Download The Aggregate-Demand/Aggregate

Chapter Twelve
The AggregateDemand/AggregateSupply Model
Aggregate Demand & Aggregate Supply
• A model of the overall economy that we can use to
understand long-term output growth, business cycles, etc
• Aggregate demand tells us the total amount of goods
and services being purchased
• Aggregate supply tells us the total amount of goods and
services produced
• Equilibrium is where aggregate demand = aggregate
supply
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Aggregate Demand
• Aggregate demand is the total demand for
goods and services by everyone in the economy
– Consumption: demand by people for consumer goods
– Investment: demand by business firms for equipment
and buildings, and demand by people for housing
– Net exports: demand by foreigners for our goods and
services
– Government spending: demand by the government for
goods and services, as well as government
investment spending
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Consumption
• Largest component of
aggregate demand (about
2/3 of total)
• Durable goods: autos,
furniture, and major
appliances
• Nondurable goods: do not
last as long as durables
• Services: consumed
immediately
• Housing is not considered a
durable good, but rather an
investment good, which will
be discussed later.
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Consumption (cont’d)
What affects consumption?
• current income …Consumers buy more goods and
services when they have more income
• future income …If you expect a future income
increase, you may spend more now
• wealth …People with greater accumulated assets
generally spend more
• taxes…The more taxes consumer have to pay, the
less disposable income they have to spend
• the real interest rate …Higher real interest rates
encourage consumers to save rather than spend
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Investment
• Investments in physical capital are about 1/6 of
aggregate demand
• Physical capital is the equipment and
structures firms use in production and houses
that people live in
• The total amount of physical capital in an
economy is its capital stock
• Financial investment is NOT included; only
investment in physical capital
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Investment (cont’d)
What affects business investment?
• Size of existing capital stock compared to desired
capital stock
• Future consumption spending on the part of
consumers (businesses want to anticipate consumer
demand)
• Firms’ ability to pay for the new capital
– May use retained earnings in times of profit
– Lower real interest rates stimulate investment as the
opportunity cost of investing or holding cash goes down
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Net Exports
• International trade must be included when calculating
aggregate demand
• Americans import more than they export
• Net exports = exports – imports
– This is the only component of aggregate demand which may be
negative
• The level of net exports depends on
– Current domestic income (-)
• Domestic citizens import more from abroad if their incomes are higher
– Current foreign income (+)
• Domestic companies export more to foreigners if foreigners have
higher income
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Government Spending
• Government spending accounts for about 1/6
of aggregate demand
• Includes payments to government workers,
government purchases of goods and services,
gross government investment in physical
capital
• We assume government spending is chosen
exogenously, and not explained by the AD-AS
model
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The Aggregate Demand Curve
• Aggregate demand is the sum of all
spending in the economy (consumption,
investment, net exports, and government
spending)
• The aggregate-demand curve shows
combinations of the price level and output
that are consistent with equilibrium in the
goods market and money market
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The Aggregate Demand Curve (cont’d)
– Goods market
• Endogenous variables: current income, real interest rate
• Exogenous variables: future income, wealth, taxes, future
consumption, profits, business optimism, foreign income
– Money market
• Endogenous variables: price level, current income, nominal
interest rate
• Exogenous variables: quantity of money supplied, expected
inflation rate
– Relationship between them
• Nominal interest rate = real interest rate + expected inflation
rate
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The Money Market After a Decline in
the Price Level
A decline in the price level decreases the demand for
money, resulting in a lower nominal interest rate
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The Aggregate Demand Curve
• The price level is a key endogenous variable.
• An inverse relationship exists between aggregate
demand and the price level.
• Any point along the AD curve is one for which both the
goods and money markets are in equilibrium.
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Aggregate Supply
• Aggregate supply is the economy’s total
production of goods and services
• Economists distinguish between short- and
long-run aggregate supply
• LRAS is fixed at full employment
• In the short-run, output increases with the
price level, as producers are incentivized
to offer more for sale
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Long-Run Aggregate Supply
• Does the price level affect the amount
produced in the long run?
– Full employment: when capital and labor are fully
utilized; the unemployment rate = the natural rate
of unemployment (reflecting normal job turnover)
– Full-employment output: the output produced
when the economy is at full employment
– Full-employment output is not affected by the price
level, so the long-run aggregate supply curve is
vertical
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Short-Run Aggregate Supply
• Does the price level affect the amount
produced in the short run?
– The amount of capital in the economy is fixed in
the short run, so SRAS cannot be adjusted
– Producers are reluctant to increase prices when
demand increases, so higher demand leads to
increased output
– If prices throughout the economy rise (because of
inflation), a firm might think increased demand for
its product means demand for its product has
increased, instead of realizing that it should raise
its prices
– The firm is fooled into producing too much
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Aggregate Supply
In the short run, the relationship between output and the price level is
positive. In the long run, the economy is at full employment, so
increases in the price level have no effect on output
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Short-Run Aggregate Supply (cont’d)
• The location of the SRAS curve depends on the
expected inflation rate, since whether firms are
fooled depends on the inflation rate they expect
to prevail. When they are wrong, the economy
may be located at a point on the SRAS curve,
rather than the LRAS curve
• As inflation expectations adjust, the SRAS curve
shifts
– Higher expected inflation causes the SRAS curve to
shift to the left
– For a given price level, higher inflation means lower
relative prices, so firms produce less
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Equilibrium in the AD-AS Model
Short-run equilibrium
Intersection of the AD and SRAS curves. Determination of output and price
level in the short run; output may differ from full-employment output
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Equilibrium in the AD-AS Model
Short-run equilibrium
Intersection of the AD and LRAS curves. Determination of output and price
level in the long run; output must equal full-employment output
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Equilibrium in the AD-AS Model (cont’d)
• How does the economy adjust to move
from the short run to the long run?
