MACROECONOMIC EQUILIBRIUM: AD – AS MODEL Aggregate demand Aggregate supply Macroeconomic equilibrium and shifts of AD and AS

1. Aggregate demand (AD) and its features Aggregate demand is the total demand for final goods and services in the economy (Y) at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is often abbreviated as 'AD'.

AD includes: Investment spending of private firms – I Consumption spending of households – С Investment spending of private firms – I Government spending – G Net export – NX (= X – M) so AD = C + I + G + NX AD curve illustrates how the volume of output varies with price level

AD curve The aggregate demand curve is downward sloping: real balances effect - a fall in the price level increase the purchasing power of consumers' wealth so consumption spending rises. The most obvious explanation for the downward slope of the aggregate demand curve is that cheaper prices make money more valuable. It means, that the real value of money is measured by how many goods and services each dollar will buy. In this respect, lower prices make you richer - you can buy more goods. Lower prices increase your wealth. That mean, that you feel less need to save and prefer to buy more goods and services. Thus the aggregate demand curve slopes downward to the right.

AD curve The aggregate demand curve is downward sloping: foreign purchases effect - a fall in the price level makes domestic goods relatively cheaper compared to foreign goods so imports fall and exports rise. The downward slope of the aggregate demand curve is reinforced by changes in imports and exports. Consumers have the option of buying either domestic or foreign goods. An important factor in choosing between imported or domestic goods is their relative price.

AD curve The aggregate demand curve is downward sloping: interest rate effect - a fall in the price level reduces the inflation rate so interest rates fall, meaning that any spending that is interest rate sensitive such as consumption and investment spending rises. Changes in the price level also affect the amount of money people need to borrow, and so tend to affect interest rates. At lower price levels, consumer borrowing needs are smaller. If the demand for loans decreases, interest rates tend to decline as well. This "cheaper" money stimulates more borrowing and loan-financed purchases.

AD curve General Price level AD Real GDP

Factors for AD shifts taxes a reduction in taxes leaves households with more disposable income so consumption spending rises   → AD increases and the AD curve shifts up to the right a tax increase leaves households with less disposable income to spend   → AD decreases and the AD curve shifts down to the left

Factors for AD shifts interest rates lower interest rates decrease the cost of borrowing money so households and business borrow more to spend and invest in new capital → AD curve shifts up to the right higher interest rates make money more expensive for households and businesses to borrow so consumption and investment spending fall   → AD curve shifts down to the left

Factors for AD shifts consumer and business confidence more optimistic   → AD curve shifts up to the right more pessimistic   → AD curve shifts down to the left government spending government spending is one of the components of aggregate demand so an increase in government spending causes AD to increase   → AD curve shifts up to the right decrease in government spending   → AD curve shifts down to the left

Factors for AD shifts strength of the currency a rise in the value of the national currency increases imports and reduces exports  →  AD curve shifts down to the left a fall in the value of the national currency lowers imports and increases exports  → AD curve shifts up to the left

2. Aggregate supply (AS) Aggregate supply is the total supply of goods and services produced by a national economy during a specific time period. It is the total amount of goods and services in the economy available at all possible price levels. The aggregate supply curve is upward sloping over much of its relevant range. Higher output prices have an opposite effect. Because many costs are relatively constant in the short run, higher prices for goods and services tend to increase profit. In this case, producers want to produce and sell more goods. Thus we expect the rate of output to increase when the price level rises.

2. Aggregate supply (AS) The form of Aggregate supply curve is totally dependent on the statements of mainstream economic theories: Classical against Keynesian. According to the Classical view, the economy "self-adjusts" to deviations from its long-term growth trend. The corner stones of Classical optimism were flexible prices and flexible wages. If producers were unable to sell all their output at current prices, they had two choices – 1) they could reduce the rate of output and throw some people out of work or   2) they could reduce the price of their output, stimulating an increase in the quantity demanded. According to the law of demand, price reductions cause an increase in unit sales. If prices fall far enough, all the output produced can be sold. Thus, flexible prices - prices that would quickly react for consumer demand slow - virtually guaranteed that all output could be sold. No one would have to lose a job because of weak consumer demand.

