Download The Modern Macroeconomic Debate

Aggregate Demand,
Aggregate Supply, and
Modern Macroeconomics
Chapter 9
© 2003 McGraw-Hill Ryerson Limited.
9-2
Introduction
Markets unleash individual initiative,
increase supply, and bring about
growth.
 But markets create recessions too.

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9-3
Introduction

Macro intervention tools – monetary and
fiscal policy – are tools governments
use on the aggregate demand side of
the economy to deal with recessions,
inflation, and unemployment.
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9-4
Introduction

Since politicians make policy, it is
unlikely that they would do nothing in
the face of a recession even if all
economists agreed it was the right thing
to do.
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9-5
The Historical Development
of Modern Macroeconomics

The Great Depression of the 1930s was
a defining event in society's view of
markets, and in the thinking about
government macro policy.
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9-6
The Historical Development
of Modern Macroeconomics

During the Depression, output fell by 30
percent and unemployment rose to
nearly 20 percent. People wanted to
work but could not find jobs at any
wage.
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9-7
The Historical Development
of Modern Macroeconomics

Before the Depression, the prominent
ideology was laissez-faire - keep the
government out of the economy.
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9-8
The Historical Development
of Modern Macroeconomics

After the Depression, most people
believed government should have a role
in regulating the economy.
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9-9
From Classical to Keynesian
Economics
Pre-Depression economists focused on
long-run issues such as growth.
 They were called Classical economists.

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9 - 10
From Classical to Keynesian
Economics

Depression-era economists began to
focus on short-run economic issues,
especially the issue of how to dig out of
the Depression.
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9 - 11
From Classical to Keynesian
Economics

They were called Keynesians after
economist John Maynard Keynes,
author of The General Theory of
Employment, Interest and Money, and
the founder of modern
macroeconomics.
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9 - 12
Classical Economics
The Classical economists' approach
was laissez-faire (leave the market
alone).
 They felt the market was self-adjusting,
and they also concentrated on the longrun and largely ignored the short-run.

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9 - 13
Classical Economics

When the Great Depression hit with
high unemployment, their response was
to refer to supply and demand in the
labour market.
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9 - 14
Classical Economics

Their solution to the high unemployment
was to eliminate labour unions and
government policies that kept wages too
high.
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9 - 15
The Layperson's Explanation
for Unemployment
The layperson's explanation for
unemployment was different.
 They were not pleased with the
classical argument but believed instead
that the Depression was caused by an
oversupply of goods that glutted the
market.

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9 - 16
The Layperson's Explanation
for Unemployment

Lay people advocated hiring people
even if the work was not needed.
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The Layperson's Explanation
for Unemployment

Classical economists opposed deficit
spending, arguing that the money to
create jobs had to come from
somewhere.
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9 - 18
The Layperson's Explanation
for Unemployment
Government demands for capital would
crowd out private demands for money
so the net effect would be zero,
according to the Classical view.
 Their advice was to have faith in the
markets.

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9 - 19
The Essence of Keynesian
Economics
The essence of Keynesian economics is
stabilization through government efforts.
 As Keynes put it: “In the long run we are
all dead”.

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The Essence of Keynesian
Economics

By changing his focus, he created the
macroeconomic framework that
emphasizes stabilization policy.
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The Essence of Keynesian
Economics

Keynes thought that the economy could
be stuck in a rut as wages and price
level adjusted to sudden changes in
expenditures.
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9 - 22
The Essence of Keynesian
Economics

The Keynesian linkage was:
decrease in investment demand  job
layoffs  fall in consumer demand 
firms decrease production  more job
layoffs  further fall in consumer
demand, and so forth
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The Essence of Keynesian
Economics
Too little spending caused
unemployment.
 To break out of the rut, spending had to
increase.

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Equilibrium Income
Fluctuates
Income is not fixed at the economy's
long-run potential income – it fluctuates.
 For Keynes there was a difference
between equilibrium income and
potential income.

