Chapter 15 Aggregate Demand and Aggregate Supply
Chapter 15 Aggregate Demand and Aggregate Supply Econ 202 - 01
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Date Created: 04/27/16
Chapter 15 ~ Aggregate Demand and Aggregate Supply Introduction The US economy as measured by rGDP grows at approximately 3% annually. However this is not always the case in which contractions called recessions occur. A Recession ~ is a period of declining real incomes and rising employment A Depression ~ is a very severe and long-lasting economic recession The model of aggregate demand and aggregate supply studies and analyzes the variables: rGDP, unemployment, interest rates and price levels; along with the policies of government spending, taxes and the money supply: It is associated only with short-run economics. Most used model by economists to explain short-run economic fluctuations and forces 1 piece is the aggregate-demand curve 2 piece is the aggregate-supply curve 3 Key Facts about Economic Fluctuations 1. Economic fluctuations in the business cycle are often irregular and unpredictable ~ in other words, economic fluctuations correspond to changes in business conditions. a. Over the long run, rGDP grows about 3% per year. b. Short-run economic fluctuations are often called business cycles 2. Most macroeconomic quantities fluctuate together; such as, rGDP, investment spending and the unemployment rate. a. Real GDP measures the total quantity (value) of all final goods and services produced by all firms in all markets within a country during a given time period. b. Real GDP (rGDP) measures total income c. Real GDP is most used to measure short-run changes in the economy d. If Investments ↓ → rGDP↓ 3. As output falls ↓; unemployment increases ↑ (decrease of economy’s utilization force) Explaining Short-Run Economic Fluctuations Classical dichotomy (classical view ~ money is a veil) ~ is the separation of nominal variables that measures money from real variables that measure quantities or relative prices. Real variables ~ quantities and relative prices Nominal variables ~ measured in terms of money There’s a breakdown in classical dichotomy in the short-run supply and demand Nominal ~ means “nearly insignificant” Money neutrality ~ changes in the money supply affect nominal variables and NOT real variables. Most economists believe that classical theory explains the long-run and NOT the short-run. However, in the short-run, real and nominal variables are highly intertwined, and changes in the money supply (and/or prices) can temporarily push rGDP away from its long-run trend and also affect unemployment. So, the new model of aggregate-demand and aggregate-supply abandons the classical dichotomy and money neutrality and studies the relationship between prices and rGDP. Model of Aggregate Demand and Aggregate Supply ~ is the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend. Aggregate-Demand Curve ~ is a curve that shows the quantity of all goods and services that households, firms, the government and customers abroad (demand) want to buy at each price level. When prices change, there is a “movement” along the aggregate-demand curve and affects consumption, investment and net exports. When rGDP (Y) changes, there is a “shift” of the aggregate-demand curve. There is NOT a single price, and changes in prices does NOT shift the LRAD curve. Aggregate-Supply Curve ~ is a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. The Aggregate-Demand Curve: Y = C + I + G + NX 3 Reasons for the downwards slope of the aggregate-demand curve: 1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption. Assume prices rise: The dollars that people hold buys fewer goods and services, so real wealth is lower, and people “feel” poorer. Then consumption falls. Negative relationship between price and consumption. 2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on investment. Assume prices rise: Buying the goods and services requires more dollars. To get their dollars, people sell bonds or other assets which drives up the interest rate. Investment falls, prices increase, interest rate increases and investment decreases. Negative relationship between price and investment. Positive relationship between price and interest rates. 3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports. Assume the US interest rate rises: Prices ↑ → r.i.r. ↑ → NCO ↓ → RER ↑ → NX ↓. Domestic and foreign entities (investors) desire (buy) more US bonds and the supply of US dollars in the FCX ↓. US exports become more expensive to people abroad, and imports are cheaper to US citizens: NX ↓ 4 Reasons why the aggregate-demand curve will shift ~ Note: When there is any change in rGDP’s variables (C, I, G, NX), then there is a “shift” of the aggregate-demand curve. Price ∆’s, by themselves, do NOT shift the LRAD curve. Price ∆’s, on their own, cause a movement along the LRAD curve. 