Aggregate Supply and Demand

Macro View Macroeconomics is the study of the aggregate economic behavior of the economy as a whole.

Macro Outcomes The basic macro outcomes include: Output — The total volume of goods and services produced (real GDP). Jobs — The levels of employment and unemployment.

Macro Outcomes The basic macro outcomes include: Prices — The average price of goods and services. Growth — The year-to-year expansion in production capacity.

Macro Outcomes The basic macro outcomes include: International balances — The international value of the dollar, trade, and payment balances with other countries

Macro Determinants The determinants of macro performance include: Internal market forces — Population growth, spending behavior, invention and innovation, and the like.

Macro Determinants The determinants of macro performance include: External shocks — Wars, natural disasters, trade disruptions, and so on.

Macro Determinants The determinants of macro performance include: Policy levers — Tax policy, government spending, changes in the availability of money, and regulation.

The Macro Economy MACRO ECONOMY DETERMINANTS OUTCOMES Jobs Output Jobs Prices Growth International balances Policy levers Internal market forces External shocks MACRO ECONOMY

Stable or Unstable The central concern of macroeconomic theory is whether the internal forces of the marketplace will generate desired outcomes.

Classical Theory Prevalent theory prior to the 1930s. The economy self-adjusts to deviations from its long-term growth.

Self Adjustment The cornerstones of the Classical Theory are flexible wages and flexible prices.

Flexible Prices Flexible prices virtually guarantee that all output could be sold. No one would lose a job because of weak demand.

Flexible Wages Flexible wages ensure that everyone who wants a job would have a job.

Say’s Law According to Say’s Law, supply creates its own demand. Unsold goods will ultimately be sold when buyers and sellers find an acceptable price.

Say’s Law In the labor market, some people will be unemployed, but can find new jobs if they are willing to accept lower wages.

Say’s Law According to Classical economists, government intervention in a self-adjusting macro economy is unnecessary.

Inflation and Unemployment, 1900 – 1940 ANNUAL RATE OF INFLATION OR UNEMPLOYMENT (percent) 1900 1910 1920 1930 1940 – 8 – 4 4 8 12 16 20 24 Unemployment Prices

The Keynesian Revolution The Great Depression was a stunning blow to Classical economists. John Maynard Keynes provided an alternative to the Classical Theory.

The Keynesian Revolution Keynes argued that the Great Depression was not a unique event. It would recur if reliance on the market to “self-adjust” continued.

No Self-Adjustment Keynes asserted that the private economy was inherently unstable. This instability requires government intervention. Policy levers are necessary and effective.

The Aggregate Supply-Demand Model Any influence on macro outcomes must be transmitted through supply or demand.

Aggregate Demand Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Real GDP (Output) Real GDP is the inflation-adjusted value of GDP. It is the value of output in constant prices.

Price Level The aggregate demand curve illustrates how the volume of purchases varies with average prices. Purchases of real output increase as average prices fall.

Aggregate Demand Curve The AD is downward sloping for three reasons: Real balances effect Foreign trade effect Interest-rate effect

Real Balances Effect The real value of money balances is measured by how many goods and services each dollar will buy. As prices fall, money balances can purchase more goods.

Foreign Trade Effect If domestic prices decline consumers demand more domestic output and fewer imports.

Interest-Rate Effect At lower price levels, interest rates fall as consumers borrow less. Lower interest rates stimulate borrowing and loan-financed purchases.

Aggregate Demand Higher prices Lower prices Aggregate demand REAL OUTPUT (quantity per year) PRICE LEVEL (average price) Higher prices Lower prices Aggregate demand Less output demanded More output demanded

Aggregate Supply The total quantity of output producers are willing and able to supply at alternative price levels in a given time-period, ceteris paribus.

Aggregate Supply The aggregate supply curve is upward-sloping. We expect the rate of output to increases when price level rises.

Profit Margins Producers’ short-run costs, like rent and negotiated wages, are relatively constant. Higher product prices tend to widen their profit margins. They will want to produce and sell more.

Costs Production costs tend to increase as producers try to produce more. They must acquire more resources and use existing plant and equipment more intensively.

Costs The aggregate supply curve is relatively flat when capacity is underutilized. It begins to slope upward as producers approach capacity.

Aggregate Supply Higher prices Aggregate supply More output supplied PRICE LEVEL (average price) REAL OUTPUT (quantity per year) Higher prices Aggregate supply More output supplied

Macro Equilibrium Aggregate supply and demand curves summarize the market activity of the whole (macro) economy.

Macro Equilibrium Macro equilibrium – the combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

Macro Equilibrium It is the only price-output combination mutually compatible with both buyers’ and sellers’ intentions.

Macro Equilibrium Aggregate supply PRICE LEVEL (average price) E PE Aggregate demand QE REAL OUTPUT (quantity per year)

Disequilibrium If the price level is higher than at equilibrium, buyers will want to buy less than producers want to produce and sell.

