Download Chapter 24 Aggregate Demand and Aggregate Supply

Chapter 24 Aggregate Demand and Aggregate Supply
Aggregate Demand
Liquidity Preference
Perhaps the easiest way to derive an aggregate demand curve is by using
something we have already discussed, liquidity preference. Recall from Chapter
5 we looked at the Keynesian demand for money function (also called liquidity
preference). One of the graphs we used there showed the relationship between
the demand for money and the supply of money. We also used the graph to
show what would happen to the demand for money as the price level increased
and the subsequent effect on interest rates.
Figure 24—1 An increase in the price level shifts the demand for money curve to
the right.
If the price level rose then people would need to hold more money to purchase
the same amount of real goods (they buy the same things but these things cost
more). This we represent by shifting the money demand curve to the right.
Notice that the effect is to raise interest rates.
The effect of a price level increase is to raise the interest rate.
P  i 
But we also learned in an earlier chapter that changes in interest rates affected
business investment spending. That is if interest rates increased businesses
would be less willing to borrow money to spend on new plant and equipment.
i  I  i  
Spending on U.S. produced output
Next consider the entities that purchase output produced in the U.S. They
buyers are consumers ( C ) , businesses ( I(i) ), governments ( G ), and
foreigners (NX for net exports). So total spending on U.S. output is
Y D  C  i   I  i   G  NX
What we want to do is to determine what will happen to spending in the economy
as prices increase. The logic is
P  i  I  i   Y D 
P  i  C  i   Y D 
So when the price level increases, spending on U.S. output will decrease. This
results in the aggregate demand curve as shown in Figure 24—3. In this figure
when the price level increases less output is bought.
Price changes will also affect net exports. If the price level increases U.S. goods
will become more expensive to foreigners and foreign goods will become
cheaper to U.S. residents. So net exports should decline
P  NX  Y D 
Figure 24—3. The aggregate demand curve
Thing that might shift the aggregate demand curve
Anything that increases Y D while holding prices fixed will shift the aggregate
demand curve to the right. Anything that decreases Y D while holding prices fixed
will shift the aggregate demand curve to the left.
Y D  C  i   I  i   G  NX
Suppose that consumers decide to begin to spend more of their income (even
though there is no change in interest rates). In that case the aggregate demand
curve will shift from Y1D to Y2D as shown in Figure 24—4.
C  i   Y D 
.FIGURE 24--4 The aggregate demand curve shifts to the right
Anything (other than a price change) that makes C(i), I(i), G, or NX get larger will
shift the curve to the right. If they get smaller the curve will shift to the left.
Keynes believed that business people often made irrational decisions regarding
investment spending. We have considered investment spending I  i  to be
determined by interest rates. Keynes believed that it was largely determined by
“animal spirits”. So if animal spirits increase investment spending the curve will
shift to the right, if they decrease investment spending the curve will shift to the
left (we assume here that interest rate, i, do not change.
I i   Y D 
Suppose that the government increases taxes on households and that
households respond by reducing spending
T  C  i   Y D 
If the government decided to increase government spending then
G  Y D 
Suppose that U.S. residents decide to import more foreign goods (they just like
them better)
NX  Y D 
On the other hand if foreigners decide they like U.S. goods better
NX  Y D 
Suppose that the Fed increased the money supply
M  i  I  i   Y D 
Crowding out
The response to an increase in government spending, G, is a bit more complex
than indicated above. For one thing the spending increase must be financed. If
the spending increase is financed by increasing taxes, the rightward shift due to
the spending increase will be largely offset by a leftward shift due to households
reducing spending.
The Fed could finance the spending increase by instructing the Treasury to sell
more securities. In that case the price of bonds will increase and the interest rate
will increase. In such case household consumption will likely decrease
(households will not borrow as much and will save more) and business
investment spending I(i) will decrease. So we have
G  Y D 
G  i  C  i  , I  i   Y D 
This offsetting shifts in the aggregate supply curve is known as crowding out.
