Download 4. Aggregate Demand Policy Under Alternative Supply Assumptions

AGGREGATE SUPPLY AND DEMAND
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AGGREGATE SUPPLY AND DEMAND
FOCUS OF THE CHAPTER
• In this chapter we begin to study how output varies over the short and long run, when
potential output is fixed.
• We develop the aggregate supply/demand model, in the short and long run, to show how the
supply and demand sides of the economy interact to uniquely determine output and the price
level.
SECTION SUMMARIES
1.
The Aggregate Supply Curve
The aggregate supply (AS) curve describes the amount of output that firms are willing to supply
at different price levels. The fact that there is a relationship between output and the price level
should be somewhat disturbingif everyone is perfectly informed and all markets clear (so that
supply equals demand in each of them), output should be fixed at the level of potential output
whatever the price level.
In the long run, when markets clear and all inputs are fully employed, output is fixed at the level
of potential output, and the AS curve is vertical. We call this the classical case.
If we characterize the short run as a period over which prices cannot adjust, the short-run AS
curve must be horizontal. (We call this a Keynesian aggregate supply curve.)
The assumption that prices are fixed (and therefore that the AS curve is horizontal) in the short
run works well when output is below potential output. It does not work, however, when output
is above potential output. In this case resources are over employed. Workers must be paid a
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higher wage to entice them to work more; the owners of capital must similarly be paid a higher
rate of interest. These higher wages drive up the price level, making the short-run AS curve slope
sharply upwards at the point where output equals potential output.
P
short-runshort–run
AS
AS
The AS curve, even in the short run,
is really a curve and not a straight line.
Y
Figure 51
A MORE ACCURATE PICTURE OF AGGREGATE
SUPPLY IN THE SHORT RUN
The fact that resources can be over-employed suggests that the natural rate of unemployment is
not zero. This is true. Some frictional unemployment exists even when resources are “fully
employed,” as there are always people switching jobs and looking for new ones.
2.
The Aggregate Supply Curve and the Price Adjustment Mechanism
The aggregate supply curve describes the price adjustment mechanism of the economy. In the
very short run, when prices are fixed, the AS curve is horizontal. In the medium run, because
prices are able to partially adjust, it slopes upward. In the long run, when prices are able to fully
adjust and all markets are in equilibrium, it is vertical.
The progression of time in the AS-AD model is represented by a gradual (counterclockwise)
rotation of the AS curve. As time passes, prices are able to better adjust to old shocks, and output
is less able to deviate from potential output. The rate at which the AS curve rotates reflects the
rate at which prices in an economy are able to changewhen prices adjust quickly to
macroeconomic shocks, the AS rotates quickly, reaching its long-run equilibrium earlier than it
would, were its prices less able to respond to changing market conditions.
We use the following equation to describe the adjustment of prices over time:
AGGREGATE SUPPLY AND DEMAND
 
Pt 1  Pt 1   Y  Y 
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
This simply says that the price level rises when output is above potential output, and falls when
output is below potential output.  describes the speed of price adjustment—high values of 
mean that prices adjust quickly to clear markets, so that output will return quickly to potential
output. Low values mean that prices adjust slowly.
We also can visualize the transition from the short to the long run as a series of inward shifts in
the short-run AS curve. Suppose, for example, that we had a monetary expansion at a time when
P
AS
AS1
AS0
We can visualize the transition
form the short run to the long run
as a series of inward shifts in the
short-run AS curve.
AD0
Y*
AD1
Y
Figure 52
THE TRANSITION FROM THE SHORT RUN TO
THE LONG RUN
output was already equal to potential output. The expansion would increase both output and the
price level in the short run, but over time prices would have to rise and output would have to
return to its long-run equilibrium; the AS curve would have to shift gradually inward.
3.
The Aggregate Demand Curve
The aggregate demand curve describes all of the combinations of output and the price level for
which the goods and assets markets are simultaneously in equilibrium. It slopes downward
because of the interaction between these markets: a decrease in the price level, because it
increases the real money supply, causes the real interest rate to fall. Lower interest rates make
investment less costly, so that more occurs. Aggregate demand increases.
Most of us have great intuition about goods markets. We know that a tax cut will leave us with
more money to spend. We are also willing to believe that an increase in consumer confidence
causes people to spend more of the money that they already have, as they do not need to save as
much in anticipation of trouble. It isn’t terribly difficult to convince us that aggregate demand
increases in either of these cases.
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Few of us have as strong an intuitive understanding of the way that asset markets work. For this
reason, we provide a brief introduction to them here.