Macro Disequilibrium PRICE LEVEL (average price) REAL OUTPUT (quantity per year) Aggregate supply P1 E PE Aggregate demand D1 QE S1

Macro Failure There are two potential problems with macro equilibrium — undesirability and instability.

Macro Failure Undesirability — the price-output relationship at equilibrium may not satisfy our macroeconomic goals.

Macro Failure Instability — even if designated macro equilibrium is optimal, it may be displaced by macro disturbances.

Undesirable Outcomes Unemployment — the inability of labor-force participants to find jobs. Inflation — an increase in the average level of prices of goods and services

An Undesired Equilibrium PRICE LEVEL (average price) REAL OUTPUT (quantity per year) Aggregate demand Aggregate supply Unemployment arises when QE< QF E PE F P* Equilibrium output Full employment QE QF

Unstable Outcomes Shifts in aggregate supply and aggregate demand can upset a full employment equilibrium.

Shifts in Aggregate Supply A leftward shift of aggregate supply results in higher prices and less output.

Shifts in Aggregate Demand A leftward shift of aggregate demand results in less output.

Recurrent Shifts Business cycles are a result of recurrent shifts of the aggregate supply and demand curves. Business cycles are alternating periods of economic growth and contraction.

Macro Disturbances (a) Supply shifts (b) Demand shifts AS1 AS0 AS0 AD0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) AS1 AS0 AS0 AD0 G P1 F F P* P* H P2 AD0 AD1 Q1 QF Q2 QF

Shift Factors There are lots of reasons to expect aggregate supply and aggregate to shift.

Demand Shifts The aggregate demand curve might shift as a result of changes in: Consumer sentiment. Taxes on consumer income. Interest rates.

Supply Shifts Price or availability of raw materials. Business tax changes. Environmental and work place regulations.

Competing Theories of Short-Run Instability Economists are not in complete agreement about how to achieve desired macro outcomes.

Competing Theories of Short-Run Instability Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them.

Demand-Side Theories Keynesian Theory Monetary Theories

Keynesian Theory Keynes argues that if people demand a product, producers will supply it. If aggregate spending isn't sufficient, some goods will remain unsold and some production capacity will be idled.

Keynesian Theory Keynesian theory urges increased government spending or tax cuts as mechanisms for increasing aggregate demand.

Monetary Theories Monetary theories focus on the control of money and interest rates as mechanisms for shifting the aggregate demand curve.

Monetary Theories Money and credit affect the ability and willingness of people to buy goods and services.

Monetary Theories If right amount of money is not available, aggregate demand may be too small. High interest rates decrease aggregate demand.

Supply-Side Theories A decline in aggregate supply causes output and employment to fall. The focus of supply-side theories is to get more output by shifting the AS curve to the right.

Eclectic Explanations Shifts in both supply and demand curves may occur.

Origins of a Recession: Demand Shifts REAL OUTPUT (quantity per year) PRICE LEVEL (average price) AS0 E0 E1 AD0 AD1 Q1 QF

Origins of a Recession: Supply Shifts REAL OUTPUT (quantity per year) PRICE LEVEL (average price) AS1 AS0 E2 E0 AD0 Q2 QF

Origins of a Recession: Supply and Demand Shifts REAL OUTPUT (quantity per year) PRICE LEVEL (average price) AS1 AS0 E3 E0 AD0 AD1 Q3 QF

Policy Options The government has three policy options: Shift the aggregate demand curve. Shift the aggregate supply curve. Do nothing.

Fiscal Policy Fiscal policy is the use of government taxes and spending to alter macro-economic outcomes. Fiscal policy is conducted by Congress and the President.

Monetary Policy Monetary policy is the use of money and credit controls to influence macro-economic activity. The Federal Reserve is regulatory body that controls supply of money.

Supply-Side Policy Supply-side policies seek to increase the ability and willingness to produce goods and services.

Supply-Side Policy Supply-side policies include cutting tax rates, deregulation, and other production enhancing mechanisms.

The Changing Choice of Policy Levers A do nothing approach prevailed until the Great Depression. The Great Depression spurred a desire for a more active government role.

The Changing Choice of Policy Levers: 1960s Fiscal policy dominated the economic debate in the 1960s. The promise of fiscal policy was tarnished by its failure to control inflation in the late 1960s.

The Changing Choice of Policy Levers: 1970s Monetary policy dominated macro policy in the 1970s. The heavy reliance on monetary policy ended with a recession in the late 1970s.

The Changing Choice of Policy Levers: 1980s Supply-side policies prevailed in 1980’s with Ronald Reagan.

The Changing Choice of Policy Levers: 1990s The George H. Bush administration pursued a less activist approach in the early 1990s. Bill Clinton pursued a contractionary fiscal policy in the mid-1990s. This fiscal policy retreat cleared the way for a reemergence of monetary policy.

Current Policy The fiscal restraint of the late 1990's helped the federal budget move from deficits to surpluses.

Current Policy In 2001, 2002, and 2003 Congress cut taxes in an attempt to deal with a recession.

Aggregate Supply and Demand End of Chapter 11