2. Aggregate supply (AS) Flexible prices had their counterpart in factor markets. If some workers were temporarily out of work, they would compete for jobs by offering their services at lower wages. As wage rates declined, producers would find it profitable to hire more workers. Ultimately, flexible wages would ensure that everyone who wanted a job would have a job. These optimistic views of the macro economy were summarized in Say's Law. Say's Law - named after the nineteenth-century economist Jean-Baptiste Say - states that "supply creates its own demand." Whatever was produced would be sold. All workers who seek for a job will be hired. Unsold goods and unemployed labor could arise in this Classical system. But both will disappear as soon as people have time to adjust prices and wages.

2. Aggregate supply (AS) The Keynesian Revolution. Keynes has developed an alternative view of the macro economy. Whereas the Classical economists, Keynes asserted that the private economy was inherently unstable. Small changes in output, prices, or unemployment were likely to be enlarged, not eliminated by the invisible hand of the market. Keynes said that the Great Depression was not a unique event. Macro failure was the rule, not the exception, for a purely private economy. The inherent instability of the marketplace required government intervention. When the economy falters, we cannot afford to wait for some assumed self-adjustment mechanism but must do something to protect our jobs and income. The government can do this by buying more output, employing more people, providing more income transfers, and making more money available. When the economy overheats, the government must cool it down with higher taxes, spending reductions, and less money. Keynes's criticism of the Classical theory did not stop the macroeconomic debates. On the contrary, economists continue the fights about the stability of the economy.

2. Aggregate supply (AS) Modern Views of Macro Instability To determine how the government should try to control the business cycle, we first need to understand its origins. What causes the economy to expand or contract? What forces of the market dampen ("self-adjust") or magnify economic swings?

2. Aggregate supply (AS) The primary outcomes of the macro-economy are on the right side of the figure. These basic macro outcomes include: • Output: total volume of goods and services produced • Jobs: levels of employment and unemployment • Prices: average price of goods and services • Growth: year-to-year expansion in production capacity • International balances: trade and payments balances with other countries.  These macro outcomes define our economic welfare. That is to say, we measure our economic well-being in terms of the volume of output produced, the number of jobs created, price stability, and the rate of economic expansion. We also seek to maintain a certain balance in our international trade and financial relations. The performance of the economy is rated by the "scores" on these five macro outcomes.

Three determinants of macro performance include: • Internal market forces: population growth, spending behaviour, invention and innovation, etc. • External shocks: wars, natural disasters, trade disruptions, etc. • Policy levers: tax policy, government spending, changes in the availability of money, credit regulation, for example  In the absence of external shocks or government policy, an economy would still function - it still produce output, create jobs, develop prices and maybe even grow. Even today, many less-developed countries and areas operate in relative isolation from government or international events. In these situations, macro outcomes depend only on internal market forces. Keynes argued that policy levers were both effective and necessary. Without such intervention, he believed the economy was doomed (обрекать) to repeated macro failure. Modern economists hesitate to give policy intervention that great role. All economists recognize that policy intervention affects macro outcomes. But there are great arguments about just how effective any policy lever is.

Aggregate supply

Aggregate supply also is highly connected with the period of economic activities. The short-run period is characterized by inelastic supply, as it is impossible to raise production without additional investments and enlarging of productivity factors (e.g. buildings, machinery and innovative equipment). Finally, in this period economy could operate at not optimal level. It includes unemployment, average demand deficit and downtime. The long-run period is characterized by very elastic supply limited the PPF only. In situation of full usage of resources, GDP real = GDP natural = GDP maximal (potential output), so economy works perfectly and have no abilities to raise output (in stable recourses quantity and technology). Intermediate range is the part of short-run range of AS curve reasoned by the rule of diminishing marginal revenue: when output is expanded beyond this range the diminishing returns and rising marginal costs occur which ultimately cause the aggregate supply curve to slope upward gently.

