Aggregate Supply and Demand Ch.33 Aggregate Supply and Demand AGGREGATE DEMAND AND AGGREGATE SUPPLY

Introduction Over the long run, real GDP grows about 3% per year on average. In the short run, GDP fluctuates around its trend. Recessions: periods of falling real incomes and rising unemployment Depressions: severe recessions (very rare) Short-run economic fluctuations are often called business cycles. AGGREGATE DEMAND AND AGGREGATE SUPPLY 1

Three Facts About Economic Fluctuations FACT 1: Economic fluctuations are irregular and unpredictable. U.S. real GDP, billions of 2000 dollars The shaded bars are recessions Recessions (represented by the shaded bars) are of different durations and do not occur with any regularity. Hence, the common term “business cycle” is a bit misleading, as “cycle” implies something more regular and predictable. UNITS: Billions of chained 2000 dollars ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ SERIES: GDPC1 2 2

Three Facts About Economic Fluctuations FACT 2: Most macroeconomic quantities fluctuate together. Investment spending, billions of 2000 dollars Point out that investment falls during each recession. This is true of other variables as well: When the economy is in recession, incomes fall, consumer spending falls, profits fall, many stock prices fall, tax revenue falls (causing the budget deficit to rise), and spending on imports falls (causing the trade deficit to shrink). UNITS: Billions of chained 2000 dollars ORIGINAL SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ SERIES NAME: GPDIC1 3 3

Three Facts About Economic Fluctuations FACT 3: As output falls, unemployment rises. Unemployment rate, percent of labor force During each recession, the unemployment rate rises. When firms cut back on production, they don’t need as many workers. Similarly, during expansions, we see the unemployment rate falling – as firms increase their output, they need more workers. UNITS: Percent of labor force (seasonally adjusted) ORIGINAL SOURCE: U.S. Department of Labor, Bureau of Labor Statistics WEBSITE WHERE I FOUND THIS DATA: http://research.stlouisfed.org/fred2/ series “UNRATE” Note: The source data was monthly. To be consistent with Figure 1c of the text, I graphed quarterly data, where each quarterly value is a simple average of the three monthly values. 4 4

Introduction, continued Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. Most economists use the model of aggregate demand and aggregate supply to study fluctuations. This model differs from the classical economic theories economists use to explain the long run. AGGREGATE DEMAND AND AGGREGATE SUPPLY 5

Classical Economics—A Recap The previous chapters are based on the ideas of classical economics, especially: The Classical Dichotomy, the separation of variables into two groups: Real – quantities, relative prices Nominal – measured in terms of money The neutrality of money: Changes in the money supply affect nominal but not real variables. AGGREGATE DEMAND AND AGGREGATE SUPPLY 6

Classical Economics—A Recap Most economists believe classical theory describes the world in the long run, but not the short run. In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate). To study the short run, we use a new model. As in previous chapters, “u-rate” is short for unemployment rate. AGGREGATE DEMAND AND AGGREGATE SUPPLY 7

The Model of Aggregate Demand and Aggregate Supply P Y The price level AD SRAS “Short-Run Aggregate Supply” The model determines the eq’m price level P1 Y1 “Aggregate Demand” and eq’m output (real GDP). Real GDP, the quantity of output AGGREGATE DEMAND AND AGGREGATE SUPPLY 8

The Aggregate-Demand (AD) Curve P Y The AD curve shows the quantity of all g&s demanded in the economy at any given price level. AD P2 Y2 P1 Y1 As in previous chapters, “g&s” stands for “goods and services.” AGGREGATE DEMAND AND AGGREGATE SUPPLY 9

Why the AD Curve Slopes Downward Y = C + I + G + NX Assume G fixed by govt policy. To understand the slope of AD, must determine how a change in P affects C, I, and NX. P Y AD P2 Y2 P1 Y1 Y1 AGGREGATE DEMAND AND AGGREGATE SUPPLY 10

