Download aggregate demand-aggregate supply model

AGGREGATE DEMAND-AGGREGATE SUPPLY
MODEL
Be sure to read the relevant sections of Chapters 15 and 19 in the textbook (see syllabus).
If you lose this handout, you may download a copy from my website:
webpages.shepherd.edu/lkinney
AGGREGATE DEMAND – THE BUYER’S SIDE OF THE MACROECONOMY
AGGREGATE DEMAND CURVE – a relationship between the price level (P)
and the aggregate quantity of domestically-produced goods and services
(real output = Q) that buyers are willing to purchase. The inverse relationship
between the price level and the quantity of goods and services people desire to
purchase is based on the behavior of buyers as reflected in the GOODS and
MONEY MARKETS.
GOODS MARKET – The simple Keynesian Model.
EQUILIBRIUM: Q
=
C + I + G (XGS – IMPGS)
E
NOTE:
1.
2.
3.
4.
Aggregate demand increases when C, I, G, or X increases or IMP
decreases.
I is inversely related to the interest rate (i).
X GS are positively related to foreign real income (Q*) and inversely
related to the real exchange rate (R = P/(e$ per SF1P*))
IMPGS are positively related to Q and R.
E
A
E = C + I + G (XGS – IMPGS)
45o
Q1
Q
MONEY MARKET – The money market is in EQUILIBRIUM at the interest rate
where the real quantity of money supplied = the real quantity of money
demanded; M/P = L(Q,i). This is demonstrated in the following diagram.
2
i
M/P
Real Quantity of Money Supplied
A
i1
L(Q,i)
Real Quantity of Money
Demanded
NOTE:
1.
The real quantity of money demanded is the level of purchasing
power people desire to hold. It is positively related to real income (Q) and
inversely related to the interest rate (i).
2.
The real quantity of money supplied is the actual purchasing power
of the nominal money supply. It is positively related to the nominal money supply
(M) and inversely related to the price level (P).
The nominal money supply is assumed to be the sum of domestic
currency in the hands of the public and checkable deposits at commercial banks.
The size of the nominal money supply (M) is determined by the Central Bank’s
monetary policy. The Central Bank can change the nominal money supply by
buying and selling domestic government bonds (GB) or foreign exchange
reserves (FXR). The equation below summarizes this:
M=
mm
Money
Multiplier
x(
GB
+
FXR
)
Central Bank’s Central Bank’s
holdings of
holdings of
domestic
foreign exchange
government
reserves
bonds
The equation says that when the Central Bank buys government bonds or foreign
exchange reserves, the domestic money supply increases by a multiple of the
amount of bonds or foreign exchange reserves purchased. When the Central
Bank sells government bonds or foreign exchange reserves, the domestic money
supply falls.
3
DERIVATION OF AGGREGATE DEMAND CURVE (AD) UNDER FIXED
EXCHANGE RATES
P
A
P1
Q1
I
M1/P1
Q
E
A
E
Q1
Q
A
i1
L
P ==>i ==>  I ==>  Q
P ==>R ==>  XGS &  IMPGS ==>  Q
** UNDER FLEXIBLE EXCHANGE RATES, the AD curve is still downward
sloping, but changes in P (and therefore the relative prices of domestic and
foreign goods and services) affect “THE” BOP and therefore change the nominal
exchange rate (e). Thus, the slope of the AD curve reflects changes in e that
result from changing prices.**
4
CHANGES IN FACTORS OTHER THAN THE PRICE LEVEL (P) SHIFT THE
AD CURVE.
Of particular note are changes in fiscal and monetary policy.
DECREASE AD ==> SHIFT LEFT
1. Decrease M (contractionary
monetary policy).
2. Decrease G or increase T
(contractionary fiscal policy)
INCREASE AD ==> SHIFT RIGHT
1. Increase M (expansionary monetary
policy).
2. Increase G or decrease T
(expansionary fiscal policy)
AGGREGATE SUPPLY – THE PRODUCER’S SIDE OF THE
MACROECONOMY
AGGREGATE SUPPLY CURVE – a relationship between the price level (P)
and the aggregate quantity of goods and services (real output = Q) that
producers are willing to produce. It reflects the behavior of firm owners who hire
inputs and of input suppliers: workers, owners of capital, sellers of natural
resources and energy.
THE MEDIUM-RUN AGGREGATE SUPPLY CURVE
The aggregate supply curve is upward-sloping in the MEDIUM-RUN, i.e.
an increase in the price level (P) will increase the quantity of goods and services
produced (Q). An increase in the price level means that producers are receiving
higher prices on average for the products they sell. Other things constant, this
gives firms an incentive to produce more output. The medium-run aggregate
supply curve (MRAS) is often drawn steeper as real output (Q) increases (see
below). This is because a given increase in the price level will increase output
more when output and employment are low (i.e. below full-employment levels)
than when they are high (i.e. near full-employment levels).