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Equilibrium Income
Fluctuates

Equilibrium income – the level of
income toward which the economy
gravitates in the short run because of
the cumulative circles of declining or
increasing production.
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Equilibrium Income
Fluctuates

Potential income – the level of income
that the economy technically is capable
of producing without generating
accelerating inflation.
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Equilibrium Income
Fluctuates
Keynes felt that at certain times the
economy needed help to reach its
potential income.
 Market forces would not work fast
enough and not be strong enough to get
the economy out of a recession

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9 - 28
Equilibrium Income
Fluctuates

Because short-run aggregate
production decisions and expenditure
decisions were interdependent, the
downward spiral could start at any time.
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9 - 29
The Paradox of Thrift
The paradox of thrift is important to the
Keynesian story.
 According to the paradox of thrift, an
increase in savings can lead to a
decrease in expenditures, decreasing
output and causing a recession.

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The Paradox of Thrift

Saving can be seen as something good,
it leads to investments that leads to
growth.
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The Paradox of Thrift

But if savings were not translated into
investment as happened during the
Great Depression total spending would
fall and unemployment would rise.
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The Paradox of Thrift

These concerns led to the development
of the aggregate demand/aggregate
supply model.
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9 - 33
The Paradox of Thrift

It is this model that most economists
use to discuss short-term fluctuations in
output and unemployment.
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The AS/AD Model

The AS/AD model consists of three
curves: the short run aggregate supply
curve (SRAS), the aggregate demand
curve (AD), and the long run aggregate
supply curve (LRAS).
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The AS/AD Model

The short run aggregate supply
curve – the curve describing the supply
side of the aggregate economy.
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The AS/AD Model

The aggregate demand curve – the
curve describing the demand side of the
aggregate economy.
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The AS/AD Model

The long run supply curve – the curve
describing the highest sustainable level
of output.
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9 - 38
The AS/AD Model

The AS/AD model is fundamentally
different from the microeconomic
supply/demand model.
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The AS/AD Model
In the microeconomic supply/demand
model the price of a single good is on
the vertical axis and the quantity of a
single good on the horizontal axis.
 The shapes are based on the concepts
of substitution and opportunity cost.

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The AS/AD Model

In the AS/AD model the price of all
goods,measured by the GDP deflator, is
on the vertical axis and aggregate
output is on the horizontal axis.
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The AS/AD Model

The AS/AD model is an historical model
that starts at a point in time and says
what will happen when changes affect
the economy.
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The Aggregate Demand
Curve
The aggregate demand (AD) curve
shows how a change in the price level
changes aggregate expenditures on all
goods and services in an economy.
 The AD curve is an equilibrium curve.

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The Slope of the AD Curve
The AD is a downward sloping curve.
 Aggregate demand is composed of the
sum of aggregate expenditures.

Expenditures = C + I + G +(X - IM)
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The Slope of the AD Curve
The slope of the curve depends on how
these components respond to changes
in the price level.
 A falling price level is assumed to
increase aggregate expenditures, due
to the

 Wealth
effect
 Interest rate effect
 International effect
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9 - 45
The AD Curve, Fig. 9-1, p 215
Price
level
Wealth, interest rate, and
international effects
P0
Multiplier effect
P1
Aggregate
demand
Y0 Y1
Ye
Real output
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9 - 46
The Wealth Effect

The wealth effect tells us that as the
price level falls, the value of cash rises
so that those who hold money and other
financial assets become richer, and buy
more.
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9 - 47
The Wealth Effect

While economists accept the logic of the
argument, they do not see the wealth
effect as strong.
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The Interest Rate Effect

The interest rate effect is the effect a
lower price level has on investment
expenditures through the effect that a
change in the price level has on interest
rates.
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9 - 49
The Interest Rate Effect
The linkage is:
a decrease in the price level  increase
of real cash  interest rates fall 
banks have more money to lend 
investment expenditures increase 
jobs are created  consumer
expenditures increase

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The International Effect

The international effect tells us that as
the price level falls (assuming the
exchange rate does not change), net
exports will rise.
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The International Effect
The linkage is:
a decrease in the price level in Canada 
the fall in price of Canadian goods
relative to foreign goods  Canadian
goods become more competitive
internationally  Canadian exports rise
and imports fall.

