Download Macro Lecture 4: Aggregate Demand (AD) Curve

Macro Lecture 4: Aggregate Demand (AD) Curve
Review: Market for a Good
Figures 4.1, 4.2, and 4.3 illustrate the basics of the market for a good.
Equilibrium
Quantity Demanded = Quantity Supplied
Price of Beer ($/can)
S
P*
D
Quantity of Beer (cans)
Figure 4.1: Market Equilibrium
Market Demand Curve
Demand Question: How many cans of beer
would consumers purchase (the quantity
demanded), if the price of beer
were ____, given that everything else
relevant to the demand for beer
remains the same.
Market Supply Curve
Supply Question: How many cans of beer
would firms produce (the quantity
supplied), if the price of beer
were ____, given that everything else
relevant to the supply of beer
remains the same.
Price of Beer ($/can)
Price of Beer ($/can)
If P=2.00
If P=2.00
If P=1.50
If P=1.50
If P=1.00
If P=1.00
S
If P=.50
If P=.50
D
Quantity of Beer (cans)
Figure 4.2: Demand curve for beer
Quantity of Beer (cans)
Figure 4.3: Supply curve for beer
2
π (%)
Aggregate Demand/Aggregate Supply Model
We will now introduce the aggregate demand/aggregate supply model
which in a general sense extends the demand/supply model for a single
good to the macro economy. We begin with a preview and then focus on
the aggregate demand in this lecture.
Preview: The aggregate demand/aggregate supply model seeks to explain
an economy’s GDP and inflation rate. We place final goods and services
(G&S) on the horizontal axis and the inflation rate (π) on the vertical
axis. The aggregate demand (AD) curve is downward sloping and the
aggregate supply (AS) curve upward sloping as illustrated in figure 4.4.
The intersection of the aggregate demand (AD) and aggregate supply
(AS) curves determines the actual GDP and the actual inflation rate.
AS
AD
G&S
Figure 4.4: Aggregate
demand/aggregate supply preview
The aggregate demand (AD) curve illustrates how many final goods and services are purchased and the
aggregate supply (AS) curve how many final goods and services are produced by answering a series of
questions:
Aggregate Demand (AD) Curve:
Aggregate Supply (AS) Curve
AS Question: How many final goods and services
AD Question: How many final goods and services
would be produced if the inflation rate (π) were
would be purchased if the inflation rate (π) were
_______ percent, given that all other factors
_______ percent, given that all other factors
relevant to supply remained the same?
relevant to demand remained the same?
In equilibrium, the goods and services purchased equal the goods and services produced:
Goods and services
Goods and services
=
(G&S) purchased
(G&S) produced
↓
↓
AD
=
AS
Recall that GDP measures the final goods and services produced. Also, we divide the purchased into
three categories: those purchased by households, firms, and governments.4
Goods and services
Goods and services
Goods and services
Goods and services
=
+
+
purchased
purchased by households
purchased by firms
purchased by governments
↓
↓
↓
↓
AD
=
C
+
I
+
G
Let us now summarize the equilibrium:
Goods and services
Goods and services
=
purchased
produced
↓
↓
AD
=
AS
↓
↓
C + I + G =
GDP
Both the aggregate demand (AD) and aggregate supply (AS) curves answer a series of questions that
are similar to the series of questions answered by the market demand and supply curves for a good. As
we will see, there are important differences, however. We begin with the aggregate demand (AD)
curve.
4
To make our analysis less cumbersome, we begin with a “closed economy;” that is, we assume that there
are no exports or imports and consequently net exports (NX) are 0. This simplifying assumption makes our
analysis more straightforward and does not affect any of our conclusions.
3
Summary
Figure 4.5 summarizes the basics of the aggregate demand/aggregate supply model:
π (%)
AD Question: How many
final goods and services
would be purchased if the
inflation rate (π) were
_______ percent, given
that all other factors
relevant to demand
remained the same?
AS
AS Question: How many
final goods and services
would be produced if the
inflation rate (π) were
_______ percent, given
that all other factors
relevant to supply
remained the same?