The key to understanding asset markets is to think in terms of interest rates. The real interest rate
is the equilibrium “price” of money, and, like all prices, is determined by the intersection of
supply and demand. It is also a variable that firms care a lot about: the real interest rate is the
cost, for firms, of investing. (Think of these firms as having to borrow money in order to invest.)
So the first step is to ask how a particular change in some asset market affects the real interest
rate. The second is to ask how the change in the real interest rate affects investment demand. By
looking at the effect of the real interest rate on investment, we connect assets and goods markets,
and are able to translate changes in assets markets into shifts in AD.
It is necessary to distinguish between nominal and real money balances when looking at the
market for money. Nominal balances are just the number of bills and coins floating around (M);
real balances are the value of these bills and coins (M/P). The real interest rate is determined by
the supply of and demand for real money balances.
Although the central bank only has direct control over nominal money balances, it is able to affect
real money balances in the short run, when the price level is fixed. A decrease in nominal
balances lowers real balances for any given price level, and therefore shifts out the AD curve.
Always think in terms of interest rates when analyzing monetary policy: How does the real
interest rate change, and how does that change affect investment demand? An increase in
investment demand will increase AD; a decrease will cause it to fall.
The quantity theory of money provides more good intuition. It tells us that the total value of
output must equal the number of dollars circulating in the economy multiplied by the number of
times the average dollar changes hands:
MxV=PxY
“M” here represents the money supply; “V” is a term representing the velocity of money, or the
number of times one dollar changes hands in the course of a year. “P” is the price level, and “Y”
outputtogether, they represent either nominal GDP or nominal GNP. Notice that when both
velocity and the money supply are assumed to be constant, there is an inverse relationship
between P and Y; when one rises, the other must fall. This is consistent with our downwardsloping aggregate demand curve. Likewise, an increase in the money supply will increase output
for any given price level (or increase the price level for a given level of output); it will cause the
aggregate demand curve to shift outwards.
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AGGREGATE SUPPLY AND DEMAND
Long–run AS
P
An increase in the money supply will
raise output for any given price level,
shifting the AD curve outward.
Still, we can’t say what will happen
P2
P1
AD’
to output and the price level until we
AD
introduce an AS curve.
Y*
Y
Figure 53
THE LONG-RUN EFFECT OF A SHIFT IN AD
P
Demand management policies
(policies that shift only the
P1
AD curve) cannot affect output
AD’
in the long run.
AD
Y
Figure 54
AN INCREASE IN THE MONEY SUPPLY
SHIFTS THE AGGREGATE DEMAND CURVE
OUTWARD
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4.
Aggregate Demand Policy Under Alternative Supply Assumptions
Changes in aggregate demand only affect output in the short and medium run, when the AS
curve is not vertical.
When the AS curve is vertical (in the long run, or classical case), neither fiscal nor monetary
policy can affect output. Shifts in the AD curve only change the price level. Output is fixed at
potential output (Y*).
5.
Supply-Side Economics
Because the AS curve is vertical in the long run, only supply-side policies (policies which shift the
aggregate supply curve) can produce long-run growth. Deregulating industries, making laws and
regulations easier to comply with, and changing or removing unnecessary laws all have the
capacity to do this.
You might wonder how the long-run AS curve can shift at all, as all factors of production are
fixed in the long run by definition. The answer, of course, is that this shift does not occur because
more inputs are being used. It occurs because these inputs are being used more effectively. It is
similar, in this way, to technological improvement.
The political meaning of the term “supply-side economics” is slightly different than the more
general economic one. This term has been used, in recent years, to refer to the idea that tax cuts
will increase output by so much that tax receipts will rise or remain constant, rather than fall.
The assumption that tax cuts increase aggregate supply as well as aggregate demand results from
an incentive effect: Tax cuts, because they allow people to keep more of the money they earn,
significantly increase the incentive to work, and therefore lower the natural rate of
unemployment (raise potential output).
Economists don’t argue about whether this incentive effect exists, or about whether a shift in
long-run AS is likely to occur. What they do argue about is the magnitude of this
shiftspecifically, about whether the AS curve shifts far enough to the right to compensate for
the effect of the lower tax rate on total tax receipts.
6.
Putting Aggregate Supply and Demand Together in the Long Run
Over time, productive capacity of the economy increases at a stable rate. Graphically, this means
the long run aggregate supply curve moves steadily to the right. The aggregate demand behavior
depends on the money supply process. At each point in time, the aggregate demand and the long
run aggregate supply intersect to determine the equilibrium price and output. Since the long run
aggregate supply curve is vertical, the equilibrium output is in essence determined by the
aggregate supply. The changes in aggregate demand, relative to shifts in aggregate supply,
determine the price level.