1. Shifts from changes in consumption: An event that causes consumers to spend more at a given price level (a tax cut, a stock market boom) shifts the aggregate-demand cure to the right. An event that causes consumers to spend less at a given price level (a tax hike, a stock market decline) shifts the aggregate-demand curve to the left. 2. Shifts from changes in investment: An event that causes firms to invest more at a given price level (optimism about the future, lower interest rates due to an increased money supply) shifts the aggregate-demand curve to the right. An event that causes firms to invest less, or not at all, at a given price level (pessimism about the future, a decrease in money supply and higher interest rates) shifts the demand curve to the left. 3. Shifts from changes in government purchases: An increase in government spending on goods and services (national defense or roads and highways) shifts the aggregate-demand curve to the right. A decrease in government spending on goods and services (cutbacks in defense spending or road maintenance) shifts the aggregate-demand curve to the left. NOTE: Government spending has the “largest” effect on the shift of the aggregate- demand curve. 4. Shifts from changes in net exports: An event that raises spending on net exports at a given price level (a boom in foreign markets, speculation that reduces the value of the US dollar and the real exchange rate) shifts the aggregate-demand curve to the right. An event which decreases spending on net exports at a given price level (a recession overseas, an appreciation of the US dollar and the real exchange rate) shifts the aggregate-demand curve to the left. Taxes ↓ → Consumption (spending) ↑ and in reverse; Taxes ↑ → Consumption (spending) ↓ Investment Tax Credit → Capital Investment ↑ ~ a repeal of Investment Tax Credit → Investment ↓ Money Supply ↑ → Interest Rate ↓ → Capital Investment ↑ Y↑ = C + I + G↑ + NX ~ Government Purchases ↑ → Y↑ → aggregate-demand curve shifts right NX ↓ → aggregate-demand curve shifts left ~ when NX ↑ → aggregate-demand curve shifts right Money Supply ↓ → RER ↑ → 1/P ↑ → Prices ↑ → NX ↓ (appreciation of US dollar) → AD shifts left Money Supply ↑ → RER ↓ → 1/P ↓ → Prices ↓ → NX ↑ (depreciation of US dollar) → AD shifts right Prices ↓ → interest rate ↓ → RER ↓ → 1/P ↓ → NX ↑ → aggregate-demand curve shifts right Prices ↑ → interest rate ↑ → RER ↑ → 1/P ↑ → NX ↓ → aggregate-demand curve shifts left Money supply ↓ → 1/P ↑ → dollar appreciates and foreign goods and services are cheaper Prices ↑ → 1/P ↓ → people feel “poorer” → consumption ↓ → LRAD curve shifts left Negative relationship between price and consumption Prices ↑ → money supply ↑ → interest rate ↑ → investment ↓ → LRAD curve shifts left Negative relationship between price and investment Disposable Income (Y–T) ↑ → consumption ↑ → aggregate-demand curve shifts right Y–T (Disposable Income) ↓ → consumption ↓ → aggregate-demand curve shifts left The Aggregate-Supply Curve: Y = A × F[L, K, H, N] The Aggregate-Supply Curve represents the Natural Rate of Output which is the amount of output the economy produces when unemployment (frictional and structural) is at its natural rate. o Supply is fixed at “Y” when the AS curve is vertical: If the aggregate supply curve is vertical, fluctuations in the aggregate demand do NOT cause fluctuations in output or employment. If the aggregate supply curve slopes upward, then AD does affect output and employment. In classical dichotomy, a ∆ in price doesn’t affect the following determinates: L, K, H and N. Any event which ∆’s any of the preceding determinates will shift the LRAS curve. o Labor ↑ (immigration↑) → LRAS curve shifts to the right o Government policies ↓ unemployment → LRAS curve shifts to the right o Baby-Boomers retire → LRAS curve shifts to the right o ↑ in K or H → LRAS curve shifts to the right o Shitty weather for farmers → LRAS curve shifts to the left o ↓ oil availability → LRAS curve shifts to the left o ↑ resources → LRAS curve shifts to the right o ∆’s or ↑ in technologies → LRAS curve shifts to the right There is a time horizon associated with the short-run aggregate-supply curve of < 3 years. In the long-run, only, the axis is vertical (because it is unaffected by prices and money and output is also unaffected by prices and money) In the short-run, the axis is sloped upward (because of sticky wages & prices and misperceptions) o Output deviates from its natural rate when the actual price level deviates from the price that people expected. 3 Reasons (theories) of why the short-run aggregate-supply curve slopes upwards: 1. The Sticky-Wage Theory: An unexpectedly low price level raises the “real” wage, which causes firms to hire fewer workers and produce a smaller quantity of goods and services. a. When Price > ???????????????????? , ????evenue is higher but labor costs aren’t, production is more profitable so firms increase output and employment. (???????????????????? Is????the price level & doesn’t represent a single product). b. When P > ???? → Y > ???? ???? ???? i. Profits = Total Revenue – Total Cost ii. Profits = P × Y – W × L iii. Expected Profit = ???? × ???? – W × L = 0 iv. Actual Profit = P × Y – W × L > 0 2. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher-than- desired prices, which depresses their sales and leads them to cut back production. a. Many prices are “sticky” in the short run due to menu costs: Firms without menu costs can raise prices immediately. Firms which have menu costs wait to raise prices, and meanwhile their prices are relatively low. These latter firms experience increased demand because of lagging prices of their products, so they ↑ output and employment. 3. The Misconceptions Theory: An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall in production. a. Firms may confuse changes in Price with changes in the relative price of the products they sell and make changes in output and employment with disregard to relative prices. 5 Possibilities that might cause a shift in the aggregate-supply curves: 1. Shifts arising from changes in labor: An increase in the quantity of labor available (perhaps ↓ in unemployment) shifts the aggregate-supply curve to the right. A decrease in the quantity of labor available (perhaps ↑ natural rate of unemployment or due to ↑ minimum wage law) shifts the aggregate-supply curve to the left. 2. Shifts arising from changes in capital: An increase in physical or human (training) capital shifts the aggregate-supply curve to the right. A decrease in physical or human (education) capital shifts the aggregate-supply curve to the left. 3. Shifts arising from changes in natural resources: An increase in the availability of natural resources shifts the aggregate-supply curve to the right. A decrease in the availability of natural resources shifts the aggregate-supply curve to the left. 4. Shifts arising from changes in technology: An advance in technological knowledge shifts the aggregate-supply curve to the right. A decrease in the available technology (perhaps due to government regulation) shifts the aggregate-supply curve to the left. a. NOTE: Changes in technology are considered to be the most important influence in regards to causing a shift in the long-run aggregate-supply curve. b. ↑ technology → ↑ rGDP and an ↑ the money supply and ongoing inflation 5. Shifts arising from changes in expected price levels: A decrease in the expected price level shifts the short-run aggregate-supply curve to the right. An increase in the expected price level shifts the short-run aggregate-supply curve to the left. th NOTE: The first 4 possibilities affect the long-run aggregate-supply curve. The 5 and final possibility affects the short-run aggregate-supply curve. The long-run level of production is sometimes called potential output or full-employment output. The Natural Level of Output ~ is the production of goods and services that an economy achieves in the long-run when unemployment is at its normal rate. As technology improves or increases over time, the aggregate-supply curve moves to the right. As the money supply increases over time, the aggregate-demand curve moves to the right. So, these two determine long-run growth and inflation. The quantity of output supplied deviates from its long-run, or natural, level when the actual price level in the economy deviates from the price level that people expected. In the short-run, ↑ in prices → quantity of goods and services ↑ Sticky-Wage Theory ~ says that nominal wages are slow to adjust Sticky-Price Theory ~ says that prices are slow to adjust which are related to menu costs o Positive association between price and rGDP o ↑ Money Supply → ↑ Prices → ↓ 1/P Misperceptions Theory ~ there is a misunderstanding between nominal prices and relative prices by suppliers Quantity of output supplied = Natural level (rate) of output + a × (Actual price level – Expected price level). Y =???????? + a(P – ???? ) o ???? o???? ???????????????????? is????expected price o a > 0 and is a constant that measures how much Y responds to unexpected ∆’s in price o ???? is the natural rate ???? o Y is output (rGDP) o P is the “actual price” P = ????????there is NO change P > ???? then Y > ???? ???? ???? P < ???? then Y < ???? ???? ???? Understanding the short-run aggregate-supply curve (SRAS) shift: SRAS curve is governed by o Sticky wages o Sticky prices o Misperceptions of relative prices to nominal prices Anything that shifts the long-run AS curve will also shift the short-run AS curve o If ???? rises, workers and firms set higher wages at each Price↑ and production is less ???? profitable, then “Y” falls and the SRAS curve shifts to the left. People’s prevailing expectations of prices and their response to price changes o ↑ price → ↓ demand → ↓ supply (Y) → SRAS shifts to the left o ↓ price → ↑ demand → ↑ supply (Y) → SRAS shifts to the right Price level only affects the SRAS and NOT the LRAS Changes in costs due to labor o ↑ price → ↑ wages & costs → ↓ Y and the SRAS shifts to the left o ↓ price → ↓ wages & costs → ↑ Y and the SRAS shifts to the right 2 Causes of Economic Fluctuations The 2 (two) basic causes of short-run fluctuations are: 1. Shifts in aggregate demand, and 2. Shifts in aggregate supply. Because the economy is always in a short-run equilibrium, the short-run aggregate-supply curve passes through the intersection of the aggregate-demand and aggregate-supply curves, which indicates that the expected price level has adjusted to this long-run equilibrium: The expected price level must equal the actual price level so that the intersection of aggregate demand with short-run aggregate supply is the same as the intersection of aggregate demand with long-run aggregate supply. 