P
MRAS
Q
5
SHIFTING THE MEDIUM-RUN AGGREGATE SUPPLY CURVE
The most important factor that shifts the medium-run aggregate supply
curve is a change in the price or cost of an input which, in turn, changes the
costs of production. As a result, producers will alter how much they produce at
given price levels.
SHIFT MRAS LEFT
Increase in costs of production
(increase in wage rates, energy costs,
prices of natural resources)
MRAS’
P
SHIFT MRAS RIGHT
Decrease in costs of production
(decrease in wage rates, energy costs,
prices of natural resources)
MRAS
P
MRAS
Increase costs
MRAS’
Decrease costs
Q
Q
THE LONG-RUN AGGREGATE SUPPLY CURVE
The aggregate supply curve is drawn as a vertical line in the LONG-RUN
because we assume that in the long-run, the economy operates at its fullemployment level of output, which is assumed fixed in this model.
P
LRAS
Qf
Full-employment output
Q
6
LONG-RUN EQUILIBRIUM OCCURS WHEN THE AD AND MRAS CURVES
CROSS AT THE FULL-EMPLOYMENT LEVEL OF OUTPUT
LRAS
MRAS
P
P1
A
AD
Qf
Q
THE MAJOR LESSON OF THE EXERCISES BELOW IS THAT OUTPUT CAN
BE ABOVE OR BELOW THE FULL-EMPLOYMENT LEVEL TEMPORARILY
(i.e. IN THE MEDIUM-RUN). HOWEVER, THE AUTOMATIC ADJUSTMENT
MECHANISM MOVES OUTPUT TO THE FULL-EMPLOYMENT LEVEL IN THE
LONG-RUN.
Exercise 1: Central Bank increases the money supply (expansionary
monetary policy).
LRAS
MRAS
P
P1
A
AD
Qf
Q
7
Exercise 2: The foreign price level decreases, making domestic goods
relatively expensive. Thus, exports decrease and imports increase,
reducing the demand for domestic goods.
LRAS
MRAS
P
P1
A
AD
Qf
Q
Exercise 3: Expansionary fiscal and monetary policy can reverse a
recession more quickly than the automatic adjustment mechanism.
P
LRAS
P1
MRAS
A
AD
Q1
Qf
Q
8
THE IMPACT OF THE EXCHANGE RATE REGIME AND CAPITAL FLOWS
We have not yet considered the impact on the macroeconomy of the type
of exchange rate regime or of inflows and outflows of international investment
capital.
MEDIUM-RUN POLICY GOALS IN THE OPEN ECONOMY:
1.
INTERNAL BALANCE: Full-employment and stable prices.
2.
EXTERNAL BALANCE: The nominal exchange rate (e) is such that the
foreign exchange market is in equilibrium and thus “THE” domestic BOP = 0.
For example, external balance for the U.S. implies that “THE” US BOP =
CAB + KAB = 0, where CAB = Autonomous US XGS – Autonomous US IMPGS
And KAB = Autonomous US XA – Autonomous US IMPA.
If “THE” US BOP =0, the current foreign exchange rate between the US
dollar and foreign currencies (say, the Swiss franc) is at the equilibrium
level (e1 or $.60 per SF in the diagram below).
SSF
e$ per SF1
“THE” US BOP > 0  EXCESS SUPPLY OF SF/EXCESS DEMAND FOR $
e2
“THE” US BOP = CAB + KAB = 0
$.60 = e1
DSF
e3
“THE” US BOP < 0  EXCESS DEMAND FOR SF/EXCESS
SUPPLY OF $
Q of SF
“THE” BOP changes when there is a change in either the CAB or the KAB,
ceteris parabis. In turn, the following functions summarize the factors that
change the CAB and KAB.
(+) (-) (-)
CAB = US XGS – US IMPGS = f(Q*,Q, R)
(-) (+) (-)
KAB = US XA – US IMPA = g(i*, i, ee$per SF1)
variables from uncovered interest arbitrage
If “THE” US BOP is not “balanced” (i.e. “THE” BOP  0) and therefore there is
either excess demand for or supply of foreign currency (see diagram above),
either the nominal exchange rate will move or the government must intervene to
keep the exchange rate at the current level.
9
Politicians tend to prefer fiscal and monetary policies that increase
national production and employment. Thus, they have a fondness for
expansionary fiscal and monetary policies: tax cuts, increases in government
programs and spending, and “loose” monetary policy that keeps interest rates
low. However, in the open economy, the requirements for achieving external
balance can prevent expansionary fiscal and monetary policies from increasing
production. Whether expansionary fiscal and monetary policies increases
production or not depends on (1) the type of exchange rate regime the nation has
and on (2) the degree of international capital mobility.
1.
