Download The Aggregate Demand Schedule

The Aggregate Demand Schedule
Pedro Serôdio
July 20, 2016
Learning objectives
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To understand:
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An essential part of the tool-kit. How the quantity theory of
money, IS-LM and IS-MP models give rise to the Aggregate
Demand curve.
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The potential importance of wealth effects and forwardlooking behaviour for Aggregate Demand.
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How various assumptions about expectations, the workings of
the labour market, and price-setting affect the shape of the
Aggregate Supply curve and give rise to different empirical
predictions and policy prescriptions.options.
Outline
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Derivation of AD curve in the IS-LM, quantity theory and
IS-MP models.
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The slope of the AD curve.
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Wealth effects.
The AD schedule
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The AD curve shows combinations of the price level and real
output (for the IS-LM and quantity theory models) and
between inflation and real output gap for the IS-MP model.
In any of these
1. Actual and planned expenditure on real output are equal;
2. The price level (inflation) and real output (output gap)
correspond to an equilibrium in the money market (or
operation of the monetary rule).
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The AD curve plots the price level (inflation rate) at which
the IS and LM (MP) curves intersect, for all levels of output
gap (the output gap).
The AD schedule
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Taking the expression for equilibrium output in the IS-LM
model, we have that:
y∗ =
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d
h
(a − ct + b + g ) +
(m − p)
(1 − c)h + dk
(1 − c)h + dk
Differentiating p with respect to y , we get:
∂p
(1 − c)h + dk
=−
∂y
d
Which gives us the slope of the aggregate demand schedule in
(p, y ) space.
The AD schedule
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In the IS-MP framework, the equilibrium level of output is
given by:
1
(a − ct + b + g ) +
1 − c − dφy
d
+
(¯
r + φy ȳ − φπ π)
1 − c − dφy
y∗ =
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Differentiating π with respect to y , we get:
(1 − c) + dφy
∂π
=−
∂y
dφπ
Which gives us the slope of the aggregate demand schedule in
(π, y ) space.
The AD schedule
The equation of exchange and the aggregate demand schedule.
I The equation of exchange is a useful identity that holds in any
monetary economy and is a useful starting point for a number
of important theories:
MV ≡ PY ,
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where M is total amount of money, V the velocity of
transactions, P the aggregate price level and Y the level of
output.
Here, we focus on the implicit relationship it has for the shape
of the aggregate demand schedule.
Solving the equation for P, we have:
P=
M s V (i)
Y
The AD schedule
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Taking logs, we have:
p = m + ηi − y
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Notice that this is simply an alternative formulation for a
linear money demand function:
(m − p)d = y − ηi
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Under this specification, the aggregate demand schedule will
again be a negative function of the price level and, therefore,
the aggregate demand schedule will be downward sloping.
Aggregate Demand
MP0
r
MP1
A
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B
IS
y
π
A
B
AD
y
The AD curve has a negative slope
∂p
in (p, y ) space ∂y
< 0. as long as:
1. The real rate rises when output
increases because the money
supply falls.
2. A rise in the real interest rate is
associated with a fall in real
output. These effects can be
shown in r − y space, as here, or
in a combination of r − π and
r − y spaces.
Aggregate Demand
r
MP0
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IS1
IS0
y
π
AD1
AD0
y
The AD curve will be flatter in
(p, y ) space:
1. The larger is the MPC;
2. The larger is the responsiveness
of consumption and investment
to the real interest rate Cr , Ir (d
in the expression above) (shown
left).
3. The less monetary policy
responds to output fluctuations
(the lower is φy );
4. The more monetary policy
responds to inflation fluctuations
(the larger is φπ );
Criticism
The MP model improves on the LM model by more accurately
capturing policy and response to inflation. It is possible to criticise
the basic IS curve:
1. The interest rate relevant for spending might differ from the
policy target rate.
2. Wealth effects are absent, though they can be added to the
model (we’ll discuss these ahead).
3. A third objection is that the IS curve remains ’Keynesian’ in
nature. It is ’static’ and not explicitly microfounded. An
alternative, microfounded, Dynamic IS curve (DIS) has been
developed, and is currently used in modern New Keynesian
models, which we’ll cover in when we discuss the New
Keynesian model.
Aggregate Demand
r
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A special case of the aggregate
demand schedule occurs when the
interest sensitivity of both
investment and consumption to the
interest rate is zero.
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We know that the slope of the
aggregate demand schedule is
given by:
IS1
LM0
IS0
y
π
AD1
∂p
(1 − c)h + dk
=−
∂y
d
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Taking the limit as d → 0, it is
clear that:
lim
AD0
y
d→0
∂p
= −∞
∂y
Aggregate Demand
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If the planned expenditure function (here, planned
consumption and investment) is interest-inelastic
Cr = 0, Ir = 0, where Cr is the interest elasticity of
consumption and Ir interest elasticity of investment), then
monetary policy is ’ineffective’: it cannot alter output,
although it can affect the price level.