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The Multiplier Effect
A change in quantity demanded has
repercussions on production (supply
decisions) and subsequently on income
and expenditures (demand decisions).
 These repercussions are called
multiplier effects.

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The Multiplier Effect

As the price level falls, the initial
changes due to the wealth, interest rate,
and international effects set in motion a
process in the economy that amplifies
the initial effects.
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The Multiplier Effect
The multiplier effect is the
amplification of initial changes in
expenditures.
 The multiplier effect makes the
aggregate demand curve flatter.

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Shifts in the AD Curve

Except for a change in the price level,
anything that changes aggregate
expenditures shifts the AD curve.
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Shifts in the AD Curve

The main shift factors of aggregate
demand are
 foreign
income,
 expectations about future output or prices,
 exchange rate fluctuations,
 the distribution of income, and
 monetary and fiscal policies.
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Foreign Income
When Canada’s trading partners go into
a recession, the demand for Canadian
goods (exports) will fall, causing the
Canadian AD curve to shift to the left.
 A rise in foreign income leads to an
increase in Canadian exports and a
rightward shift of the Canadian AD
curve.

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Exchange Rates

When a currency loses value relative to
other currencies, export goods
produced in that country become less
expensive and imports into that country
become more expensive.
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Exchange Rates
Foreign demand for its goods increases
and its demand for foreign goods
decreases as individuals do their
spending at home.
 The AD curve will shift to the right.
 When a currency gains value, the AD
curve shifts to the left.

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Expectations About Future
Output
If businesses expect demand to be high
in the future, they will want to increase
their capacity to produce.
 Their demand for investment, a
component of aggregate equilibrium
demand will increase as well.
 The AD curve will shift to the right.

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Expectations About Future
Output
When consumers expect the economy
to do well in the future, they will spend
more now.
 The AD curve shifts to the right.

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Expectations of Future Prices
If one expects the prices of goods to
rise in the future while the current price
remains constant, it pays to buy goods
now before the prices rise.
 The AD curve will shift to the right.
 This is most acutely felt in a
hyperinflation.

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Expectations of Future Prices

It is difficult to specify the exact reason
why expectations will cause a shift in
the AD curve because of the
interrelatedness of various types of
expectations.
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Distribution of Income

People tend to spend a greater
percentage of their wage income as
compared to their profit income.
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Distribution of Income
As real wages increase, while total
income remains constant, it is likely that
the AD curve will shift to the right.
 As real wages decrease, it is likely that
the AD curve will shift to the left.

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Monetary and Fiscal Policy
Activist macro policy makers think they
can control the AD curve to some
extent.
 Macro policy is the deliberate shifting
of the AD curve to influence the level of
income in the economy.

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Monetary and Fiscal Policy

If the federal government spends lots of
money or lowers taxes, it shifts the AD
curve to the right.
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9 - 68
Monetary and Fiscal Policy

When the Bank of Canada expands the
money supply, it can often lower interest
rates and thereby shift the AD curve to
the right.
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Monetary and Fiscal Policy
Expansionary macro policy shifts the AD
curve to the right.
 Contractionary macro policy shifts it to
the left.

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Multiplier Effects of Shift
Factors
An AD curve cannot be treated like a
micro demand curve.
 When a shift factor of the AD curve
causes it to move, it moves by more
than the initial shift factor because of
the multiplier effect.