Type of Exchange Rate Regime
When the exchange rate is fixed, the Central Bank must respond to
imbalances in “THE” BOP and therefore excess demand for or excess supply of
foreign currency by buying or selling foreign currency from its foreign exchange
reserves to maintain the currency’s value and thus external balance. This in turn
changes the nominal domestic money supply:
M=
mm
Money
Multiplier
x(
GB
+
FXR
)
Central Bank’s Central Bank’s
holdings of
holdings of
domestic
foreign exchange
government
reserves
bonds
SSF
e$ per SF1
“THE” US BOP > 0  EXCESS SUPPLY OF SF/EXCESS DEMAND FOR $
e2
e3
 CB BUYS FXR (SF) INCREASE M ($)
DSF
“THE” US BOP < 0  EXCESS DEMAND FOR SF/EXCESS
SUPPLY OF $  CB SELLS FXR (SF) DECREASE M ($)
Q of SF
For example, if the exchange rate is fixed at e3 in the diagram above, a deficit in
the “THE” BOP and corresponding excess demand for foreign currency, will
require the Central Bank to sell some of its foreign exchange reserves (SF),
reducing its holdings of reserves and thus reducing the domestic money supply
($). Similarly, if the exchange rate is fixed at e2, the Central Bank will have to buy
foreign currency (SF) which will increase the nominal domestic money supply ($).
Thus, if an expansionary fiscal or monetary policy produces an imbalance in
“THE” BOP, the domestic money supply may have to change to restore external
10
balance if the nation operates under a fixed exchange rate regime. The resulting
change in aggregate demand due to the money supply change may offset the
impact of the fiscal or monetary policy on aggregate demand.
If the exchange rate is flexible, maintaining external balance requires that
the nominal exchange rate automatically move in response to imbalances.
SSF
e$ per SF1
e2
SF dep/S app
SF app/$ dep
e3
“THE” US BOP > 0  EXCESS SUPPLY OF SF/EXCESS DEMAND FOR $
 e DECREASES: SF DEPRECIATES/$ APPRECIATES
DSF
“THE” US BOP < 0  EXCESS DEMAND FOR SF/EXCESS
SUPPLY OF $  e INCREASES: SF APPRECIATES/$
DEPRECIATES
Q of SF
If “THE” BOP > 0 (a surplus), the resulting excess supply of foreign currency will
cause the domestic currency ($) to appreciate. A deficit in “THE” BOP will result
in a depreciation of the domestic currency. Thus, if expansionary fiscal or
monetary policy alters the nominal exchange rate, exports and imports of goods
and services and thus aggregate demand can change. The change in aggregate
demand due to changes in the exchange rate may offset the effect on aggregate
demand of the fiscal or monetary policy.
2.
Degree of International Capital Mobility
We will assume that capital is perfectly mobile across national borders, i.e.
that each nation does not restrict the extent to which capital can move into and
out of the country. In this type of environment, even miniscule changes in
domestic interest rates relative to foreign interest rates can produce large
changes in capital flows between countries. As a result, domestic and foreign
interest rates will tend to equalize (when adjusted for risk).
11
EVALUATING THE IMPACT OF FISCAL AND MONETARY POLICIES IN THE
MEDIUM RUN IN THE “OPEN ECONOMY”
CHANGE IN FISCAL POLICY:
1.
Start with AD/AS diagram to see what impact the policy potentially has on
domestic aggregate demand and therefore on domestic production and prices in the
medium-run.
2.
Since the link between the domestic economy and the international economy is
the domestic interest rate relative to the foreign interest rate, go to the money market
diagram to see what happens to the domestic interest rate.
3.
Determine the impact of the policy on external balance: explain what impact
the change in domestic interest rates relative to foreign interest rates will have on the
KAB and therefore on “THE” BOP.
4.
Determine whether the change in “THE” BOP produces an excess demand for or
supply of foreign currency, using the foreign exchange market diagram.
5.
Indicate the change in the nominal money supply, using the money market
diagram (fixed exchange rate regime), or the change in the nominal exchange rate,
using the foreign exchange market diagram (flexible exchange rate regime), required
to restore external imbalance.
6.
Analyze the impact of the restoration of external balance (step 5) on aggregate
demand using the AD/AS diagram.
CHANGE IN MONETARY POLICY
1.
Start with the money market diagram to see what impact the change in the
money supply will have the domestic interest rate.
2.
Go to the AD/AS diagram to see what impact the policy potentially has on
domestic aggregate demand and therefore on domestic production and prices in the
medium-run.
3.
Determine the impact of the policy on external balance: explain what impact
the change in domestic interest rates relative to foreign interest rates will have on the
KAB and therefore on “THE” BOP.
4.
Determine whether the change in “THE” BOP produces an excess demand for or
supply of foreign currency, using the foreign exchange market diagram.
5.
Indicate the change in the nominal money supply, using the money market
diagram (fixed exchange rate regime), or the change in the nominal exchange rate,
using the foreign exchange market diagram (flexible exchange rate regime), required
to restore external imbalance.
6.
Analyze the impact of the restoration of external balance (step 5) on aggregate
demand using the AD/AS diagram.