AS curve General Price level 1 – Keynesian (short-run) range 2 – Classical (long-run) range 3 – Intermediate range Qf – GDP potential if cycle unemployment = 0 2 3 1 Qf Real GDP

3. Macroeconomic equilibrium Macroeconomic equilibrium is an economic state in an economy where the quantity of aggregate demand equals the quantity of aggregate supply. Significant changes in either aggregate demand or aggregate supply will have important effects on price, unemployment, and inflation. As there is difference between the long-run and the short run aggregate supply curves, the long-run equilibrium differs from the short-run macroeconomic equilibrium. While long-run equilibrium is the state towards which the economy is moving, short-run equilibrium is the actual state of the economy in the short run as it fluctuates around potential GDP.

Short-run Macroeconomic Equilibrium: Short-run macroeconomic equilibrium occurs at the price level at which aggregate output demanded equals aggregate supply of output. That is, short-run equilibrium is reached at the price level at which aggregate demand curve AD intersects the short-run aggregate supply curve SAS. This is shown in Figure (next slide), where AD is the aggregate demand curve and SAS is the short-run aggregate supply curve. It will be seen that the short-run macroeconomic equilibrium occurs at point E at which the price level is P0 and the real GDP is Y0. If price level is different from P0, the economy will not be in equilibrium. Suppose, for example, price level is P2, the quantity P2A of the real GDP demanded at P2 is less than the quantity P2 B of real GDP supplied. This means the firms will not be able to sell all their output.

Short-run Macroeconomic Equilibrium: It is worthwhile to note that in the short run the money wage rate is fixed. It does not adjust to bring macro-equilibrium at full-employment level of real GDP. Thus, in the short run macro- equilibrium can be attained with real GDP less than or greater than potential GDP (i.e. the level of GDP at which there is full employment of labour) depending on the level of aggregate demand. It is only in the long run when money wage rate adjusts that equilibrium is restored at potential GDP. As Keynes emphasized, the equilibrium between aggregate demand and aggregate supply may not necessarily be at full-employment level. Besides, when the economy is working at the level of full productive capacity, the increase in aggregate demand will lead to inflation in the economy.

General Macroeconomic Equilibrium: Equilibrium is the situation where there is no tendency for change. The economy can be in equilibrium at any level of economic activity that is a high level (boom) or a low level (recession). Due to the size of many modern economies, equilibrium is a very temporary state, as changing variables shift affect the economy.

Disequilibrium Two potential problems with macro equilibrium are Undesirability: The price-output relationship at equilibrium may not satisfy our macroeconomic goals. Instability: Even if the indicated macro equilibrium is optimal, it may be displaced by macro disturbances.  Undesirability. The macro equilibrium is simply an intersection of two curves. All we know for sure is that people want to buy the same quantity that businesses want to sell at the price level Pe. This quantity (Qe) may be more or less than our full-employment capacity. The output level represents our full-employment potential. In this case, the equilibrium rate of output (Qe) falls far short of capacity production. We have failed to achieve our goal of full employment. Similar problems may arise from the equilibrium price level. Suppose that Pa represents the most desired price level. If market behavior determines prices, the price level will rise above the desired level. The resulting increase in average prices is what we call inflation.

Disequilibrium Instability. Imagine that macro equilibrium yielded the optimal levels of both employment and prices, satisfying our two main macroeconomic goals. If this happened, could we stop worry about the state of the economy? Unfortunately, even “perfect” macro equilibrium doesn't ensure a happy end. The aggregate supply and demand curves that bring us macro “happiness” are not permanently locked into their positions. They can shift - and they will, whenever the behavior of buyers and sellers changes.