4 steps to analyzing equilibrium in aggregate demand and supply curves: 1. Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve or perhaps both. 2. Decide the direction in which the curve shifts. 3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run. 4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium. The Effects of a Shift in Aggregate Demand: Y = C + I + G + NX st 1 : In the short run, shifts in aggregate demand causes fluctuations in the economy’s output of goods and services. A contraction (fall in) aggregate demand shifts the aggregate-demand curve to the left and both prices and goods and services decrease. 2 : In the long run, shifts in aggregate demand affect the overall price level but do NOT affect output. The long-run effect of a shift in aggregate demand is a nominal change (the price level is lower), but it is NOT a real change (output is the same). 3 : Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations. The demand curve shifts to the right with increased government spending or an increase in the money supply: So, only in the short run, a change in money supply has “real” effects. There were two (3) big shifts that occurred in the aggregate-demand curve: Y = C + I + G + NX The “Great Depression” of the 1930’s o People were taking their money out of the banks and the money supply ↓ o The stock market crashed and fear ran high and production ↓ & unemployment ↑ World War II in the 1940’s o There was a large ↑ in government spending for the war effort. GDP doubled during this period and unemployment ↓ to 1% The recent “Recession” of 2008-2009 o A housing “boom” was fueled by very low interest rates after 2001-2002 o Subprime borrowers got loans which they should have never got o Securitization occurred with the loans made by banks and bundled these loans for sale through and as mortgage-backed securities. o The prices in houses peaked-out and devalued (crashed). Borrowers (being under water) then defaulted on their loans, because the loans were worth more than their houses. o Then, financial institutions which owned these loans suffered huge losses. o There was a large contraction of the aggregate demand, and rGDP and employment both fell sharply. In order to shift the aggregate-demand curve back to the “right,” the banks intervened with 3 policies. 1. The Fed cut its target rate on the Federal Funds rate 2. Equity was injected into the system via the treasury department 3. A large government spending and stimulus bill was signed into law How these variables fit together and work: In the long run o P = ???? ????nd Y = ???? ????and I’m betting the odds that U = ???? ????oo in the long run) o P ~ is the “actual price” How stock market crashes affect US consumption and shifts the AD curve (in the short run): Prices ↓ and output ↓ and unemployment ↑ (U > ???? ) a????d new price level at “B” o Overtime, the ???? ????alls, the SRAS curve shifts to the right until there’s a long-run equilibrium at the new price level of “C,” and unemployment and output are back at their initial levels. o ???? 2 P < ???? ???? ???? 1 o ???? ↓ due to expectations ???? o A → B → C; Price ↓ and Wages ↓; Sticky wages & sticky prices become flexible o SRAS curve shifts to the right in response to decreased labor and production costs o ???? 3 P < ???? ???? ???? 1 o AT “C,” prices are lower, Y = ???? and U → ???? ????nd output equilibrium is reestablished o “C” eventually becomes the new long-run equilibrium where: P = ???? ???? If an economic “boom” happens in Canada and how it affects the US economy (in the short run): Prices ↑ and output ↑ and unemployment ↓ (U < ???? ), and the AD curve shifts to the right. ???? In the short run, a new price occurs at “B.” o ???? 2 P > ???? ???? ???? 1 o ???? ???? due to expectations along with wages o ???? → B → C; and Price ↑ and wages ↑; Sticky prices & wages become flexible o SRAS curve shifts to the left in response to increased costs by reducing its labor o ???? 3 P > ???? ???? ???? 1 o At “C,” prices are higher, Y =???????? and U → ????????and output equilibrium is reestablished o “C” eventually becomes the new long-run equilibrium where: P = ???? ???? Government interventions that shift the AD curve to the left that can potentially mitigate the severity of economic fluctuations: ↓ Spending ↑ Taxes ↓ Money supply → ↑ r.i.r. → ↓ investments The Effects of a Shift in Aggregate Supply: Y = A × F[L, K, H, N] 1 : Shifts in aggregate supply can cause can cause stagflation ~ a combination of recession (falling output and production) and inflation (rising prices). 