The Wealth Effect (P and C ) Suppose P rises. The dollars people hold buy fewer g&s, so real wealth is lower. People feel poorer. Result: C falls. AGGREGATE DEMAND AND AGGREGATE SUPPLY 11

The Interest-Rate Effect (P and I ) Suppose P rises. Buying g&s requires more dollars. To get these dollars, people sell bonds or other assets. This drives up interest rates. Result: I falls. (Recall, I depends negatively on interest rates.) AGGREGATE DEMAND AND AGGREGATE SUPPLY 12

The Exchange-Rate Effect (P and NX ) Suppose P rises. U.S. interest rates rise (the interest-rate effect). Foreign investors desire more U.S. bonds. Higher demand for $ in foreign exchange market. U.S. exchange rate appreciates. U.S. exports more expensive to people abroad, imports cheaper to U.S. residents. Result: NX falls. AGGREGATE DEMAND AND AGGREGATE SUPPLY 13

The Slope of the AD Curve: Summary An increase in P reduces the quantity of g&s demanded because: P Y P2 Y2 the wealth effect (C falls) P1 the interest-rate effect (I falls) AD the exchange-rate effect (NX falls) Y1 AGGREGATE DEMAND AND AGGREGATE SUPPLY 14

Why the AD Curve Might Shift Any event that changes C, I, G, or NX – except a change in P – will shift the AD curve. Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right. P Y AD2 AD1 P1 Y1 Y2 A change in P won’t shift the AD curve, but will cause a movement along the AD curve. AGGREGATE DEMAND AND AGGREGATE SUPPLY 15

Why the AD Curve Might Shift Changes in C Stock market boom/crash Preferences re: consumption/saving tradeoff Tax hikes/cuts Changes in I Firms buy new computers, equipment, factories Expectations, optimism/pessimism Interest rates, monetary policy Investment Tax Credit or other tax incentives AGGREGATE DEMAND AND AGGREGATE SUPPLY 16

Why the AD Curve Might Shift Changes in G Federal spending, e.g., defense State & local spending, e.g., roads, schools Changes in NX Booms/recessions in countries that buy our exports. Appreciation/depreciation resulting from international speculation in foreign exchange market AGGREGATE DEMAND AND AGGREGATE SUPPLY 17

The Aggregate-Demand curve What happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers’ wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains. 18

I falls, AD curve shifts left. Answers A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left. B. The U.S. exchange rate falls. NX rises, AD curve shifts right. C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect). D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right. 19

The Aggregate-Supply (AS) Curves The AS curve shows the total quantity of g&s firms produce and sell at any given price level. P Y LRAS SRAS AS is: upward-sloping in short run The slope of the AS curve depends on the time horizon: In the short run, the aggregate supply curve is upward-sloping. (“SR” = “short run”). In the long run, the aggregate supply curve is vertical. These slopes will be explained in the following slides. vertical in long run AGGREGATE DEMAND AND AGGREGATE SUPPLY 20

The Long-Run Aggregate-Supply Curve (LRAS) The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output or full-employment output. P Y LRAS The book does not use the notation YN. I use it here to keep the slides from getting too cluttered, and also to make it easier for students to take notes: it’s easier for them to write “YN” than “the natural rate of output.” YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 21

(Classical dichotomy) Why LRAS Is Vertical YN determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in P P Y LRAS P2 P1 does not affect any of these, so it does not affect YN. (Classical dichotomy) This is review from the chapter “Production and Growth.” YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 22

Why the LRAS Curve Might Shift P Y LRAS1 LRAS2 YN ’ Any event that changes any of the determinants of YN will shift LRAS. Example: Immigration increases L, causing YN to rise. YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 23

Why the LRAS Curve Might Shift Changes in L or natural rate of unemployment Immigration Baby-boomers retire Govt policies reduce natural u-rate Changes in K or H Investment in factories, equipment More people get college degrees Factories destroyed by a hurricane AGGREGATE DEMAND AND AGGREGATE SUPPLY 24