Keynesian economists believe that the offset is not very large. Other
economists, particularly monetarists, believe the offset is complete. Even if the
offset is complete that does not mean that the there is no effect on the economy.
What the government gets the private sector does not get.
There is yet a further possibility. The government could finance the deficit by
printing money. The result would be inflation but the possible shifts in the curves
get more complex. This won’t be discussed here.
Aggregate supply
The short run
The aggregate supply curve is a short—run concept. By short run we mean a
time period so short that firms can vary output only by hiring more or less labor.
There is not enough time for a firm to build a new plant and hire labor to staff it.
Labor will have to use existing plant and equipment.
Further we will assume that wages and the costs of all other inputs are fixed.
Profits are determined by total revenue less total costs, or
  PY S  wL  iK  cm m
where  is profits, P is the price level, Y S the amount of output produced, w the
wage rate, L the number of labor hours employed, i interest rates, K the amount
of capital used, cm the cost of materials, and m is the quantity of materials used in
the production. We will also call Y S the aggregate supply curve. Note that we
are pretending the entire economy can be modeled using this single relation.
Now if the price level increases firm will receive more profit. But note that the
price per unit of output has increase while the cost per unit of output has
remained fixed (at least in the short run). This suggests that it will be more
profitable for firms to increase output.
So we will use the following
P  Y S 
which leads to the aggregate supply curve shown in Figure 24—5.
Figure 24—5. The aggregate supply curve.
The long run
In the long run the factors we held fixed in the previous section can change.
These factors will shift the aggregate curve. In the previous section we held
wages fixed. Suppose that the wage rate started to increase raising the unit cost
of producing output. Firms would respond by reducing output which we will
represent by a leftward shift in the aggregate supply curve.
Figure 24—6. A leftward shift in the aggregate supply curve due to a rise in the
wage rate.
If the firms decided to employee more capital that would shift the aggregate
supply curve to the right. If capital became more productive that would also shift
the curve to the right. A decrease in the cost of materials will shift the curve to
the right.
Equilibrium in the short run
Figure 24—7 Equilibrium in the short run.
The macro economy will be in equilibrium at price P1 and level of output Y1 . If the
price level is above the equilibrium level, supply will exceed demand and prices
will fall. If the price level is below the equilibrium level prices will rise until supply
equals demand.
Equilibrium in the long run
Suppose that the economy is in equilibrium at  P1 , Y1  as shown in Figure 24—7.
Now suppose that managers animal spirits make them decide to buy less output
(investment spending declines). This will shift the aggregate demand curve to
the left. This will provide a new short run equilibrium at  P2 , Y2  as shown in
Figure 24—8
Figure 24—8. A leftward shift in the aggregate demand curve.
What has happened is that the price per unit producers receive has fallen but the
cost per unit has remained the same. Producers will respond by producing less
output. The economy will remain at this new equilibrium at  P2 , Y2  unless (a) the
aggregate demand curve shifts again or (b) the cost per unit changes.
One potential outcome is that the cost per unit of production will fall enough that
the aggregate supply curve will shift to the right enough to establish a new
equilibrium at  P3 , Y2  . This is exactly the long run solution predicted by both
Keynesian and monetarist economists.
First note that at the initial short run solution  P2 , Y2  there will be less labor hired
and fewer materials used. This should start wages and the cost of materials
falling. Further because the decrease in price will increase the real money
supply, interest rates will fall reducing the cost of capital. You should note the
relationship between prices changes and output that occurs when the aggregate
demand curve shifts. A leftward shift in the aggregate demand curve will cause a
price decrease and output decrease. A rightward shift causes price increases
and output increases.
Figure 24—9. The long run equilibrium
Labor costs account for about 70% of the cost of production. So most of what
will shift the aggregate supply curve will be determined by what happens with the
wage rate. To give a idea of why the economy should tend to a certain level of
output we will have to consider the natural rate of unemployment.
