Download Eco120Int_Lecture4

ECO 120
Macroeconomics
Week 4
Aggregate Demand and
Aggregate Supply
Lecturer
Dr. Rod Duncan
Topics
• Aggregate demand (AD) curve
• Aggregate supply curve (AS)- the shortrun and long-run curves
• Equilibrium in the AD-AS model
Aggregate demand
• The aggregate demand (AD) curve shows the
relationship between the aggregate price level,
P, and the equilibrium level of GDP, Y.
– We are thinking of the level of Y depending on the
price level, P. Much like in Micro, where demand for a
good depends on its price.
– We could represent this relationship as a graph of AD,
as a table of values or as an equation Y = AD(P).
• So what is the relationship between aggregate
prices and equilibrium output?
Aggregate demand
• We know from our
previous lectures that
we can calculate
equilibrium GDP, Y*:
AE
Y
– Y* = AE = C(Y* - T) + I
+ G + NX
Y*
• Or we can use a table
or a graph.
Y*
Y
Deriving the AD curve
• But in this way we are calculating Y* for a fixed
level of our exogenous variables, I, G, NX and
also for a other factors, such as:
– Weather or natural disasters
– Aggregate price level
• If a change in P affects C, I or NX, it will also
change the equilibrium level of Y.
• So how can a change in P affect the level of C, I
and NX? We take each of these in turn.
Real balances effect (P→C)
• We assumed before that households make
consumption decisions based on their
disposable incomes, so C depends on Y – T.
• But people also take into account their wealth:
–
–
–
–
Equity in their home
Retirement accounts
Money in the bank
Savings bonds, corporate bonds, stockmarket
investments
– Future income (also called “human capital”)
Real balances effect (P→C)
• We would expect that a person with the same
income but greater wealth would consume more
than a person with lesser wealth.
– You inherit $500,000 from your aunt. You stay in your
old job. Do you consume the same things as you did
yesterday?
– Or your house doubles in value.
– Or you win the lottery.
• So C depends both on disposable income, Y – T,
and on household wealth.
Real balances effect (P→C)
• A lot of household wealth is held in the form of
bonds and other types of “fixed income
securities”.
• A bond or “fixed income security” is a piece of
paper (a contract) that says something like:
The Australian Treasury (or Ford Motor Company or …)
promises to pay the holder of this bond $100 in 2006.
• If the average level of prices rise between 2005
and 2006, then this bond is worth less than it
would be at lower prices in 2006. Worth less is
real terms- in which it can buy.
Real balances effect (P→C)
• As P rises, the real value of bonds and
other fixed income securities falls. So as
P rises, household wealth falls.
• As household wealth falls, we would
expect C to drop.
• So the real balances effect predicts that a
rise in P should lead to a fall in C.
Interest-rate effect (P→I)
•
A second channel through which P might affect
Y* is through the effect of P on investment, I.
• We can imagine at least 2 paths for this effect:
1. A rise in prices means that people will need
more money to make their purchases- driving
up the demand for money.
An increase in the demand for money will raise
the “price” of money- the nominal interest rate,
i. We will spend more time on this in the
lecture on monetary policy.
Interest-rate effect (P→I)
2. An greater increase in prices than expected is
a rise in expected inflation. Inflation is a cost
for people who save, as inflation means prices
of goods in the future are higher, so money
saved is worth less.
The rise in expected inflation will push up
nominal interest rates- to compensate savers
for higher future prices.
• So both of these channels would suggest that
higher P leads to higher nominal interest rates,
i.
Interest-rate effect (P→I)
• Higher P leads to higher i.
• But higher i will lead to lower levels of
investment, I, as some investment projects
that were profitable at lower i are
unprofitable at a higher i. We will be going
into this effect in more detail in the next
lecture.
• Higher P should lead to a fall in I.
Foreign-purchases effect (P→NX)
• A third channel through which P can affect Y is
through the effect of higher P on NX.
• A higher P means that (all else held constant,
such as currency exchange rates) Australian
goods are more expensive relative to foreign
goods.
• If Australian goods are more expensive, we
would expect fewer foreign purchases of our
goods- our exports, X, drop.
• If Australian goods are more expensive, we
would expect Australians to buy more goods
from overseas- our imports, M, rise.