AD
G&S
Equilibrium
Goods and services
Goods and services
=
purchased
produced
↓
↓
AD
=
AS
↓
↓
C+I+G
+
GDP
Figure 4.5: Aggregate demand/aggregate supply
Aggregate Demand (AD) Curve
It is important to remember that while both the aggregate demand (AD) curve and the demand curve
for a good are downward sloping, the reasons differ. It is easy to explain why the market demand curve
for a good is downward sloping: when a good becomes more expensive consumers purchase less of it.
It is a little more difficult to explain why the aggregate demand (AD) curve is downward sloping,
however.
The Real Interest Rate, the Nominal Interest Rate, and the Inflation Rate
The nominal interest rate on a savings account is the interest rate that is advertised by a bank. The
real interest rate reflects purchasing power by accounting for inflation:
Real
Nominal
Inflation
interest
=
interest
−
rate (π)
rate (r)
rate (i)
4
The Real Interest Rate and the Purchases of Final Goods and Services
Higher real interest rates slow down the economy; that is, higher real interest rates reduce the final
goods and services purchased. Why? Perhaps the easiest way to understand this intuitively is to
focus on the construction of new homes. When real interest
Real interest rate (r) increases
rates rise, home mortgages become more costly for
↓
households. This discourages households from purchasing
Loans become more costly
new homes. Similarly, as higher real interest rates rise, it
↓
becomes more costly for firms to finance new investment
Consumers
and
firms purchase
projects, purchase new equipment, etc.; consequently,
fewer
goods
firms finance fewer investment projects. Figure 4.6
↓
sketches out the logic.
Fewer goods and services
purchased
Summary: The real interest rate (r) affects the final goods
Figure 4.6: Real interest rate and
and services purchased by households and firms. When the
goods and services purchased
real interest rate (r):
• Rises, fewer goods and services are purchased.
• Falls, more goods and services are purchased.
The Federal Reserve Board (Fed) and the Real Interest Rate
The Federal Reserve Board (the Fed) is charged with stabilizing the economy. It is a semiautonomous government agency. The President nominates members to the Federal Reserve Board
and the Senate must confirm them. Once confirmed, however, members of the Federal Reserve
Board have a specified term of fourteen years. Consequently, the Federal Reserve Board has
considerable independence.
The Federal Reserve Board (Fed) is very powerful because it can influence the real interest rate
(r). For the moment do not worry about how the Fed does this, we will explain how in a few
lectures. For the time being just assume that the Fed can do so.
Taylor Principle
The Federal Reserve Board (the Fed) seeks to mitigate recessions and to prevent excessive
inflation thereby stabilizing the economy. It does so by applying the Taylor principle:
• An increase in the inflation rate (π) leads the Fed to increase the real interest rate (r).
• A decrease in the inflation rate (π) leads the Fed to decrease the real interest rate (r).
To show why the Taylor principle stabilizes the economy, consider two scenarios: one in which
the inflation rate increases and a second in which the inflation rate decreases:
• Inflation rate increases (π). As a consequence of the Taylor principle, the Fed
increases the real interest rate (r) making loans more costly. Households and
firms purchase fewer goods and economic activity “slows down.” The economy
is stabilized.
• Inflation rate decreases (π). As a consequence of the Taylor principle, the Fed
decreases the real interest rate (r) making loans less costly. Households and
firms purchase more goods and economic activity “speeds up.” The economy is
stabilized.
5
Figure 4.7 provides a summary:
Inflation rate (π) increases
↓
Fed increases the real interest
rate (r)
↓
Loans become more costly
↓
Households and firms purchase
fewer goods and services
↓
Fewer goods and services
purchased
↓
Economy “slows down”
é
Taylor principle
Inflation rate (π) decreases
↓
Fed increases the real interest
rate (r)
↓
Loans become less costly
↓
Households and firms purchase
more goods and services
↓
More goods and services
purchased
↓
Economy “speeds up”
ã
Economy stabilizes
Figure 4.7: Taylor principle and stabilizing the economy
It is useful to think of the real interest rate (r) as the economy’s throttle. The Fed controls the
throttle. When the inflation rate (π) increases the Fed pulls back on the throttle slowing down the
economy by raising the real interest rate (r). When the inflation rate (π) decreases the Fed steps
down on the throttle speeding up the economy by lowing the real interest rate (r).