The natural rate of unemployment
If labor markets are tight (demand exceed supply) then employers will have to
compete for additional workers. In such market wages tend to rise. In slack
markets (supply exceeds demand) then wages tend to fall as workers compete
for available jobs. At the point were the labor market is neither tight nor slack
wages will tend to be stable. This point is called the natural rate of
unemployment. If the unemployment rate falls below this, wages will tend to rise.
If the unemployment rate if above the natural rate wages will tend to fall. This will
tend to drive the economy to the natural rate.
Suppose that the level of output that can be produced with the natural rate of
unemployment is Yn as shown in Figure 24—10. The level of output is called the
natural rate level of output.
Figure 24—10. The natural rate level of output
Suppose the economy is initially in equilibrium at  P1 , Yn  where Y1D and Y1s
intersect but animal spirits shift the aggregate demand curve to Y2D . At any point
to the left Yn labor markets will be slack and wages will continue to fall until the
economy comes back to the natural rate level of output. But as wages begin to
fall the aggregate supply curve will tend to shift to the right lowering prices. Long
run equilibrium is re—established at  P3 , Yn  where both the price level and the
wage rate have fallen. The real wage rate will not have changed however.
Suppose that the wage rate initially is W1 (and the price level is P1 ) at the new
equilibrium the wage rate is W3 (at the price level P3 ). By real wages being the
W W
same we mean 1  3 . Workers ought to supply the same amount of labor in
P1
P3
the long run because the real return to them for an hours work has not changed.
The long run effect of a leftward shift in the aggregate demand curve is to lower
the price level. There is no long run effect on output.
The effects of a rightward shift in the aggregate demand curve would be to
initially raise prices and output. But now labor markets will become tight and
wages will start to increase. The cost of materials used in the production process
will also start to increase. These will shift the aggregate supply curve to the left.
The long run result will be a return to the natural rate level of output and
unemployment and a higher price level.
Aggregate demand shocks
Aggregate demand shocks are a potential source of instability to the economy.
Animal spirits on the part of business managers (reducing investment spending)
or on the part of households (reducing consumption) can shift the aggregate
demand curve to the left causing a recession. A shift to the right would be
inflationary. The question is what, if anything, can be done about these shocks.
Both monetarists and Keynesians believe that the economy will tend to the
natural rate level of output and the natural rate of unemployment. The chief
questions are (a) how long does the adjustment take and (b) can we speed up
the adjustment process without creating new problems.
Briefly the monetarists believe that the adjustment process occurs very quickly
and the economy will correct itself without government intervention. They further
believe that Fed intervention is probably the primary cause of any difficulty in the
first place. One of the reasons why monetarists believe the adjustment process
operates quickly is that the believe labor markets are very flexible. They believe
that workers are very sensitive to changes in real wages. If the price level falls
then workers will be willing to lower wages so that the real wage remains
unchanged.
Keynesians believe that the adjustment process can be quite lengthy and the
government should do what it can to speed it along. In Keynes phrase “In the
long run we are all dead’. So even if the long run adjustment is to the natural
rate, it may get there far too late. One of the reasons that Keynesians believe
that the adjustment process is so slow is that they think labor markets are not
very flexible. They believe that workers are very reluctant to reduce the wage
rate even if prices have fallen.
Keynesians believe that a leftward shift in the aggregate demand curve should
be offset by the government of the Fed doing something to shift the aggregate
demand curve back to the right. What sort of things could the government do to
shift it to the right?
Fiscal policy
G  Y D 
T  C  i   Y D 
Monetary policy
M  i  C  i  , I  i   Y D 
The monetarists believe that fiscal policy is largely ineffective. Recall that the
budget deficit will have to be financed by borrowing. This will raise interest rates
reducing consumer spending and business investment spending (crowding out).