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If AS is also inflation-inelastic, an AD-AS equilibrium might
not exist. In that case, if the AD curve lies to the left of the
AS curve, the level of output is demand- determined.
Furthermore, the excess supply could not be eliminated by
disinflation or falling prices.
The Pigou effect
A response of consumption to real wealth can be captured fairly
easily by simply making consumption respond directly to wealth.
I This effect is named the Pigou effect, after Cambridge
economist Arthur C. Pigou.
I Pigou suggested real wealth could be modelled as
A = M/P + (P B /P)B , but Ricardian Equivalence (Barro:
government bonds are not net wealth) would suggest just
including real money balances. The Pigou effect is also known
as the real balance effect.
I How does the Pigou effect operate?
I A reduction in the price level raises consumers’ net real wealth
at any given income level.
I Reducing saving (since there is less need to accumulate wealth
to fund future consumption) and
I Increasing current consumption demand.
The Pigou effect
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Going back the planned expenditure function introduced
earlier, we can see that consumption depends partly on the
amount of assets owned by the households. Recall that:
Pb
M
+
B , where 0 < CA < 1
Y = C Y − T, r,
P
P
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Real balances, MS/P, affect the position of the IS curve.
A rise in real balances shifts the IS schedule outwards, for any
given level of the real interest rate.
The Pigou effect is probably best known for its implications
concerning the effect of deflation - and the consequences for
the possibility of a liquidity trap.
If the Pigou effect operates, a reduction in the price level can
cause a direct increase in AD.
Direct effect: It occurs even without a reduction in the
interest rate.
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The Pigou effect
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Deflation is more expansionary. The AD curve is flatter than
it otherwise would be.
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In a liquidity trap (not shown here), the Pigou effect acts
contrary to the negative impact of deflation via the
autonomous rise in the real interest rate p and via
expectations of future lower prices.
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In practice, real money balances are a small fraction of real
wealth. The marginal propensity to consume out of real
wealth is estimated to be about CA = 0.1, whereas that out of
disposable income is around CY = 0.8. Thus the size of the
Pigou effect is likely to be small.
The Pigou effect
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The type of money supply increase relevant here is a
helicopter drop. Ricardian Equivalence states that government
bonds are not net wealth, implying that an increase in the
money supply due to central bank bond purchase would also
increase net wealth. But: Does Ricardian Equivalence hold? If
not, bond-money swaps have less/no effect on net wealth.
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If their nominal value (asset price) remained unaltered, the
real value of other forms of wealth would also rise following
deflation, which could boost consumption through a wealth
effect. However, price deflation - particularly in a liquidity trap
- is often accompanied by falls in asset prices (so no increase
in real wealth from that source).
The Tobin-Fisher effect
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The Tobin-Fisher effect is also known as the redistribution
effect, or the debt-deflation effect.
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An unexpected reduction in the price level (deflation) can
cause a direct decrease in AD, if it changes the distribution of
wealth from high-spending borrowers to low-spending lenders.
The Tobin-Fisher effect: Intuition
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Debt contracts are usually set in nominal terms, i.e. they
specify interest (and capital) payments in money value.
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Suppose that there is a reduction in the price level that was
not anticipated by either creditors or debtors at the time of
signing the debt contract.
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Moreover, suppose that the nominal debt contract is neither
indexed to the price level, nor can be renegotiated by the
parties.
The Tobin-Fisher effect: Intuition
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Borrowers (e.g. people with mortgages, entrepreneurs,
farmers) see that the real value of their debt has increased,
which implies that lenders (banks, savers) receive more
payments in real terms.
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In other words, there is a redistribution from debtors to
creditors.
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If debtors have a higher marginal propensity to spend than
creditors, this redistribution effect causes a reduction in AD:
creditors spend a smaller fraction of their additional income,
and debtors are forced to cut back consumption and
investment to reduce/repay their debts.
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Eventually, debtors can become insolvent (e.g. firms can shut
down plants).
The Tobin-Fisher effect: Intuition
LM0
r
LM1
The Tobin-Fisher wealth redistribution
effect counteracts monetary policy
A
B
C
IS0
IS1
y
π
A
B
C
AD1
AD0
y
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The AD curve is steeper than it
otherwise would be.
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In a liquidity trap (not shown
here), the Tobin-Fisher effect adds
to the negative impact of deflation
via the autonomous rise in the real
interest rate and via expectations
of future lower prices.
Summary and Look Forward
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We have defined the AD curve.
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We have seen what determines its slope.
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You should also make sure that you can pinpoint everything
that will shift the AD curve.
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The simple AD model can be extended to capture financial
frictions, confidence and wealth effects, which all affect the IS
curve. - These are important to capture accurately responses
to financial crises, monetary expansion and deflation.
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We will see ahead that the static IS curve can be replaced
with a dynamic version.
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Next: We summarise what the AS curve looks like under
various assumptions about wage-setting, price-setting and
expectations.