: usually positive but not constant. One episode of growth<0
GDP growth in the world economy: fluctuating with irregular and unpredictable timing
Source: IMF World Economic Outlook Database, April 2014
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We want to develop basic model to explain economic fluctuations
•Two variables are used to develop a model to analyze the short-run fluctuations :
• The economy’s output of goods and services measured by real GDP
• The overall price level measured by the CPI or the GDP deflator
•We use the model of aggregate demand and aggregate supply (AD-AS) to explain short-run fluctuations in economic activity around long-run trends
What the basic model says
•Three main things
• Monetary , fiscal and exchange rate policies (AD policies) affect real GDP in the short run but not in the long run
• Money and policy do not affect “real” variables” (Gdp, C, I) in the long run, but they do in the short run. Long-run Money and policy neutral in the long run, not in the short run
• Hence: when studying year-to-year changes in the economy, we will not assume money and policy neutrality
The model of aggregate demand and aggregate supply
Equilibriumoutput
Quantity ofOutput
PriceLevel
0
Aggregatesupply
Aggregatedemand
AD and AS
• The aggregate demand (AD) curve shows the quantity of goods and services that households, firms, and the government are willing to buy at any price level
– Note: The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy
• The aggregate supply (AS) curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level
– Note The AS curve is not a market supply curve, and it is not the sum of all market supply curves in the economy
AD curveThe four components of GDP (Y) contribute to the aggregate demand for goods and services:
Y = C + I + G + NX
Quantity ofOutput
PriceLevel
0
Aggregatedemand
P1
Y1 Y2
P2
1. A decrease in the pricelevel
2. …increases the quantity of goods and services demanded.
Why the AD is downward sloping
Price level Quantity of good demanded
Pigou (wealth) effect
price level
consumers feel wealthier
Encouraged to spend
more
larger quantity of goods and services demanded
Keynes (interest rate) effect
price level
Lower domestic interest rate
Firms encouraged to invest more
greater spending on investment goods
Mundell-Fleming (exchange rate) effect
(domestic) price level
Lower interest rate, capital goes abroad
Exchange rate
depreciates, gain in competitiveness
increase in exports and
decrease in imports, increase in net exports
• Pigou’s effect (or real balance effect):
ADCP
WealthP
• Keynes’ effect (or interest rate effect):
ADIipBondsMP Bondsdd
• Mundell-Fleming’s effect (or exchange rate effect):
ADNXEXPORTS
IMPORTSenesscompetitivP
Shifts in the AD curveAnything that makes buyers more or less willing to buy goods and services for any given level of price shifts the AD curve.
• Consumers, firms: exogenous changes in spending plans by consumers or firms (e.g. household savings before the Iraq war; pessimism after Lehman Bros bankruptcy)
• Government: exogenous changes in fiscal, monetary and exchange rate policy
Output
Price
0
P1
Y1 Y2
AD1 AD2
The multiplier: by how much AD shifts
Extent of the AD shifts determined by size of multiplier Multiplier: process that makes initial increase in income bigger due to
further increases in C and I triggered by initial increase in GDP
Example: Suppose Govt raises defense spending G income of G producers consumption of G producers income of
C producers and so on Total rightward shift of AD given by sum of all income increments If GDP very close to full employment, demand increase feeds into higher
inflation and not Gdp gains
Aggregate supply curve
Preview of main arguments
In the short run, the aggregate-supply curve is upward sloping
In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services
• The price level does not affect these variables in the long run
Hence: In the long run, the aggregate-supply curve is vertical
The short run AS curveIn the short run
• An increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied for given costs of production
• A decrease in the level of prices tends to reduce the quantity of goods and services supplied (see picture)
Y1
P1
P2
1. A decrease in the price level
Quantity of output
Price Level
0
Short-runaggregate
supply
Y2
2. reduces the quantity of goods and services supplied in the short run
Why the short run AS is upward sloping
Price level Quantity of good supplied
New classical misperceptions theory
Aggregate price
producers temporarily perceive it as a decline in ‘their’ individual sale
price
decrease of goods and services supplied
Keynesian sticky wages theory
Aggregate price
nominal wages do not fall immediately
labor costs go up
firms reduce production
New Keynesian sticky prices theory
Aggregate price
some firms do not adjust their own price to save on “menu costs”
sales reduced, hence
firms reduce production
Bottom line: Experts’ opinions vary as to why, but – reassuringly - the SLOPE of the AS is anyway positive!