Foreign-purchases effect (P→NX)
• If the price of our cars go up, we would
expect fewer foreigners to buy our cars,
and more Australians to buy foreign cars.
• We will be going into these topics in a lot
more detail in lectures on international
trade.
• A high level of P should lead to a fall in
NX, as:
– NX↓ = X↓ - M↑
Deriving AD
• So as P↑, we expect:
– C↓ (real balances)
– I↓ (interest rate)
– NX↓ (foreignpurchases)
• So as P↑, we expect:
AE = C↓ + I↓ + G + NX↓
• The AE curve shifts
down.
• Equilibrium Y* falls.
Deriving aggregate demand
• How do average prices affect demand for goods and
services?
– Real balances effect: higher prices means our assets have less
value so people are poorer and consume less.
– Interest-rate effect: higher prices drive up the demand for
money and so drive up interest rates, at higher interest rates,
investment falls (see later)
– Foreign-purchases exports: at higher Australian prices, foreign
goods are cheaper, so net exports falls (see later)
• As the average price level rises, demand for goods and
services should fall, with all else held constant.
Aggregate demand
• We would like to have
a relationship
between the demand
for goods and
services and the price
level. We call this the
“aggregate demand”
(AD) curve.
• The AD curve is
downward-sloping in
aggregate price.
P0
P1
AD
Y0
Y1
Y
Shifts of the AD curve
• Factors that affect the AE curve will affect the AD
curve. For example, if household wealth rose,
then C would increase for all levels of
disposable income. Demand would be higher
for all levels of prices, so the AD curve shifts to
the right.
– C: household wealth, household expectations about
the future
– I: interest rates, business expectation about the
future, technology
– G and T: changes in fiscal policy
– NX: the currency exchange rate, change in output in
foreign countries
Shifts of the AD curve
• Any change in these
factors will produce a
shift of the whole AD
curve.
• If G↑ then the AE↑, so
the AD curve shifts to
the right. Likewise if
T↓ then the AE↑, so
the AD curve shifts to
the right.
G↑ or T↓
P0
AD1
AD0
Y0
Y1
Y
AD and the multiplier
• A change in G or I or
NX will shift the AE
curve up. This will
produce a shift to the
right of the AD curve.
• The shift in the AD
curve will be the
change in I times the
multiplier.
Aggregate supply
• The aggregate demand curve showed the
relationship between goods demand and the
average level of prices.
• The aggregate supply (AS) curve shows the
relationship between goods supply and the
average level of prices.
• By goods supply, we are thinking about all of the
goods and services provided by all the
producers in the economy.
• How does the aggregate price level affect the
aggregate level of goods and services supply?
Deriving the AS curve
• We will differentiate between goods supply in the
short-run (SR) and in the long-run (LR).
• The crucial difference between the two time
periods is that we will assume that nominal
wages for employees are fixed in the SR.
Workers’ money wages do not change in the
SR. But workers’ wages are free to move in
the LR.
• So we will have two different AS curves- the SR
AS and the LR AS curves.
Fixed nominal wages
• How can we defend the assumption that wages
are fixed in the SR?
– All wages in a modern economy are set either via
contracts between employers and employees or via a
labour agreement between unions and employers.
– These contracts specify well in advance (a few
months to several years) what the wages of a worker
will be in nominal terms.
– These contracts are usually very difficult to change.
Supply of an individual firm
• So what effect will this assumption of fixed
wages have? To think about this, we will think
about the supply of a small firm in our economy.
• Intuition: If the output price for a firm rises, but
the cost of labour stays the same, a firm will
want to increase profits by producing more
output. But if the output price and the cost of
labour both rise by the same amount, a firm will
not increase output.
Supply of an individual firm
• Imagine we have a firm that buys labour, L, at a
wage cost, W per unit, and sells output, Q, at a
price, P per unit.
• Imagine our firm needs a certain amount of
labour to produce output:
– L = f(Q)
• Profits = Revenues – Costs
– Revenues = Sales = PQ
– Costs = Labour Costs = WL
• Firm profits = PQ – WL or PQ – Wf(Q)
Supply of an individual firm
• The firm’s supply problem is to choose Q* to
maximize profits, given P, W and f().
• Assume W is constant, but that P changes, how
does firm supply, Q*, change?