Keynesians will argue that consumption and business investment spending are
not as interest rate sensitive as the monetarists claim.
If monetarists believe that consumer and business spending is strongly
influenced by interest rates, they must believe that monetary policy is effective.
The monetarists do believe that monetary policy is a powerful tool, but that
powerful tools are dangerous. They argue that an increase in the money supply
will reduce interest rates, but that we just can’t be sure how long it will take.
Suppose that it takes a year before interest rates fall. In that time a recession
might already have cured itself (remember monetarists believe that the economy
will return to the natural rate position fairly quickly). Suppose after a year that the
economy has cured itself and now the interest rate decrease kicks in. Now we
get a shift of the aggregate demand curve to the right of the natural rate level and
price increases.
The monetarists believe that monetary policy, rather than being a stabilizing tool,
is more likely to be a destabilizing tool. They think that we just don’t know
enough about how money supply changes will effect the economy (how long will
the take? what will be the size of the change?). They think than many
recessions have been caused by bad monetary policy.
Monetarists believe that the Great Depression was caused by mismanaged
monetary policy. At the start of the banking panics the Fed could have acted as
the lender of last resort but refused to do so. Banks found out that they would
have to protect themselves against bank runs. So how do you do that? Build up
excess reserves, which is just what they did. The initial bank panics reduced the
money supply and banks building up excess reserves continued the decline in
the money supply.
Another prime example of monetary policy mismanagement from a monetarist
point of view occurred in the late 1970’s and early 1980’s. This was the period of
time with the greatest rate of inflation in the U.S. during the 20 th century. The
Fed reduced the money supply to increase interest rates thus shifting the
aggregate demand curve to the left. The aggregate demand curve shifted too far
with a resulting recession.
Keynesian view of monetary policy
Keynesians believe that the monetarists critique is largely overblown and that the
Great Depression had causes other than the reduction in the money supply.
They also believe that while the aggregate demand curve will eventually return to
the natural rate level, the length of time required to do so will result in
unnecessary economic hardship. They believe that consumer spending and
business investment spending is not as strongly determined by interest rates as
the monetarists believe and that crowding out is not very severe. If so, the
government can use fiscal policy to shift the aggregate demand curve to the right
to cure a recession. The role of monetary policy would be to keep interest rates
low to prevent crowing out (if any) from occurring.
Monetarists view of monetary policy
From what we said above it seems fairly clear that the monetarists do not feel
very comfortable with the Feds ability to successfully manage monetary policy.
So what do the monetarists recommend? They suggest a monetary policy that
leads to price stability. They do not recommend a monetary policy that tries to
control interest rates. If you try to control interest rates you will have to change
the money supply and this leads to price instability.
So how do you achieve price stability? If the money supply grows at the same
rate as the rate of growth, prices should be stable (the same proportion of dollars
chasing the same proportion of goods). So if the economy grew at 3% a year
then the money supply should grow at 3% a year as well. The economy does not
grow at precisely the same rate every year and the rate of growth is not well
known at any time. So what to do then?
Milton Friedman suggests that we pick the average rate of growth over the past
several years and set the money supply growth rate at that level. Sometimes
you will have money growing at a higher rate than the rate of growth, at other
times lower, but on average you won’t be to far off. At any rate this is much
better that giving the Fed a chance to foul up. Friedman believes our knowledge
of how money affects the economy is far to limited to allow the Fed control of an
extremely powerful tool.
Aggregate supply shocks.
A supply side shock is illustrated in Figure 24--11. Such a shock occurred in the
1970’s when the Organization of Petroleum Exporting Countries (OPEC) tried to
increase the world price of oil by an embargo (restring output). This raised the
cost of raw materials that shifted the aggregate supply curve to the left.
Figure 24—11. An increase in the cost of raw materials shifts the aggregate
supply curve to the left raising prices and reducing output.