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Effect of a Shift Factor on the
AD Curve, Fig. 9-2, p 219
Price
level
Initial effect
100
200
Multiplier
effect
P0
Change in total
expenditures
AD0
AD1
300
Real output
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The Aggregate Supply Curve

The Short run aggregate supply
(SAS) curve shows how firms adjust
the quantity of real output they will
supply when the price level changes,
holding all input prices fixed.
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The Slope of the SAS Curve

The SAS curve is an upward sloping
line because:
Firms
adjust both price and quantity in
response to changes in aggregate demand.
Differences between expected and actual
price causes firms to i) adjust output
believing there was a relative price change; ii)
adjust quantity when it is costly to change
price; and iii) change employment and
production when real wages is not as
expected.
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Shifts in the SAS Curve

Firms change their quantity and pricing
decisions when aggregate demand
changes as well as in response to
changes in their cost of production.
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Shifts in the SAS Curve
Costs of production include wage rates,
interest rates, energy prices, and
change in prices of other factors of
production.
 SAS will shift in response to the change
in productivity, as well as change in
costs of production.

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Shifts in the SAS Curve

The net effect on prices :
% change in the price level =
% change in wages – % change in
productivity
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Shifts in the SAS Curve
An increase in factor prices increases
the costs of production and shifts the
SAS curve leftward.
 A decline shifts it to the right.

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Shifts in the SAS Curve
An increase in productivity reduces the
cost of production and shifts the SAS
curve to the right.
 A decrease shifts it to the left.

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The Short Run Aggregate
Supply, Fig. 9-3a and b, p 220
Price level
SAS1
Wage rates
rise
SAS0
P1
P0
Real output
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The Long Run Aggregate
Supply Curve
The final curve that makes up the
AD/AS model is the long run supply
curve.
 The long run supply curve shows the
amount of goods and services an
economy can produce when both labour
and capital are fully employed.

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The Long Run Aggregate
Supply Curve

LRAS is vertical since at potential
output, a rise in the price level means
that all prices, including input prices
rise.

Available resources do not rise, thus,
neither does the potential output.
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The Long Run Aggregate
Supply Curve, Fig. 9-4, p 222
LRAS
Potential output
Real output
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Equilibrium in the Aggregate
Economy

Changes in the aggregate supply,
aggregate demand, and potential output
curves affect short-run and long-run
equilibrium.
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Short-Run Equilibrium
Short-run equilibrium is where the SAS
and AD curves intersect.
 Shifts in either AD or SAS will affect
price levels and output.

 If AD
increases (decreases), so do output
and prices.
 If SAS increases (decreases), output will
also increase (decrease), while price levels
move in the opposite direction.
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Short-Run Equilibrium:
Shift in Aggregate Demand,
Fig. 9-5a, p 222
Price
level
SAS
P1
P0
F
E
AD1
AD0
Y0
Y1
Real output
© 2003 McGraw-Hill Ryerson Limited.
Short-Run Equilibrium:
Shift in Short-run Aggregate
Supply, Fig. 9-5b, p 222
SAS
9 - 86
1
Price
level
P2
G
SAS0
E
P0
AD0
Y2
Y0
Real output
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Long-Run Equilibrium
Long-run equilibrium is determined by
the intersection of the AD curve and
LRAS curve.
 In the long run, output is fixed and the
price level is variable.

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Long-Run Equilibrium
Aggregate demand determines the price
level.
 Increases (decreases) in aggregate
demand lead to higher (lower) prices.

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Long-Run Equilibrium, Fig. 9-6, p
225
Price
level
P1
P0
LRAS
H
E
AD1
AD0
Y0
Real output
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Integrating the Short-Run
and Long-Run Frameworks

When SAS and AD curves intersect at
the potential output, the economy is in
both the long run and the short run
equilibrium.
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Integrating the Short-Run
and Long-Run Frameworks
The ideal situation is for aggregate
demand to grow at the same rate as
aggregate supply and potential output.
 Unemployment and growth will be at
their target rates with no inflation.