– Adjustment does not occur immediately
• Producers may be fooled and cannot distinguish
changes in overall prices from changes in their
own prices
• Wages and prices may be slow to adjust; for
example, wages may be negotiated and firms may
hesitate to change menus or catalogs
• Adjustment occurs gradually over time as the
SRAS curve shifts until it crosses the intersection
of LRAS and AD
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AD-AS Model Shifters
An increase in
Causes this curve to shift
In this direction
Future income
AD
Right
Wealth
AD
Right
Taxes
AD
Left
Real interest rate
AD
Left
Future consumption
AD
Right
Profits
AD
Right
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AD-AS Model Shifters (cont’d)
An increase in
Causes this curve to shift
In this direction
Business optimism
AD
Right
Foreign income
AD
Right
Government spending
AD
Right
ATM costs or other
Variables that increase
money demand
AD
Left
Money supply
Right
AD
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AD-AS Model Shifters (cont’d)
An increase in
Causes this curve to shift
Productivity
In this direction
LRAS
Right
SRAS
Right
LRAS
Right
SRAS
Right
LRAS
Right
SRAS
Right
SRAS
Left
Costs of producing Output SRAS
Left
Capital stock
Labor force
Expected price level
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Example: A Drop in Business Optimism
• If business firms lose confidence, they may
become pessimistic about the future and decline
to invest in new capital
• The AD curve would shift to the left
• In the short run, the price level decreases and
output as businesses produce fewer goods
• In the long run, the SRAS curve shifts to the
right. Restoring equilibrium
• Long-run equilibrium has the same fullemployment output and a higher price level
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Example: A Drop in Business Optimism
The initial effect is a decrease in AD. Eventually,
SRAS shifts right and restores equilibrium.
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Equilibrium in the AD-AS Model
What if exogenous variables shift?
1. Determine which curve (SRAS, LRAS, AD) is
affected and in which direction each curve shifts
2. Find the new short-run equilibrium (price level and
output)
3. Determine how the SRAS curve must shift to
restore equilibrium
4. Find the new long-run equilibrium
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Monetary Policy & the AD-AS Model
• Monetary policy refers to the Fed’s decisions
about the size of the money supply
• An increase in the money supply shifts AD right;
a decrease in money supply shifts AD left
• If the economy is in a recession, the Fed can
shift the AD curve to the right by increasing the
money supply, restoring full-employment
equilibrium with a higher price level
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Monetary Policy &
the AD-AS Model (cont’d)
The economy is in recession when AD intersects SRAS at less
than full employment. An increase in the money supply
starts the process back toward long-run equilibrium.
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Monetary Policy &
the AD-AS Model (cont’d)
If the Fed uses expansionary policy when the economy is at
full employment, the result is temporarily higher output and
much higher prices
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Fiscal Policy & the AD-AS Model
• Fiscal policy refers to the government’s
decisions regarding levels of taxation and
government spending
• The government can increase aggregate
demand by reducing taxes or increasing
government spending, and vice-versa
• If in recession, the government might cut
taxes or increase government spending to
attempt to restore full employment
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Fiscal Policy & the AD-AS Model (cont’d)
When the economy is in recession, government might try to
shift back toward long-run equilibrium though the
manipulation of aggregate demand
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Large, Structural
Macroeconomic Models
• Large, structural macroeconomic models are models
with many equations that describe the economy in great
detail and are based on the assumption that their
equations do not change over time
• Their development was led by the Keynesians, focusing
on how government could shock aggregate demand to
temper the business cycle
• Policymakers use the models to analyze historical
events and to guide future policy decisions
• Eventually, equations began to break down and
economists became skeptical of the model’s efficacy
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Large Macro Models & Their
Performance in the 1970s
• In the early 1970s, macroeconomics as a field
was considered to be solved. Economists
believed
– Large macro models provided good forecasts
– Policy control of economy could eliminate the
business cycle
– Policymakers needed to decide on the desired tradeoff between unemployment and inflation
• The stagflation of the 70s seemed to disprove
the models
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Rational Expectations Theory
• Introduced by skeptics of Keynesian theory
• Rational expectations theory means that
people use all available information in making
economic decisions
• Large macro models assume people do not
have rational expectations; treat expected
inflation as exogenous, based on past data
• Under rational expectations, expected inflation
becomes an endogenous variable to which
people can respond in a future-oriented manner
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Rational Expectations Theory
• The argument that the macro models are
fundamentally flawed is known as the Lucas
critique, which argues
– A change in policy will alter the structure of large
macro models
– The large macro models are flawed, because they
treat some coefficients as constant; under rational
expectations theory, those coefficients will change as
policy changes
– Models must consider people’s expectations about
policy to gage their reactions to it
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