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Aggregate Demand
and Supply
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“additional materials” on course
website – not under electronic
course reserve.
Stable Prices

Why is inflation bad?

If wages and prices move together, what is
wrong with inflation?
Prices: key to allocating resources
 Risk: the higher the level of inflation, the more
volatile it becomes.

Makes economic decisions difficult
 Stems production of output
 Can lead to unanticipated swings in output.

Stable Output

Why is volatile output bad?
Creates risk for investors
 Investors demand compensation for bearing risk
 Firms face higher cost of borrowing
 Lower borrowing implies lower output.

Level and Volatility of Growth
Level and Volatility of Growth

If GDP grows by 4% annually


Output doubles in about 18 years
If GDP grows by 2% annually

Output grows by about 40% in 18 years
Is Government Policy Useful?

Can government policy lower inflation? Or
does policy just add extra volatility to
inflation?

Can government policy reduce fluctuations
in the business cycle and lower the volatility
of output?

Monetariasts vs. Keynsians
Aggregate Demand

Aggregate demand: total quantity of an
economy’s goods and services demanded at
each price level.

Single good: output or GNP
• Y=number of “goods” produced
• Y=real output

Single price
• P=price of one unit of Y
• P*Y=nominal spending (or nominal output)
• M=money supply
Aggregate Demand

Demand curve for an individual asset
relates demand for the asset to the price of
the asset relative to other goods.

Aggregate demand curve relates demand
for output to general price level.

If all prices decrease by 10%, why should
aggregate demand increase?
Aggregate Demand

When general price level decreases investors have
the option of either


Buying more of some good
Holding more dollars

Assuming holding real goods is better than holding
dollars, as price level decreases, aggregate demand
increases

Real money supply – purchasing power of M =M/P

When prices decrease, M/P increases holding M
constant.
Aggregate Demand

Island Economy
Current money supply: M=2 dollars
 Price of a gallon of milk: 2 dollars
 Price of a loaf of bread: 2 dollars


Each day:
$2
milk
Baker
Farmer
bread
$2
Aggregate Demand

Each day total aggregate demand = 2
1 loaf of bread
 1 gallon of milk
 Y=2

Same $2 gets spent twice
 Total nominal spending = $4 = PY
 Velocity = (PY)/M = 4/2 = 2

Aggregate Demand
Assume money supply is constant
 Assume prices decrease

Bread = $1
 Milk=$1

Farmer can now begin day by buying more
than 1 loaf of bread.
 Baker can then buy more gallons of milk.

Aggregate Demand

Assume



Each day total aggregate demand = 4






farmer buys 2 loaves of bread
baker buys 2 gallons of milk
2 loaves of bread
2 gallons of milk
Y=4
Same $2 gets spent twice
Total nominal spending = $4 = PY=1*4
Velocity = (PY)/M = 4/2 = 2
Velocity

Velocity – the same dollar is spent several
times within an economy.
P Y
M
V
 V
Y
M
P
V  velolcity
P  Y  nominal spending
M  money supply
As prices decrease, Y increases
holding V and M constant.
Aggregate Demand
P
Aggregate Output Demanded, Y
Keynsians

Aggregate demand is determined by the
sum of the parts:
Y ad  C  I  G  NX
Y ad  aggregate output demanded
C  consumer demand
I  investment demand
G  government demand
NX  export demand
Keynsians
Holding prices constant, a change in
demand by any one sector will change
aggregate demand.
 Demand curve shifts right with

•
•
•
•
•
Increases in government spending
Decreases in taxes
Increases in money supply, M.
Business/Consumer optimism
Increase in Exports
Monetariast View

The only factor that shifts the demand curve is the
money supply.

If government increases spending, why does that not
increase aggregate demand?

Monetariast answer: complete crowding out.





To buy more, government must issue bonds
Shifts supply of bonds to the right
Increases yield
Consumers cannot afford to borrow
Consumer demand declines
Long Run Aggregate Supply
LRS

Determined by




The amount of capital
The amount of labor (natural rate of unemployment)
Available technology
In the long run, the farmer and baker don’t have
the ability to continually produce 2 loaves of bread
and 2 gallons of milk.