Note here that we have a case where price increases are associated with output
decrease (known as stagflation). Suppose something had happened to reduce
input costs—this would have shifted the aggregate supply curve to the right
causing a price decrease and output increase.
In any case the movement away from the natural rate level will set forces in
motion to drive the aggregate supply curve back to its original position (assuming
no change in the aggregate demand curve in the meantime). In Figure 24—11
the short run equilibrium is one where labor markets are slack. This will causes
wages to fall and the aggregate supply curve to shift to the right.
Monetary and fiscal policy are called demand management policies because the
operate to shift the aggregate demand curve. They do so by either buying output
directly (G) or by encouraging members of the private sector to buy output (C,I).
The government does not have any short run supply management tools. The
government could, I suppose, direct workers to take an immediate pay cut. I
doubt that said government would be around very long.
Questions
1) A decrease in the price level leads to an increase in aggregate demand
because
a) Governments will buy more output.
b) The demand for money increases, raising interest rates and stimulating
investment spending and consumption.
c) The demand for money decreases, lowering interest rates and stimulating
investment spending and consumption.
d) Foreign goods become cheaper
e) None of the above
2) According to the monetarists an increase in the money supply will shift the
aggregate ____________ curve to the ____________.
a) demand, left,
b) supply, left
c) demand, right
d) supply, right
3) According to the Keynesians an increase in the money supply will shift the
aggregate ____________ curve to the ____________.
a) demand, left,
b) supply, left
c) demand, right
d) supply, right
4) The Keynesian analysis of aggregate demand indicates that an increase in
exports
A) shifts the aggregate demand curve to the right
B) shifts the aggregate demand curve to the left
C) moves the economy along the aggregate demand curve rather than
shifting it.
D) has no effect on aggregate demand.
5) The Keynesian analysis of aggregate demand indicates that an increase in
imports
A) shifts the aggregate demand curve to the right
B) shifts the aggregate demand curve to the left
C) moves the economy along the aggregate demand curve rather than
shifting it.
D) has no effect on aggregate demand.
6) According to the Keynesians, an increase in government spending, other
things equal, shifts the aggregate _____ curve to the _____.
A) demand; right B) demand; left C) supply; left D) supply; right
7) According to the Keynesians, a decrease in government spending, other
things equal, shifts the aggregate _____ curve to the _____.
A) demand; right B) demand; left C) supply; left D) supply; right
8) According to the Keynesians, an increase in taxes, other things equal, shifts
the aggregate _____ curve to the _____.
A) demand; right B) demand; left C) supply; left D) supply, right
9) An increase in the price of raw materials
A) shifts the aggregate supply curve to the right
B) shifts the aggregate supply curve to the left
C) moves the economy along the aggregate demand curve rather than
shifting it.
D) has no effect on aggregate supply.
10) An increase in the wage rate
C) shifts the aggregate supply curve to the right
D) shifts the aggregate supply curve to the left
C) moves the economy along the aggregate demand curve rather than
shifting it.
D) has no effect on aggregate supply.
11) The monetarists believe that changing the money supply
a. has a very powerful effect on the economy and should be used in
preference to fiscal policy in order to stabilize the economy.
b. has a very little effect on the economy so we don’t need to worry to
much about it.
c. Has such a powerful effect and dangerous effect on the economy
that it should not be used to try to cure recessions.
d. Will lead to crowding out.
12) Monetarists argue that the Federal Reserve should pursue
A) an interest-rate targeting strategy.
B) an exchange-rate targeting
strategy.
C) a discretionary monetary policy.
D) a constant rate of growth of
rule.
the money supply.
13) While both monetarists and Keynesians view the aggregate demand curve as
downward-sloping, monetarists argue that
A) changes in government spending and taxes are the only factors causing
the aggregate demand curve to shift.
B) a change in the quantity of money is the primary factor causing the
aggregate demand curve to shift.
C) changes in government spending and taxes, in addition to changes in the
money supply, cause the aggregate demand curve to shift.