Why the LRAS Curve Might Shift Changes in natural resources Discovery of new mineral deposits Reduction in supply of imported oil Changing weather patterns that affect agricultural production Changes in technology Productivity improvements from technological progress AGGREGATE DEMAND AND AGGREGATE SUPPLY 25

Using AD & AS to Depict LR Growth and Inflation LRAS2000 Over the long run, tech. progress shifts LRAS to the right LRAS1990 P Y LRAS1980 AD2000 AD1990 and growth in the money supply shifts AD to the right. P2000 P1990 AD1980 P1980 Result: ongoing inflation and growth in output. In the following chapter, it will be more clear why money supply growth shifts the AD curve rightward. Y1980 Y1990 Y2000 AGGREGATE DEMAND AND AGGREGATE SUPPLY 26

Short Run Aggregate Supply (SRAS) The SRAS curve is upward sloping: Over the period of 1-2 years, an increase in P P Y SRAS P2 Y2 causes an increase in the quantity of g & s supplied. P1 Y1 AGGREGATE DEMAND AND AGGREGATE SUPPLY 27

Why the Slope of SRAS Matters LRAS P Y ADhi If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment. Phi SRAS Phi Yhi ADlo Plo Ylo If AS slopes up, then shifts in AD do affect output and employment. AD1 Plo Y1 AGGREGATE DEMAND AND AGGREGATE SUPPLY 28

Three Theories of SRAS In each, some type of market imperfection In each, some type of market imperfection result: Output deviates from its natural rate when the actual price level deviates from the price level people expected. AGGREGATE DEMAND AND AGGREGATE SUPPLY 29

1. The Sticky-Wage Theory Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly. Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. AGGREGATE DEMAND AND AGGREGATE SUPPLY 30

1. The Sticky-Wage Theory If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward. “If P > PE” means “If the actual price level turns out to be higher the price level firms had expected...” AGGREGATE DEMAND AND AGGREGATE SUPPLY 31

2. The Sticky-Price Theory Imperfection: Many prices are sticky in the short run. Due to menu costs, the costs of adjusting prices. Examples: cost of printing new menus, the time required to change price tags Firms set sticky prices in advance based on PE. AGGREGATE DEMAND AND AGGREGATE SUPPLY 32

2. The Sticky-Price Theory Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise. In the short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices. Meantime, their prices are relatively low, which increases demand for their products, so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward. AGGREGATE DEMAND AND AGGREGATE SUPPLY 33

3. The Misperceptions Theory Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping. Of the three theories, this one seems the least plausible. Firms certainly have a strong incentive to not mistake a general price increase for a relative price increase. And information about the price level is costless and available with only a short lag (especially the CPI, which is published monthly and very widely reported the moment it comes out). AGGREGATE DEMAND AND AGGREGATE SUPPLY 34

What the 3 Theories Have in Common: In all 3 theories, Y deviates from YN when P deviates from PE. Y = YN + a (P – PE) Output Natural rate of output (long-run) a > 0, measures how much Y responds to unexpected changes in P Actual price level Expected price level Economists debate which of these theories is correct. It’s possible that each of them contains some element of truth. For our purposes here, the similarities between these theories are more important than their differences: all three imply that output deviates from its long-run level (the “natural rate of output”) when the price level (P) deviates from the level people had expected (PE). AGGREGATE DEMAND AND AGGREGATE SUPPLY 35

What the 3 Theories Have in Common: Y = YN + a (P – PE) P Y When P > PE YN SRAS the expected price level PE When P < PE The preceding slide introduced an equation of aggregate supply that shows how output deviates from full-employment when the actual price level is different than expected. This slide illustrates these concepts using a graph. When P = PE, Y = YN When P < PE, Y < YN When P > PE, Y > YN Y < YN Y > YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 36

SRAS and LRAS The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible misperceptions are corrected In the LR, PE = P AS curve is vertical AGGREGATE DEMAND AND AGGREGATE SUPPLY 37

