Eco 6351 Economics for Managers Chapter 11a. Aggregate Supply and Demand Prof. Vera Adamchik

The macro economy DETERMINANTSOUTCOMES MACRO ECONOMY Policy levers Internal market forces External shocks Output Jobs Prices Growth International balances

Macro view The determinants of macro performance include: Internal market forces — Population growth, spending behavior, invention and innovation, and the like. External shocks — Wars, natural disasters, trade disruptions, and so on. Policy levers — Tax policy, government spending changes in the availability of money, and regulation.

Potential GDP The quantity of real GDP supplied when unemployment is at its natural rate and there is full employment is called potential real GDP. Over the business cycle, employment fluctuates around full employment and real GDP fluctuates around potential GDP.

Two time horizons To study the economy at full employment and over the business cycle, we distinguish two time frames: - the macroeconomic long run, - the macroeconomic short run.

The macroeconomic long run is a time frame that is sufficiently long for economic forces to bring real GDP to potential (full-employment) GDP. The macroeconomic short run is a period during which real GDP has fallen below or risen above potential GDP. At the same time, the unemployment rate has risen above or fallen below the natural rate.

The Aggregate Supply- Aggregate Demand model The AS-AD model enables us to understand three features of macroeconomic performance: Growth of potential GDP Inflation Business cycle fluctuations

Long-run aggregate supply The long-run aggregate supply is vertical because potential GDP is independent of the price level. A movement along the LRAS is accompanied by a change in two sets of prices: the prices of goods and services and the prices of productive resources. When relative prices remain constant, real GDP also remains constant.

REAL OUTPUT (quantity per year) PRICE LEVEL (average price) Long Run Aggregate Supply Long-run aggregate supply Potential (Full Employment) GDP

Aggregate demand Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. This relationship between the quantity of real GDP demanded and the price level is called aggregate demand.

Aggregate demand The AD curve is the relationship between the quantity of real GDP demanded and the price level in a given time-period, ceteris paribus. The AD curve is downward-sloping: the higher the price level, the smaller is the quantity of real GDP demanded. Reasons: real balances effect, foreign trade effect, interest rate effect.

REAL OUTPUT (quantity per year) PRICE LEVEL (average price) Aggregate demand Highe r prices Lowe r prices Less output demanded More output demanded Aggregate demand

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 is stable because of its ability to self-adjust. The cornerstones of the Classical Theory are flexible prices and flexible wages. According to Classical economists, government intervention in a self- adjusting macroeconomy is unnecessary.

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

The Great Depression The Great Depression ( ) was a stunning blow to Classical economists. In the Depression’s worst year, 1933, the production of U.S. farms, factories, shops, and offices was only 70 percent of its 1929 level and 25 percent of the labor force was unemployed. The science of economics had no solutions to the Great Depression.

Inflation and Unemployment, 1900 – 1940 ANNUAL RATE OF INFLATION OR UNEMPLOYMENT (percent) – 8 – Prices Unemployment

The Keynesian revolution John Maynard Keynes provided an alternative to the Classical Theory. In 1936, Keynes published The General Theory of Employment, Interest, and Money.

Keynes asserted that the private economy was inherently unstable. No self-adjustment. In Keynes’ view, the inherent instability of the marketplace required government intervention (“Policy levers”).

Keynes focused primarily on the short term. He wanted to cure an immediate problem almost regardless of the long- term consequences of the cure. “In the long run,” said Keynes, “we’re all dead.” Keynes believed that after his cure for depression had restored the economy to a normal condition, the long-term problems of inflation and slow economic growth will return.

Short-run aggregate supply The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in a given time-period, ceteris paribus. That is, when the money wage rate and other resource prices remain constant.

Short-run aggregate supply The aggregate supply curve is upward- sloping: the output increases when price level rises. The aggregate supply curve is relatively flat when capacity is underutilized. It begins to slope upward as producers approach capacity.

Shape of the SRAS curve Short-Run Aggregate Supply (SRAS) has three segments or ranges: –Horizontal range (Keynesian segment), –Intermediate (Upward-sloping) range, –Vertical range (Classical segment)

Short-run aggregate supply Price level Real domestic output, GDP Q P Horizontal range Upward-sloping or intermediate range Vertical range

Macroeconomic equilibrium Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied.

Macroeconomic equilibrium in the long run and the short run

Price Level Real Domestic Output, GDP Q P SRAS AD Equilibrium in the Horizontal Range QeQe Q1Q1 Q2Q2 Macro-equilibrium: Real output and the price level PePe

Price Level Real Domestic Output, GDP Q P SRAS AD Equilibrium in the Intermediate Range QeQe Q1Q1 Q2Q2 Macro-equilibrium: Real output and the price level P1P1 PePe

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 Undesirable Outcomes: –Unemployment –Recession –Inflation

Three types of short-run macroeconomic equilibrium (1) below full-employment equilibrium (real GDP is less than potential GDP and there is a recessionary gap); (2) above full-employment equilibrium (real GDP exceeds potential GDP and there is an inflationary gap); (3) at full-employment equilibrium (real GDP equals potential GDP).

E QEQE PEPE Aggregate demand Full employment Equilibriu m output Aggregate supply PRICE LEVEL (average price) REAL OUTPUT (quantity per year) QFQF P* F Below FE equilibrium

Macro failure Instability — even if designated macro equilibrium is optimal, it may be displaced by macro disturbances. Shifts in aggregate supply and aggregate demand can upset a full employment equilibrium.

Recurrent shifts Business cycles are a result of recurrent shifts of the aggregate supply and demand curves. There are lots of reasons to expect aggregate supply and aggregate to shift.

F P2P2 P* Q2Q2 QFQF AS 0 (b) Demand shifts H AD 0 AD 1 G F P1P1 P* Q1Q1 QFQF AD 0 AS 1 AS 0 PRICE LEVEL (average price) REAL OUTPUT (quantity per year) PRICE LEVEL (average price) REAL OUTPUT (quantity per year) (a) Supply shifts Macro disturbances

E1E1 AD 0 AD 1 Q1Q1 QFQF REAL OUTPUT (quantity per year) PRICE LEVEL (average price) E0E0 AS 0 Origins of a recession: Demand shifts

AS 0 E2E2 Q2Q2 QFQF E0E0 AD 0 REAL OUTPUT (quantity per year) PRICE LEVEL (average price) AS 1 Origins of a recession: Supply shifts

E3E3 AS 1 Q3Q3 QFQF AS 0 AD 0 AD 1 E0E0 REAL OUTPUT (quantity per year) PRICE LEVEL (average price) Origins of a recession: Supply and demand shift