Taylor Principle and the Fed Policy (FP) Curve
The Fed policy (FP) curve quantifies the Taylor
principle illustrating precisely how the Fed
responds to inflation. The Fed policy (FP) curve
describes the Fed’s policy toward inflation by
answering a series of questions:
FP Question: What would the real interest rate
(r) equal, if the inflation rate (π) were _______
percent, given that the Fed does not change its
inflation policy?
π (%)
FP
r (%)
As shown in figure 4.8, we place the inflation rate
Figure 4.8: Fed policy (FP) curve: Taylor
(π) on the vertical axis and the real interest rate (r)
principle – FP curve positively sloped
on the horizontal axis. The upward sloping Fed
policy (FP) curve reflects the Taylor principle:
• An increase in the inflation rate (π) leads the Fed to increase the real interest rate (r).
• A decrease in the inflation rate (π) leads the Fed to decrease the real interest rate (r).
The positive slope of the curve captures the Taylor principle.
Macro Lab 4.1 allows us to check our logic:

Macro Lab 4.1: Taylor Principle and the Fed
Policy (FP) Curve
6
Downward Sloping Aggregate Demand (AD) Curve
We now apply the Taylor principle to derive the aggregate demand (AD) curve. When the
inflation rate (π) increases, the Fed applies the Taylor principle and raises the real interest rate (r).
The higher real interest rate (r) makes loans more costly. Household and firms respond by
purchasing fewer goods and services. That is, when the real interest rate increases, final goods and
services purchased decrease as illustrated in figure 4.9:
FP Question: What would the real interest rate
(r) equal, if the inflation rate (π) were _______
percent, given that the Fed does not change its
inflation policy?
π (%)
AD Question: How many final goods and
services would be purchased, if the inflation rate
(π) were _______ percent, given that all other
factors relevant to demand remained the same?
π (%)
FP
r (%)
Inflation
rate (π)
increases
Households
Fewer goods and
and firms
→ services (G&S)
purchase less
purchased
↑
↓
↓
Taylor principle
C and I
AD = C+I+ G
(FP curve)
decrease
decreases
Figure 4.9: Downward sloping aggregate demand (AD) curve
→
Fed increases
the real
interest rate (r)
Loans
→ become more →
costly
AD
G&S
Macro Lab 4.2 allows us to check our logic:

Macro Lab 4.2: Deriving the Aggregate
Demand (AD) Curve
7
Federal Reserve Board and the U.S. Treasury
The U.S. Treasury and the Federal Reserve Board are two different government agencies. As we will
see, both of these agencies play important roles in our economy, but the roles are different. It is always
important not to confuse the two agencies:
• The U.S. Treasury is part of the President’s cabinet. The President nominates the Treasury
secretary and the Senate must confirm him/her. Once confirmed, the Treasury Secretary
serves at the pleasure of the President. The President could fire the Treasury Secretary at any
time. Like a treasury in any organization, the U.S. Treasury is responsible for collecting
revenues and paying expenses.
• The Federal Reserve Board (Fed) is a semi-autonomous government agency. The President
nominates members to the Federal Reserve Board and the Senate must confirm them. Once
confirmed, however, members of the Federal Reserve Board have a specified term of fourteen
years. Unlike the Treasury Secretary, members of the Federal Reserve do not serve at the
President’s pleasure; the President cannot fire them. This gives the Federal Reserve Board
considerable independence. The Fed is responsible for the health of the economy’s financial
system, in particular the banking system. In doing so the Fed can control the real interest rate
(r).
Strategy
We have shown that the real interest rate (r) plays a critical role in the economy. It acts as the
economy’s throttle which the Fed applies. If it seeks to slow down the economy it raises the real
interest rate (r). Alternatively, if it wants to speed up the economy, it lowers the real interest rate (r).
Our goal is to understand how the Fed accomplishes this:
Goal: Show how the Federal Reserve Board (Fed) affects the real interest rate(r).
The next three lectures are designed to achieve the goal. We will introduce the following topics:
• Financial Assets
• The banking system
• Money and the Federal Reserve Board.