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Short-Run and Long-Run
Equilibrium, Fig. 9-7a, p 225
Price
level
LRAS
SAS
E
P0
AD
Y
Real output
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The Recessionary Gap

When the economy is in short-run
equilibrium but not in long-run
equilibrium, and the output is below
potential, there is a recessionary gap.
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The Recessionary Gap

A recessionary gap is the amount by
which equilibrium output is below
potential output.
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The Recessionary Gap

If the economy remains at this level of
output for a long time, costs and wages
would tend to fall because there would
be an excess supply of factors of
production.
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The Recessionary Gap

Factor prices will fall causing the SAS
curve to shift down to eliminate the
recessionary gap.
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The Recessionary Gap, Fig. 9-7b, p
225
LRAS
Price
level
P0
SAS0
Recessionary gap
SAS1
A
B
P1
AD
Y1
Y0
Real output
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The Inflationary Gap
The inflationary gap occurs when the
economy is above potential output that
exists at the current price level.
 If the economy is in a situation where
short-run equilibrium is at a higher price
level than the economy's potential
output curve, we have inflation.

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The Inflationary Gap

Factor prices will rise causing the SAS
curve to shift up to eliminate the
inflationary gap.
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The Inflationary Gap , Fig. 9-7c, p 225
Price
level
LRAS
SAS2
D
P2
SAS0
C
P0
AD
Inflationary gap
Y0
Y2
Real output
(c)
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The Economy Beyond
Potential
How can the economy operate beyond
potential?
 It is possible to overutilize resources
beyond their potential for a brief time.

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The Economy Beyond
Potential

When a firm is below potential, firms
can hire additional factors of production
to increase production without
increasing production costs.
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The Economy Beyond
Potential
Once the economy reaches its potential
output that is no longer possible.
 If at that point, the firm wishes to
increase production, it must lure
resources away from other firms.

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The Economy Beyond
Potential
As firms compete for resources, costs
rise beyond productivity increases.
 The SAS curve shifts up and the price
level rises.

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The Economy Beyond
Potential

At this point the economy will slow down
by itself or the government will step in
with a policy to contract output and
eliminate the inflationary gap.
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Some Additional Policy
Examples

If politicians suddenly increase
government expenditures when the
economy is well below potential output,
output rises while the price level
remains unchanged.
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Some Additional Policy
Examples

If consumer optimism leads to an
increase in expenditures when the
economy is at the target rate of
unemployment, the price level rises
while output remains unchanged.
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Shifting AD and SAS Curves,
Fig 9-8a, p 228
LRAS
Price
level
90
SAS
B
A
AD1
AD0
Y0
Y1
Real output
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Shifting AD and SAS Curves,
Fig 9-8b, p 228
Price
level
LRAS
SAS1
SAS0
E
D
C
AD1
AD0
Y0 Y1
Real output
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Macro Policy Is More
Complicated Than It Looks
The problem in the AS/AD model is that
we have no way of knowing the level of
potential output.
 As a result, it is difficult to predict
whether the SAS curve will be shifting
up or not when aggregate demand
increases.

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Three Policy Ranges

An economy has three policy ranges
where the effect of an expansion of AD
on the price level will be different:
 The
Keynesian range.
 The Classical range.
 The intermediate range.
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Three Policy Ranges
The Keynesian range – when the
economy is far from potential income,
and there is little fear that an increase in
aggregate demand will cause the SAS
curve to shift up and cause inflationary
pressure.
 The SAS is horizontal in this range,
because all firms are quantity-adjusters.

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Three Policy Ranges
In the Keynesian range an increase in
aggregate demand will increase income
and have no effect on the price level.
 The price/output path of the economy is
horizontal so that prices are fixed.

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Three Policy Ranges

The Keynesian range corresponds to
the recessionary gap and it is because
of this that Keynesian economics is
sometimes called depression or
recession economics.
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Three Policy Ranges
The Classical range –the economy is
above the level of potential output so
that any increase in aggregate demand
will increase factor prices.
 The SAS curve is pushed up by the full
amount of the aggregate demand
increase.

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Three Policy Ranges
In the Classical range, an increase in
aggregate demand will push up the
price level and not affect real output.
 The price/output path is vertical so that
prices are flexible.