D) a change in the quantity of money will have no effect on the aggregate
demand curve.
14) Keynesians believe that an increase in taxes will shift the aggregate
________ curve to the __________.
A) demand, right
B) supply, right
C) demand, left
D) supply, left
14) Keynesians believe that a decrease in taxes will shift the aggregate
________ curve to the __________.
A) demand, right
B) supply, right
C) demand, left
D) supply, left
15) Keynesians believe that the economy will
a) return very quickly to the natural rate level of output
b) never return to the natural level of output
c) return only slowly to the natural level of output
d) always be unstable due to crowding out.
16) Monetarists believe that the economy will
a) return very quickly to the natural rate level of output
b) never return to the natural level of output
c) return only slowly to the natural level of output
d) never be unstable due to crowding out.
17) A decrease in investment spending on the part of businesses will
a) shift the aggregate demand curve to the left
b) shift the aggregate demand curve to the right
c) shift the aggregate supply curve to the left
d) shift the aggregate supply curve to the right
e) none of the above.
18) According to the monetarists a shift in the aggregate demand curve will be
followed by
a) a fairly rapid shift back to the original position of the aggregate demand
curve
b) a slow shift back to the original position of the aggregate demand
curve
c) a rapid shift of the aggregate supply curve so that a new equilibrium is
established at the natural rate level of output.
d) a slow shift of the aggregate supply curve so that a new equilibrium is
established at the natural rate level of output.
e) none of the above
19) According to the Keynesians a shift in the aggregate demand curve will be
followed by
a) a fairly rapid shift back to the original position of the aggregate demand
curve
b) a slow shift back to the original position of the aggregate demand
curve
c) a fairly rapid shift of the aggregate supply curve so that a new
equilibrium is established at the natural rate level of output.
d) a slow shift of the aggregate supply curve so that a new equilibrium is
established at the natural rate level of output.
e) none of the above
20) Although _____ contend that an increase in government spending will "crowd
out" private spending, _____ contend that only partial crowding out occurs.
A) Keynesians; monetarists
B) Keynesians; Hicksians
C) monetarists; Keynesians
D) monetarists; Hicksians
Figure 24-1
21) In Figure 24-1 the economy could be in long-run equilibrium only at
A) point 1.
B) point 2.
C) point 3.
D) points 1 and 3.
E) points 1, 2, 3, and 4.
22) Monetarists believe that using monetary policy to change aggregate demand
a) is the best way to cure a recession
b) is needed to make the economy return quickly to the natural rate level
of output.
c) Is very useful because the effects of changing the money supply are so
powerful
d) has often caused business cycles.
23) Stagflation results from
a) a leftward shift in the aggregate demand curve
b) a rightward shift in the aggregate demand curve
c) a leftward shift in the aggregate supply curve
d) a rightward shift in the aggregate supply curve.
24) Which of the following is true regarding a recession caused by an aggregate
supply shock:
a) The best way to cure it is by increasing government spending
b) The best way to cure it is by decreasing taxes
c) The best way to cure it is by increasing the money supply
d) Neither monetary of fiscal policy is effective against aggregate supply
shocks.
25) In the 1970s the Organization of Petroleum Exporting Countries reduced the
worlds’ supply of oil resulting in an increase in oil prices. This resulted in
a) An increase in output and decrease in the price level
b) An increase in output and an increase in the price level
c) A decrease in output and an increase in the price level
d) A decrease in output and a decrease in the price level.
26) An increase in aggregate demand will result in
a) More output and higher prices
b) More output and lower prices
c) Less output and higher prices
d) Less output and lower prices
27) An increase in aggregate supply will result in
a) More output and higher prices
b) More output and lower prices
c) Less output and higher prices
d) Less output and lower prices
28) A decrease in aggregate supply will result in
a) More output and higher prices
b) More output and lower prices
c) Less output and higher prices
d) Less output and lower prices