SRAS and LRAS Y = YN + a (P – PE) P LRAS SRAS In the long run, PE = P Y = YN + a (P – PE) P Y LRAS SRAS In the long run, PE = P and Y = YN. PE Notice that when the price level equals the expected price level, output is equal to its long-run value, the natural rate of output. Interpretation: In the short run, people may be fooled about the price level, or they may be locked into wages or prices that were set before they knew what the price level would actually be. Hence, in the short run, P may differ from PE. But in the long run, expectations catch up to reality, P = PE, and therefore Y = YN, as in the Classical model. Thus, our theory of economic fluctuations is basically the Classical model (which we studied for several chapters) augmented with some kind of market imperfection (such as sticky wages). The impact of the market imperfection occurs only in the short run, so the long-run behavior of our model is Classical. YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 38

Why the SRAS Curve Might Shift Everything that shifts LRAS shifts SRAS, too. Also, PE shifts SRAS: If PE rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left. P Y LRAS SRAS SRAS PE PE YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 39

The Long-Run Equilibrium In the long-run equilibrium, PE = P, Y = YN , and unemployment is at its natural rate. P Y LRAS SRAS PE AD YN AGGREGATE DEMAND AND AGGREGATE SUPPLY 40

Economic Fluctuations Caused by events that shift the AD and/or AS curves. Four steps to analyzing economic fluctuations: 1. Determine whether the event shifts AD or AS. 2. Determine whether curve shifts left or right. 3. Use AD-AS diagram to see how the shift changes Y and P in the short run. 4. Use AD-AS diagram to see how economy moves from new SR eq’m to new LR eq’m. This four-step approach is based on the three-step approach used in Chapter 4 to analyze changes in the basic supply & demand model. AGGREGATE DEMAND AND AGGREGATE SUPPLY 41

The Effects of a Shift in AD Event: Stock market crash 1. Affects C, AD curve 2. C falls, so AD shifts left 3. SR eq’m at B. P and Y lower, unemp higher 4. Over time, PE falls, SRAS shifts right, until LR eq’m at C. Y and unemp back at initial levels. P Y LRAS YN AD1 SRAS1 AD2 P1 A SRAS2 P2 Y2 B The results from this exercise apply to any event that shifts AD to the left, whether a stock market crash, recession abroad, wave of pessimism, or other. The stock market crash reduces consumers’ wealth, which depresses their spending. The AD curve shifts to the left. The new short-run equilibrium is at point B, where P and Y are lower, and hence unemployment is higher. (Remember Fact #3 about economic fluctuations: unemployment and output move in opposite directions.) At point B, P < PE. Over time, PE falls, wages fall, and sticky prices become flexible and fall. The SRAS curve moves rightward. This process continues until the economy arrives at point C, where GDP and unemployment are back at their natural rates, and PE = P once again. Notice that, in the absence of policy intervention, the economy “self-corrects.” Of course, this process takes time, and policymakers may not want to wait. At point B, policymakers could use fiscal or monetary policy to shift aggregate demand to the right and move the economy back to A. P3 C AGGREGATE DEMAND AND AGGREGATE SUPPLY 42

Two Big AD Shifts: 1. The Great Depression From 1929-1933, money supply fell 28% due to problems in banking system stock prices fell 90%, reducing C and I Y fell 27% P fell 22% u-rate rose from 3% to 25% U.S. Real GDP, billions of 2000 dollars Two possible causes of the Great Depression: the fall in the money supply, and the stock market crash. Either would shift the AD curve left, causing P and Y to fall and causing unemployment to rise. Data source: Bureau of Economic Analysis, U.S. Department of Commerce http://www.bea.doc.gov/bea/dn/home/gdp.htm AGGREGATE DEMAND AND AGGREGATE SUPPLY 43

