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Now that we have been introduced to macroeconomics through the idea of national
income, it is time to learn about certain macroeconomic models. The most used model is
that of aggregate demand and aggregate supply. These two terms are basically the same
as demand and supply but on a macro- level. In other words, aggregate demand is the
total demand for final goods and services in the economy while aggregate supply is the
total supply for final goods and services in the economy. The figure below is the
corresponding graph, showing how price level and real GDP are affected by shifts of AD
and AS.
Figure 1
Price Level
AS
PL2
PL1
AD’
AD
Q1
Q2
Real GDP
What would cause aggregate demand to shift to the right (or left)? The components of
aggregate demand are the same as those of GDP: Consumption, Investment, Government
spending, and net exports. For example, if the consumption of widgets increases, AD
would increase, since the market for widgets is included in aggregate demand. If the
investment by companies on capital goods decreases, then AD would decrease.
There are two “types” of aggregate supply: short run and long run. Short run aggregate
supply depicts the current supply when price of the good can change but the prices of the
factor inputs are held constant while the long run aggregate supply is that in a long period
of time when both prices of the good itself and the inputs that go into it can change.
Figure 2
PL
LRAS
SRAS
*
EL
AD
NO
Real GDP
Different schools of economic thought have different views on the long run aggregate
supply. For example, Keynesians think that the LRAS (aka the Z curve) is positively
sloped, which is justified by the fact that the sum of all income received = the sum of all
production. In the neoclassical school, they think that the LRAS should be vertical, as
illustrated in the above diagram, due to the varying nominal wage rate.
Why is the LRAS curve where it is? Answer: The full employment level of national
income! Otherwise know as the natural rate of output (NO), the full employment level
shows the point at which the production of goods and services that an economy achieves
in the long run when unemployment is at its normal rate. Any change that changes NO
would shift LRAS, such as changes in labor, capital, resources, and technological
knowledge.
Now, the equilibrium level of national income is an easier concept to comprehend, for it
is the point where AD intersects AS. (On the graph above, it is where the * is and is
labeled with EL.) When either AD or AS (LR or SR) shifts, the equilibrium level will
also change.
Price
Levels
LRAS
AS
Inflationary
Gap
Shift out
AD2
AD2
rGDP
The graph above demonstrates an inflationary gap. When the economy
experiences a boom and Aggregate Demand (AD) increases beyond the equilibrium level
(where Long Run Aggregate Supply (LRAS) Aggregate Supply (AS) and AD all
intersect.) This shift out in AD requires more goods to be produced. Because the
supplier are already using their resources to the fullest capacity, they are unable to
produce the goods at the current rate in the long run (they can pay overtime, but this is
only a short term goal). This will either drive up prices, or force suppliers to invest in
newer and/or more efficient methods of production to meet the demand. Either way, AD2
cannot be sustained and it will either shift back to AD1 or supply will shift out. Until then
(which is in the Long Run) there will be short run inflationary gap. This gap is the
triangle formed by LRAS, AS, and AD2.
An inflationary gap raises prices and GDP in the short run, as showed in the graph
above. This means that unemployment will fall and inflation rises (hence inflationary
gap). This is the apex of business cycle (explained below).
Price
Levels
LRAS
AS
Deflationary
Gap
AD1
Shift in
AD2
rGDP
The graph above demonstrates a deflationary gap. When the economy
experiences a recession and Aggregate Demand (AD) decreases below the equilibrium
level (where Long Run Aggregate Supply (LRAS) Aggregate Supply (AS) and AD all
intersect.) This shift in on AD requires fewer goods to be produced (since fewer people
want to buy). The suppliers will respond by laying people off, wage cuts, closing
factories, etc. The less amount of aggregate demand causes a decreased amount of
supply. Prices will fall (hence deflation) GDP will fall because of fewer purchases,
unemployment rises due to fewer jobs available, and eventually (according to classical
economists who claim wages are flexible) wages will fall and that will allow the suppliers
to make more, and the recession will end. Either way, AD2 will eventually shift back to
AD1. Until then (which is in the Long Run) there will be short run deflationary gap. This
gap is the triangle formed by LRAS, AS, and AD2.
A deflationary gap lowers prices and GDP in the short run, as showed in the graph
above. This means that unemployment will rise and inflation falls and becomes deflation
(hence deflationary gap). This is the trough of business cycle (explained below).
Aggregate
Economic
Activity
Economic
Expansion
Economic
Recession
Apex
Trough
rGDP
Japan's exports plunged 45.7% in January compared with a year ago to hit
the lowest figure in 10 years, official figures have shown.
Imports exceeded exports by 952.6bn yen ($9.9bn; £6.8bn). It is the largest gap
since records began in 1980.
Demand for Japanese cars in particular dropped by 69%.
Trade in electronics and other goods has also slumped as global economies and
consumer spending contract, pushing Japan deeper into recession.
"Japan is particularly vulnerable to this downturn because trade is so central to the
economy," World Trade Organization head Pascal Lamy told reporters on a visit to
Tokyo.
Serious crisis
Japanese exports to the US, where the global downturn began, fell nearly 53% in
January, while shipments to the European Union shrank by 47%, Japan's finance
ministry said.
"Exports to Asia, particularly to China, are
JAPAN CARMAKERS' EXPORTS
tumbling at about the same pace as shipments to
the United States, signalling that even China's
economy may be shrinking," said Takeshi Minami,
chief economist at Norinchukin Research Institute.
Exports to Asia dropped 47%, while those to
China fell 45%.
The government said last week that Japan's
economy was in its most serious crisis since World
War II, after it contracted at an annualised rate of
12.7% in the last quarter of 2008.
This was its worst performance in almost 35
Toyota - down 57.1% in January from
a year earlier
Honda - down 46.3%
Nissan - down 62.1%
years, officials said.
Mitsubishi - down 77.4%
Among those hit hard by the global downturn are
Mazda - down 72.1%
export-oriented Japanese electronic makers.
Suzuki - down 56.1%
As well as carmakers, they have had to cut output Source: Company results
and eliminate jobs amid a sharp drop in global
demand.
Japan carmakers' output plummets
Pioneer has announced 10,000 job cuts and Sony is trimming its global workforce by
8,000 positions.
Stimulus
Meanwhile, Japan's government is pushing bills through parliament to implement a
stimulus plan, including a cash handout of at least $130 for each Japanese taxpayer,
the BBC's Roland Buerk reports from Tokyo.
But any bold moves may be difficult to push through because of the unpopularity of
Prime Minister Taro Aso, our correspondent says.
US President Barack Obama and Mr Aso have agreed to work together to stimulate
economic demand and fight protectionism as the latter visits the US.
The US and Japanese economies are respectively the world's largest and secondlargest.
The new decrease in Japanese exports will have a major effect on the aggregate
demand for Japan. Since exports minus imports equals the net exports, net exports will
decrease. When net exports decreases, so does aggregate demand, causing a shift in in
Aggregate demand. The graph below displays the effects. First, GDP will fall in the
short term, which is normal for a recession. Second, the prices of goods and services will
fall since suppliers will have less demand (all in the short run). The decreased price will
lead to less profits and thus the suppliers will lay off, fire, or lower wages (according to
the clasical economic theory that prices are not fixed and can lower and change). The
newly unemployed people correspond directly to the decrease in GDP, which is why
decreased GDP means an increase in unemployment. The triangle formed by the LRAS,
AD2 and AS is a deflationary gap in this example (and in the long run the government
will affect the market or the market will adjust to the recession.)
LRAS
Price Level
AS
PL1
PL2
AD1
AD2
Q2
Q1
Real GDP