Prices rise
Output decreases
Long-Run Aggregate Supply
P
Aggregate Output, Y
Short Run Aggregate Supply
SRS

Firms are seeking to maximize profits
Face increasing marginal cost
 Produce where price=marginal cost


As prices increase firms are willing to produce
more
Short Run Aggregate Supply
SRS

Example: Firm produces widgets
Price at which they can sell: $10
To produce Cost
Profit

1st
2nd
3rd
$3
$5
$9.99
$7
$5
$.01
Short Run Aggregate Supply
SRS

As prices increase firms are willing to produce more to maximize
profits

Is short run, production (labor) costs do not change.
 Wages are set by long-term contracts
(about 70% of production costs)
 Raw materials bought in advance

SRS curve slopes up

Holding price constant, an increase in production costs shifts
supply curve to the left
 An increase in the cost of the “factors of production”
SRS
P
Short-run supply curve shifts
left as costs of production
increase.
Aggregate Output Supplied=Y
SRS

Factors that can shift SRS curve to left:
Increasing wages
 Increasing expected inflation

• Inflation erodes purchasing power of wages.
Workers will demand higher wages.
Strikes
 Increasing production costs other than wages.

• Natural disasters
• Increases in price of oil
Equilibrium
Labor market is loose
Low demand for workers
Downward pressure on wages
P
Labor market is tight
Large demand for workers
Upward pressure on wages
Aggregate Output, Y
Long Run Aggregate Supply
Determined by natural rate of unemployment
Equilibrium

Keynsians:
Wages are sticky.
 Short-run aggregate supply is slow to shift,
particularly when unemployment is high.
 Government is needed to restore economy
to equilibrium.

• Government spending
• Lowering taxes
Keynsian View
P
3.
2.
1.
Aggregate Output, Y
Government spending
shifts demand to right
Keynsian View
Increased government spending can
increase aggregate demand and lower
unemployment.
 Wages are slow to adjust, so the economy
stays out of equilibrium for several years.
 Eventually wages increase and short-run
supply shifts left.
 The long-run effect is just inflation.

Keynsian View
P
2.
1.
Aggregate Output, Y
Keynsian View

If economy is initially out of equilibrium

Wages are slow to adjust, so the economy can
stay out of equilibrium for several years.

Increased government spending can increase
aggregate demand.

Lower unemployment at the cost of inflation.

Keynsian view is benefit outweighs costs
Monetariast View
P
3.
1.
2.
Aggregate Output, Y
Non-Activist Monetary View
Assume short-run supply shifts left
 Economy gets kicked out of equilibrium
 Government can shift demand curve right by
increasing the money supply
 But before this happens, SRS shifts back
right, since wages adjust fast
 When demand curve shifts right, economy
gets kicked out of equilibrium again
 SRS shifts back left

Monetariast View

Result of policy:
Increases volatility of output
 Increases inflation


Conclusions: The Fed does more harm than
good when it tries to tinker with money
supply.
Non-activist Argument

Data Lag – it takes time for policy makers to obtain
the data that tell them what’s going on.


Recognition lag – it takes time for policy makers to
realize what the data is saying about the future.


Data on quarterly GDP not available for several
months until after the quarter.
NBER won’t classify the economy in a recession until 6
months after it determines one might have begun.
Effectiveness lag – Once money supply has
changed, it can take time for effects to be carried out
Deflation

Nearly all economists agree deflation is at
least as bad as inflation
With deflation, greater defaults on loans
 Greater bank failure
 Capital cannot be channeled to good
investments
 Real output declines
 May have long run effects

Monetariast View

To prevent deflation, grow money supply at
a small constant rate.

Result will be moderate inflation from year
to year, but benefit will be a hedge against
deflation.
Keynsian View
P
2.
1.
3.
Aggregate Output, Y
Keynsian View






Assume short-run supply shifts left
Economy gets kicked out of equilibrium
Government can shift demand curve right by
increasing the money supply
Wages are not perfectly flexible
Demand curve shifts right before supply curve
shifts back right.
Result of intervention is


Faster return to long run output level at cost of
moderate inflation
Activist view is that benefits outweigh costs.
Keynsian View
P
With no intervention
3.
1.
2.
Original equilibrium
Aggregate Output, Y
Keynsian View





Assume demand curve shifts right (irrational
exuberance)
Economy gets kicked out of equilibrium
Government can shift demand curve left by decreasing
the money supply
Demand curve shifts left before supply curve shifts left.
Result of intervention is


Faster return to long run output level at cost of moderate
inflation
Lower and less volatile inflation
Keynsian View
P
2.
Original equilibrium
1.
With no intervention
Aggregate Output, Y
Keynsian View






Assume demand curve shifts left (irrational pessimism)
Economy gets kicked out of equilibrium
Government can shift demand curve right by increasing
the money supply
Hopefully economy never gets to point 1.
Argument in favor of increasing money supply at small
rate –that may vary over time according to business
optimism/pessimism.
Result of intervention is


No deflation at cost of some moderate inflation
Activist view is that benefit outweighs cost.