• (Not necessary for class) You can show
mathematically that Q* will rise if P rises, for
the types of f() we normally assume.
• You can also show that if P and W both rise by
the same amount, Q* stays the same.
Deriving the SR AS curve
• In the short-run (“SR”), since wages are
fixed, a rise in P will have no affect on W,
so individual firms will find it profitable to
increase output.
• As all firms are raising output, aggregate
supply will increase in the SR if aggregate
prices rise.
• So the SR AS curve is upward-sloping in
aggregate prices.
Deriving the LR AS curve
• We assume that workers are interested in their
real wages (wages relative to prices W/P).
• If P rises, workers will demand a compensating
W rise, so as to keep real wages the same as
before.
• In the LR, real wages are unchanged by
changes in P, so output is not affected by
changes in P.
• The LR AS curve is vertical at the “natural rate of
output”.
The LR AS curve
P
• The LR AS curve is
vertical, so long-run Y
does not depend on
prices.
• The long-run Y is
determined by:
LR AS
Low
U/E
High
U/E
YLR
Y
–
–
–
–
–
Labour skills
Capital efficiency
Technology
Labour market rules
And others…
Review: Aggregate supply
• There will be a short-run AS curve which is
upward-sloping in prices.
• The SR AS (or usually just “AS”) is
used to model scenarios.
• The long-run AS curve is vertical at the
level of potential output, since wages will
change proportionately to price changes.
• The LR AS is used (mostly) to talk
about unemployment.
Shifts in the AS curves
• What factors will shift the AS curves? The
AS curves depend on the productivity of
Australian workers. What affects labour
productivity?
– Changes in prices of inputs, like land, capital
energy or entrepreneurial skill
– Changes in technology that affect productivity
– Changes in taxes, subsidies or laws affecting
business productivity
Equilibrium
• Equilibrium occurs at
a price level where
goods demand (AD)
is equal to goods
supply (SR AS).
P
AS
P0
AD
Y0
Y
Unemployment
LR AS
P
P0
Y0
YLR
• The gap between the
“natural rate of
AS
output” and current
output is called the
“recessionary gap”.
Unemployment• The level of
unemployment
AD
depends on the size
Y
of this gap.
Shift in AD (C↑ or G↑ or T↓ or I↑ or
NX↑)
Shift in AD
• We start with an economy of $10tr and a price
level of 110.
• A change in autonomous expenditure causes
the AE curve to shift from AE0 to AE1. We move
to a new AD curve at AD1.
• At the old price level of 110, AD > AS by $2tr, so
prices rise, pushing AD down and AS up until we
reach out new equilibrium.
• Our new equilibrium will have higher P and Y
than when we started.
Shift in AS (rise in oil prices)
AS1
P
AS0
P1
P0
AD
Y1
Y0
Y
• A rise in oil prices
raises the cost of
production for all
producers and shifts
the SR AS curve up/to
the left.
• At the old prices, AD
> AS, so prices rise
and output falls.
Business cycle
• Over the business cycle, we will have periods of
high output (booms) and periods of low output
(recessions).
• In booms, output is high and unemployment is
low, while in recessions, output is low and
unemployment is high.
• The “natural rate of unemployment” is the level
of unemployment in a “normal” period of the
economy. This is achieved when output is at
full-employment or the LR AS level.
A “Boom” in the Economy
LR AS
• An economy in a
boom is an economy
with an output level
higher than the
natural rate of output.
• Unemployment is
below the natural rate
in a boom.
P
AS
P0
AD
YLR
Y0
Y
A “Recession”
LR AS
• An economy in a
recession is an
economy with an
output level below the
natural rate of output.
• Unemployment is
above the natural rate
in a recession.
P
AS
P0
AD
Y0
YLR
Y
Sample AD-AS question
• The small country of Speckonamap is in longrun equilibrium with its aggregate demand (AD)
and short-run aggregate supply (AS) curves
intersecting on the long-run aggregate supply
curve (ASLR). The dot-com bubble in
Speckonmap’s industry bursts. Business
investment drops.
• a. Explain the short- and long-term
consequences of this bursting bubble using the
AD-AS diagram. Be as clear and complete as
you can.
Sample AD-AS question
• b. What policies could the government of
Speckonamap pursue to counter the
collapse of business investment? Think of
two different ways that the government
could shift the AD-AS curves.