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Aggregate Demand and Aggregate Supply: Explaining economic fluctuations Revision of main concepts Francesco Daveri Two key facts on fluctuations 1. Economic fluctuations occur systematically, but they are irregular, for their timing and duration is unpredictable • Macroeconomic variables behave as random variables 2. Most aggregate variables fluctuate together: macro-economic variables are closely related • Yet: even if most variables move together, their volatility differs across variables GDP growth in the world economy: fluctuating with irregular and unpredictable timing 6 Growth world Gdp, % 5 4 3 2 1 0 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014p 2015p -1 Growth: usually positive but not constant. One episode of growth<0 Source: IMF World Economic Outlook Database, April 2014 We want to develop basic model to explain economic fluctuations • • Two variables are used to develop a model to analyze the short-run fluctuations : • The economy’s output of goods and services measured by real GDP • The overall price level measured by the CPI or the GDP deflator We use the model of aggregate demand and aggregate supply (AD-AS) to explain short-run fluctuations in economic activity around long-run trends What the basic model says • Three main things • Monetary , fiscal and exchange rate policies (AD policies) affect real GDP in the short run but not in the long run • Money and policy do not affect “real” variables” (Gdp, C, I) in the long run, but they do in the short run. Long-run Money and policy neutral in the long run, not in the short run • Hence: when studying year-to-year changes in the economy, we will not assume money and policy neutrality The model of aggregate demand and aggregate supply Price Level Aggregate supply Aggregate demand 0 Equilibrium output Quantity of Output AD and AS • The aggregate demand (AD) curve shows the quantity of goods and services that households, firms, and the government are willing to buy at any price level – • Note: The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy The aggregate supply (AS) curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level – Note The AS curve is not a market supply curve, and it is not the sum of all market supply curves in the economy AD curve The four components of GDP (Y) contribute to the aggregate demand for goods and services: Y = C + I + G + NX Price Level P1 P2 1. A decrease in the price level 0 Y1 2. …increases the quantity of goods and services demanded. Aggregate demand Y2 Quantity of Output Why the AD is downward sloping Price level Quantity of good demanded Pigou (wealth) effect Keynes (interest rate) effect Mundell-Fleming (exchange rate) effect price level consumers feel wealthier Encouraged to spend more larger quantity of goods and services demanded price level Lower domestic interest rate Firms encouraged to invest more greater spending on investment goods (domestic) price level Lower interest rate, capital goes abroad Exchange rate depreciates, gain in competitiveness increase in exports and decrease in imports, increase in net exports • Pigou’s effect (or real balance effect): Wealth P C AD P • Keynes’ effect (or interest rate effect): P M d Bonds d pBonds i I AD • Mundell-Fleming’s effect (or exchange rate effect): IMPORTS P competitiveness NX AD EXPORTS Shifts in the AD curve Anything that makes buyers more or less willing to buy goods and services for any given level of price shifts the AD curve. • Consumers, firms: exogenous changes in spending plans by consumers or firms (e.g. household savings before the Iraq war; pessimism after Lehman Bros bankruptcy) • Government: exogenous changes in fiscal, monetary and exchange rate policy Price P1 AD1 0 Y1 Y2 AD2 Output The multiplier: by how much AD shifts Extent of the AD shifts determined by size of multiplier Multiplier: process that makes initial increase in income bigger due to further increases in C and I triggered by initial increase in GDP Example: Suppose Govt raises defense spending G income of G producers consumption of G producers income of C producers and so on Total rightward shift of AD given by sum of all income increments If GDP very close to full employment, demand increase feeds into higher inflation and not Gdp gains Aggregate supply curve Preview of main arguments In the short run, the aggregate-supply curve is upward sloping In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services • The price level does not affect these variables in the long run Hence: In the long run, the aggregate-supply curve is vertical The short run AS curve In the short run • An increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied for given costs of production • A decrease in the level of prices tends to reduce the quantity of goods and services supplied (see picture) Price Level Short-run aggregate supply P1 P2 2. reduces the quantity of goods and services supplied in the short run 1. A decrease in the price level 0 Y2 Y1 Quantity of output Why the short run AS is upward sloping Price level Quantity of good supplied Keynesian sticky wages theory Aggregate price nominal wages do not fall immediately labor costs go up firms reduce production New classical New Keynesian sticky misperceptions theory prices theory Aggregate price Aggregate price producers temporarily some firms do not perceive it as a decline adjust their own price to in ‘their’ individual sale save on “menu costs” price sales reduced, hence decrease of goods and firms reduce production services supplied Bottom line: Experts’ opinions vary as to why, but – reassuringly - the SLOPE of the AS is anyway positive! Shifts in the short run AS curve AS1 Price AS2 P1 0 Y1 Y2 output Why AS might shift In a nutshell: Anything that shifts costs of production shifts AS AS shifts to the right if: • Imported or domestic input prices go down • Costs of production going up for given price, output to be cut • Factor productivity goes up (thanks to new technologies) • allows firms to produce more at a lower cost for an unchanged sale price • Government cuts distorting taxes and regulations hampering business practices • Reduction of social security contributions reduces labor costs; reduced tax on profits raises net profitability • Expectation of lower price level in the future • This feeds into lower wage claims and thus decrease labor costs today Implication: GDP gains due to AD shifts do not last long Let’s see why Short run AS drawn for given nominal wages As nominal wages change, short-run AS (entire curve) Why do wages change? Today’s P makes wage claims at next wage negotiation round So what happens? As AD shifts to the right, this also gives rise to P. This results in rising inflation expectation for the future Higher expected inflation raises wage claims Short run AS shifts to the left Short run AS keeps shifting leftwards until GDP above its long-run average Why AD-originated Gdp gains do not last: graphics P E’’ SRAS’ SRAS E’ E AD’ AD GDP Permanent GDP As a result: The long run AS curve is vertical at the natural rate of output. Price Level Long-run aggregate supply P2 P1 2. …does not affect the quantity of goods and services supplied in the long run. 1. A change in the price level… 0 Natural rate of output Quantity of Output Long run equilibrium The intersection of the AD curve and the long-run AS curve determines the economy’s equilibrium output and price level (E) • Output is at its natural rate • The short-run AS curve goes through the point of intersection Price Long-run AS Equilibrium Price Short-run AS E AD 0 Natural rate of output Output Now ready to study the causes of recessions There are two causes of recessions • AD shift to the left • AS shift to the left See them in turn Recession I: a leftward shift of AD A decrease in one of the determinants of AD shifts the curve to the left. Hence, (i) output falls below the natural rate of employment; (ii) unemployment rises, (iii) the price level falls Long-run AS Price AS1 AS2 A P1 3. …but over time, the short-run aggregate-supply curve shifts (B to C)… B P2 P3 1. A decrease in aggregate demand… C AD1 AD2 0 2. …causes output to fall in the short run (A to B)… Y2 Y1 4. …and output returns to its natural rate. Output Recession II: a leftward shift of AS A decrease in one of the determinants of AS shifts the curve to the left: hence, (i) output falls below the natural rate of employment; (ii) unemployment rises; (iii) the price level rises Long-run AS Price AS2 AS1 1. An adverse shift in the short-run AS curve… B P2 . 3. …and P1 the price to rise. A AD1 0 2. …causes output to fall… Y2 Y1 Output Recession II = Stagflation Adverse shifts in aggregate supply cause stagflation - a combination of recession and inflation • • • Output falls and prices go up Policymakers can influence the level of aggregate demand (by increasing public consumption), much less so the level of aggregate supply Hence, they cannot offset both adverse effects simultaneously How to read supply and demand shocks in the data: the US in the 1990s US economy 1991-93 1994-96 1997-00 2001-02 GDP growth 2.4 3.2 4.2 1.3 Inflation 3.2 2.7 2.6 1.7 1990s: GDP up & inflation down, symptom of positive supply shock 2001-02: both GDP & inflation down, symptom of negative demand shock 26