Two Big AD Shifts: 2. The World War II Boom U.S. Real GDP, billions of 2000 dollars From 1939-1944, govt outlays rose from $9.1 billion to $91.3 billion Y rose 90% P rose 20% unemp fell from 17% to 1% This boom was clearly caused by a surge in govt spending. Our model predicts an increase in G would shift AD to the right, increasing P and Y, and reducing unemployment. These predictions are consistent with the data. Source for GDP data: Bureau of Economic Analysis, U.S. Department of Commerce http://www.bea.doc.gov/bea/dn/home/gdp.htm Source for data on government outlays: Economic Report of the President, 2005 edition, Table B-78. http://www.gpoaccess.gov/eop/ AGGREGATE DEMAND AND AGGREGATE SUPPLY 44

Working with the model Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a long-run equilibrium. A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. 45

Event: Boom in Canada Answers 1. Affects NX, AD curve Event: Boom in Canada 1. Affects NX, AD curve 2. Shifts AD right 3. SR eq’m at point B. P and Y higher, unemp lower 4. Over time, PE rises, SRAS shifts left, until LR eq’m at C. Y and unemp back at initial levels. P Y LRAS YN SRAS2 AD2 P3 C SRAS1 AD1 P2 Y2 B P1 A The boom in Canada increases the incomes of Canadian consumers. In turn, their spending rises. Some of their spending is on products from the U.S., so their spending increase causes U.S. exports to rise. This shifts the U.S. AD curve to the right. The new short-run equilibrium is at point B, where P and Y are higher, and hence unemployment is lower. At B, P > PE. Over time, PE rises, wages rise, and sticky prices become flexible and rise. The SRAS curve moves leftward. This process continues until the economy arrives at point C, where GDP and unemployment are back at their natural rates and expectations about P have caught up to reality. 46

The Effects of a Shift in SRAS Event: Oil prices rise 1. Increases costs, shifts SRAS (assume LRAS constant) 2. SRAS shifts left 3. SR eq’m at point B. P higher, Y lower, unemp higher From A to B, stagflation, a period of falling output and rising prices. P Y LRAS YN SRAS2 AD1 SRAS1 P2 Y2 B P1 A AGGREGATE DEMAND AND AGGREGATE SUPPLY 47

Accommodating an Adverse Shift in SRAS If policymakers do nothing, 4. Low employment causes wages to fall, SRAS shifts right, until LR eq’m at A. P Y LRAS YN SRAS2 AD2 P3 C AD1 SRAS1 P2 Y2 B Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to YN, but P permanently higher. P1 A AGGREGATE DEMAND AND AGGREGATE SUPPLY 48

The 1970s Oil Shocks and Their Effects 1973-75 1978-80 Real oil prices + 3.5 million – 0.7% + 21% + 138% + 1.4 million + 2.9% + 26% + 99% CPI Real GDP The first oil shock: 1973-75 Oil prices more than doubled in just two years, causing SRAS to shift leftward. As our model predicts, the price level rose, GDP fell, and unemployment rose. From 1975 to 1978, oil prices rose at less than the rate of inflation, the number of unemployed persons fell by 1.7 million, and real GDP grew by 16%. The economy was self-correcting. But just when things were getting better, the second oil shock hit. Oil prices doubled, due in part to a revolution in Iran in 1979. Again, as our model predicts, SRAS shifted left, inflation rose, and unemployment increased. The table shows that real GDP rose 2.9% during this period – but remember, this is not an annual rate, it is 2.9% for the entire period, which is substantially below the long-run average growth rate of about 3% per year. Data sources: CPI and unemployment: Bureau of Labor Statistics, http://www.bls.gov GDP and oil prices: FRED database, Federal Reserve Bank of St Louis, http://research.stlouisfed.org/fred2/ # of unemployed persons AGGREGATE DEMAND AND AGGREGATE SUPPLY 49

John Maynard Keynes, 1883-1946 The General Theory of Employment, Interest, and Money, 1936 Argued recessions and depressions can result from inadequate demand; policymakers should shift AD. Famous critique of classical theory: The long run is a misleading guide to current affairs. In the long run, we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat. AGGREGATE DEMAND AND AGGREGATE SUPPLY 50