Shifts in the short run AS curve
Y1
P1
output
Price
0 Y2
AS2AS1
Why AS might shiftIn a nutshell: Anything that shifts costs of production shifts AS
AS shifts to the right if:
• Imported or domestic input prices go down
• Costs of production going up for given price, output to be cut
• Factor productivity goes up (thanks to new technologies)
• allows firms to produce more at a lower cost for an unchanged sale price
• Government cuts distorting taxes and regulations hampering business practices
• Reduction of social security contributions reduces labor costs; reduced tax on profits raises net profitability
• Expectation of lower price level in the future
• This feeds into lower wage claims and thus decrease labor costs today
Implication: GDP gains due to AD shifts do not last long
Let’s see why Short run AS drawn for given nominal wages As nominal wages change, short-run AS (entire curve)
Why do wages change? Today’s P makes wage claims at next wage negotiation round
So what happens?
As AD shifts to the right, this also gives rise to P. This results in rising inflation expectation for the future Higher expected inflation raises wage claims Short run AS shifts to the left Short run AS keeps shifting leftwards until GDP above its long-run
average
AD
SRAS
AD’
SRAS’
E
GDP
P
Permanent GDP
E’
E’’
Why AD-originated Gdp gains do not last: graphics
As a result: The long run AS curve is vertical at the natural rate of output.
Quantity ofOutput
Natural rateof output
Price Level
0
Long-runaggregate
supply
P1
1. A change in the price level…
P2
2. …does not affect the quantity of goods and services supplied in the long run.
Long run equilibrium
The intersection of the AD curve and the long-run AS curve determines the economy’s equilibrium output and price level (E)
• Output is at its natural rate• The short-run AS curve goes through the point of intersection
Natural rateof output
Output
Price
0
EquilibriumPrice
Long-runAS
E
Short-runAS
AD
Now ready to study the causes of recessions
There are two causes of recessions
• AD shift to the left
• AS shift to the left
See them in turn
Recession I: a leftward shift of ADA decrease in one of the determinants of AD shifts the curve to the left.
Hence, (i) output falls below the natural rate of employment; (ii) unemployment rises, (iii) the price level falls
0
AS1
A
B
C
P1
P2
P3
Y1Y2
AD2
AS2
1. A decrease inaggregate demand…
3. …but over time,the short-run aggregate-supply curve shifts (B to C)…
2. …causes output to fall in the short run (A to B)…
4. …and output returnsto its natural rate.
Long-runASPrice
Output
AD1
Recession II: a leftward shift of ASA decrease in one of the determinants of AS shifts the curve to the left: hence, (i) output falls below the natural rate of employment; (ii) unemployment rises; (iii) the price level rises
0
AS1
B
AP1
P2
Y1Y2
AS2
2. …causes output to fall…
. 3. …and the price to rise.
Long-runASPrice
Output
1. An adverse shift in the short-run AS curve…
AD1
Recession II = Stagflation
Adverse shifts in aggregate supply cause stagflation - a combination of recession and inflation
• Output falls and prices go up• Policymakers can influence the level of aggregate demand (by
increasing public consumption), much less so the level of aggregate supply
• Hence, they cannot offset both adverse effects simultaneously
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How to read supply and demand shocks in the data: the US in the 1990s
1990s: GDP up & inflation down, symptom of positive supply shock
2001-02: both GDP & inflation down, symptom of negative demand shock
US economy
1991-93 1994-96 1997-00 2001-02
GDP growth 2.4 3.2 4.2 1.3
Inflation 3.2 2.7 2.6 1.7