2 : Policymakers who can influence aggregate demand can potentially mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation. Stagflation (stagnation + inflation) ~ occurs when there is a period of both falling output and rising prices. In “stagflation,” the aggregate-supply curves shifts to the left, and subsequently, prices increase and then production is reduced because of labor costs. Stagflation affects: Output, employment, inflation and the aggregate-supply curve. Firms respond to higher prices by raising wages. → Prices will rise even higher and pushing the aggregate-supply curve even further to the left. This phenomena is referred to as: The Wage- Price Spiral. Unemployment will eventually increase and prices will decrease. Then the aggregate-supply curve with shift back to the right in response to lower production costs. When policymakers attempt to offset effects of the aggregate-supply curve by manipulating the aggregate-demand curve (to the right), prices will permanently remain high afterwards. This process is called: Accommodation to the shift of the aggregate-supply curve. o An accommodation policy accepts a permanently higher level of prices to maintain a higher level of output and employment. 2 Scenarios of Oil and the Economy and the SRAS Curve: Y = A × F[L, K, H, N] 1. Price of oil ↑ → costs ↑ → production ↓ → leftward shift of the aggregate-supply curve 2. Price of oil ↓ → costs ↓ → unemployment ↓ → inflation ↓ → rightward shift of SRAS curve Summary of Notes and Review of Concepts These fluctuations are deviations from the long-run trends explained by the models we all learned in previous chapters. Spending by the government creates the greatest shift of the aggregate-demand curve. The quantity of money determines prices. The price level does NOT affect the long-run determinates of rGDP. Price does NOT cause the AD (aggregate-demand) curve to shift. Changes in C, I, G & NX cause/affect AD curve shifts. Changes in A, L, K, H & N cause/affect LRAS curve changes. Changes in expected prices and A, L, K, H & N cause/affect SRAS curve changes. The vertical LRAS curve represents classical dichotomy and money neutrality and is perfectly inelastic. Any event or policy that affects rGDP also affects the long-run aggregate-supply curve. Technology and money supply have the greatest effect on the long-run aggregate-supply and aggregate-demand curves: Technology shifts the LRAS curve Money supply shifts the LRAD curve Long-run trends are the background on which short-run fluctuations are superimposed. If the money supply doesn’t change, then prices ↓ as technology ↑ advances and improves. The SRAS curve slopes upwards because of market imperfections: Nominal wages are based on expected prices Sticky prices are related to menu costs Misperceptions of prices in relation to relative prices The aggregate-demand curve slopes downward for 3 reasons: The 1 is the wealth effect ~ a lower price level raises the real value of households’ money holdings, which stimulates consumer spending. The 2 is the interest-rate effect ~ a lower price level reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. The 3 is the exchange-rate effect ~ as a lower price level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange, which stimulates net exports. Any event or policy that raises consumption, investment, government purchases or net exports (Y = C + I + G + NX) at a given price level increases aggregate demand (LRAD). Any event or policy that reduces consumption, investment, government spending or net exports at a given price level decreases aggregate demand. The long-run aggregate-supply (LRAS) curve is vertical. In the long-run, the quantity of goods and services supplied depends upon the economy’s labor, capital (physical & human), natural resources and technology (Y = A × F[L, K, H, N]) but not on the overall level of prices. 3 theories have been proposed to explain the upward slope of the short-run aggregate-supply (SRAS) st curve. 1 According to the sticky-wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. 2 ndAccording to the sticky- price theory, unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut back production. 3 According to the misconceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. All 3 theories imply that output deviates from its natural level when the actual price level deviates from the price level that people expected. Events that alter the economy’s ability to produce output; such as, changes in labor, capital, natural resources and technology, shift the short-run aggregate-supply curve (and may shift the long-run aggregate-supply curve as well). In addition, the position of the short-run aggregate-supply curve depends upon the expected price level. st The 1 possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate- demand curve shifts to the left; for instance, output and prices fall in the short run. Over time, as a change in the expected price level causes wages, prices and perceptions to adjust, the short-run aggregate-supply curve shifts to the right. This shift returns the economy to its natural level of output at a new and lower price level where all 3 curves (LRAD, LRAS AND SRAS) intersect. A 2 possible cause of economic fluctuations is a shift in aggregate supply. When the short-run aggregate-supply curve shifts to the left, the effect is falling output and rising prices ~ a combination which is called stagflation. Over time, as wages, prices, and perceptions adjust, the short-run aggregate-supply curve shifts back to the right, returning the price level and output to their original levels.
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