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Three Policy Ranges

The Classical range corresponds to the
inflationary gap.
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Three Policy Ranges
The intermediate range – when the
economy is between the two ranges,
the AS curve will shift up some and real
output will increase some.
 The ratio between the two increases is
determined by how close the economy
is to its potential income.

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Three Policy Ranges
In the intermediate range, the
price/output path of the economy is
upward sloping.
 The economy is usually in this range.

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Price level
Three Ranges of the
Economy, Fig. 9-9, p 229
Keynesian
range
Intermediate
range
Classical
range
Price/output path
Price level
fixed
Price level
Price level
partially flexible very flexible
Low
potential
High
potential
Real output
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The Problem of Estimating
Potential Output
A key to policy is determining which
range we are in which requires us to
determine the level of potential output.
 Estimating potential output is difficult.

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The Problem of Estimating
Potential Output
One way of estimating potential output
is to estimate the rate of unemployment
below which inflation has begun to
accelerate in the past.
 This is called the target rate of
unemployment.

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The Problem of Estimating
Potential Output

One can then calculate output at the
target rate of unemployment, adjust for
productivity growth, and estimate
potential output.
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The Problem of Estimating
Potential Output
Unfortunately, the target rate of
unemployment fluctuates and is difficult
to predict.
 For example, we don't know if we are
dealing with structural or cyclical
unemployment.

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The Problem of Estimating
Potential Output
Another way gives us a very rough
estimate of potential output.
 The secular trend rate of growth is
added to the economy's previous
income level.

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The Problem of Estimating
Potential Output

Estimating potential income from past
growth rates can by questionable if such
shift factors as regulations, technology,
expectations, etc. are changing quickly
or dramatically.
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Some Real-World Examples

Canada in the mid-1990s:
 Unemployment
was 9 percent—high by
normal standards—while inflation was 2
percent.
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Some Real-World Examples

Canada in the mid-1990s:
 Economist
felt that the output was in the
intermediate range (close to, or at, its
potential).
 If the economy expanded, the result would
be inflation, not strong growth.
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Some Real-World Examples

Japan in the late 1990s:
 Unemployment
was at 4.6 percent and
inflation was at 1 percent.
 The majority of economists believed that
the economy had room for expansion and
was far below potential compared to other
industrial countries.
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Some Real-World Examples

The European Union in the mid-1990s:
 Unemployment
was above 10 percent
leading economists to think the EU was in
the Keynesian range.
 The EU was undergoing a restructuring of
its economy.
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Some Real-World Examples

The European Union in the mid-1990s:
 Social
programs significantly reduced
people's incentive to work.
 Economic theory could not explain what
range the EU was actually in.
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Some Real-World Examples

The United States in the mid-1990s:
 The
economy was expanding slowly albeit
accompanied with major structural
changes.
 As firms expanded, they often laid off
workers simultaneously.
 These structurally unemployed workers
needed retraining which needed time.
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Some Real-World Examples

The United States in the mid-1990s:
 Economists
maintained that
unemployment below 6.5 percent would
generate inflation.
 The unemployment rate fell to 5 percent –
no inflation
 Then to almost 4 percent – still no inflation.
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Some Real-World Examples

Structural change in these countries is
especially critical.
 Output
has fallen by 40 to 50 percent.
 As they struggle to create new institutional
structures, past data are meaningless.
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Debates About Potential
Output
Knowing potential output is crucial in
knowing what policy to advocate.
 According to real business cycle
economists, the best estimate of
potential output is the actual income in
the economy.

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Debates About Potential
Output

Their Classical supply-side explanation
is called real business cycle theory.
 All
changes in the economy result from
real shifts—shifts in potential output—that
reflect real causes such as technological
changes or shifting tastes.
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Aggregate Demand,
Aggregate Supply, and
Modern Macroeconomics
End of Chapter 9
© 2003 McGraw-Hill Ryerson Limited.