Ch. 7: Aggregate Demand and Supply Aggregate supply Aggregate demand Macroeconomic equilibrium. Effects of changes in aggregate supply and aggregate demand on economic growth, inflation, and business cycles Explain U.S. economic growth, inflation, and business cycles by using the AS-AD model. Economists as a group are ambivalent about the aggregate supply-aggregate demand (AS-AD) model. Real business cycle theorists, who like to build their models from the base of production functions and preferences, don’t use the model because the AS and AD curves are not independent. Technological change shifts both the AS and AD curves simultaneously and in complicated ways. New Keynesian economists have dropped the model in favor of a dynamic variant that places the inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of potential GDP) on the x-axis. Despite attacks on the model from both sides of the doctrinal spectrum, those of us who spend a good part of our professional lives teaching the principles course recognize the AS-AD model as the key macroeconomic model. For us, the model plays a similar role in the organization of the macroeconomics to that played by the demand and supply model in microeconomics. That is the view taken in this textbook. The AS-AD model is the best model currently available for introducing students to macroeconomics. It enables them to gain insights into the way the economy works, to organize their study of the subject, and to understand the debates surrounding the effects of policies designed to improve macroeconomic performance. Devoting about a week of lecture time to the AS-AD model is worthwhile. At this point the students don’t yet have the background to appreciate all the details that go into the AD and AS curves. But they are able to grasp the basic purpose of the model. Your goal at this point in the course is to help them understand the components of the model intuitively and to put the model to work using some of its more simple and obvious features. (The situation is very similar to that at the beginning of the microeconomics sequence when you teach demand and supply At that stage, the students don’t know about the consumer problem that lies behind the demand curve and the model of perfect competition that lies behind the supply curve when they study demand and supply at the beginning of their microeconomics course. But they can appreciate the intuition on the demand and supply curves and use the model to generate predictions.)

Aggregate Supply Aggregate Supply Fundamentals Long-run aggregate supply Short-run aggregate supply

Aggregate Supply Long-Run Aggregate Supply (LRAS) relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. Position of LRAS determined by Labor supply Labor demand Production function The flavor of the Classical-Keynesian controversy. The textbook doesn’t introduce the controversies in macroeconomics until it gets to the business cycle and policy debate in Chapters 30(15) and 31(16). But if you want to convey the flavor of the biggest controversy in macroeconomics earlier in the course, you can do so right now, using only the aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly. Along the LAS curve—two things happening. Students seem comfortable with the idea that the SAS curve has a positive slope; but they seem less at ease with the vertical LAS curve. Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate. Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified.

The combination of the labor market equilibrium and the production function determine the potential level of GDP and the position of the LRAS

Aggregate Supply The LAS curve is vertical because potential GDP is independent of the price level. Along the LAS curve all input and output prices vary by the same percentage so that relative prices and the real wage rate remain constant.

Aggregate Supply How will each of the following affect the position of the LAS curve? increase in labor supply Increase in labor demand Upward shift of the production function

Aggregate Supply Short-Run Aggregate Supply (SRAS) The macroeconomic short run a period during which some prices have not adjusted to the long run equilibrium real GDP may fall below or rise above potential GDP. the unemployment rate may rise above or fall below the natural unemployment rate. SRAS is the relationship between the quantity of real GDP supplied and the price level in the short-run when the money wage rate, the prices of other resources, and potential GDP remain constant. The flavor of the Classical-Keynesian controversy. The textbook doesn’t introduce the controversies in macroeconomics until it gets to the business cycle and policy debate in Chapters 30(15) and 31(16). But if you want to convey the flavor of the biggest controversy in macroeconomics earlier in the course, you can do so right now, using only the aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly. Along the LAS curve—two things happening. Students seem comfortable with the idea that the SAS curve has a positive slope; but they seem less at ease with the vertical LAS curve. Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate. Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified.

Aggregate Supply Along the SAS curve, a rise in the price level with no change in the money wage rate and other input prices increases the quantity of real GDP supplied—the SAS curve is upward sloping.

Aggregate Supply The SAS curve is upward sloping because: If money wage is fixed, as price level rises, real wage falls and firms hire more workers. If P=105 SAS=LAS labor market in equilibrium Unemployment rate=natural rate No pressure on real wages One LAS curve-many SAS curves. Another way of reinforcing the distinction between the two AS curves is to point out to students that at any given time, there is just one LAS curve, corresponding to potential GDP. But there is an infinite number of possible SAS curves, each corresponding to a different money wage rate.

Aggregate Supply If P>105 If P<105 SAS>LAS real wage < equilibrium Shortage of labor Unempl<natural rate Upward pressure on real wages If P<105 SAS<LAS real wage > equilibrium surplus of labor Unempl>natural rate Downward pressure on real wages One LAS curve-many SAS curves. Another way of reinforcing the distinction between the two AS curves is to point out to students that at any given time, there is just one LAS curve, corresponding to potential GDP. But there is an infinite number of possible SAS curves, each corresponding to a different money wage rate.

Aggregate Supply Movement along the LAS and SAS Curves A change in the price level with no change in the money wage causes a movement along the SAS curve.

Aggregate Supply If real wage<equilibrium: Real wages rise in long run SAS shifts left If real wage>equilibrium: Real wages fall in long run SAS shifts right

Aggregate Supply Changes in Aggregate Supply When potential GDP increases, both the LRAS and SRAS curves shift rightward. Sources of change in Potential GDP Change in the full-employment quantity of labor. Change in the quantity of capital (physical or human). Advance in technology.

Same as expenditure side of GDP Aggregate Demand AD = C + I + G + X – M. Same as expenditure side of GDP C=consumption expenditures I= investment G= government purchases, X – M = net exports Keep it simple. You know that the AD curve is a subtle object—an equilibrium relationship derived from simultaneous equilibrium in the goods market and the money market. This description of the AD curve is not helpful to students in the principles course and is a topic for the intermediate macro course. At the same time that we want to simplify the AD story, we also want to avoid being misleading. The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of AD. Not a strict ceteris paribus event. A major problem with the AD curve is that a change in the price level that brings a movement along the curve is not a strict ceteris paribus event. A change in the price level changes the quantity of real money, which changes the interest rate. Indeed, this chain of events is one of the reasons for the negative slope of the AD curve. In telling this story, we must be sensitive to the fact that the student doesn’t yet know about the demand for money. We must provide intuition with stories (like the Maria stories in the textbook) without referring to the demand for money. Income equals expenditure on the AD curve. Some instructors want to emphasize a second and more subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real GDP. That is, the AD curve is not drawn for a given level of income but for the varying level of income that equals the level of planned expenditure. If you want to make this point when you first introduce the AD curve, you must cover the AE model of Chapter 25 before you cover this chapter. (The material is written in a way that permits this change of order.) If you do not want to derive the AD curve from the equilibrium of the AE model, don’t even mention what’s going on with income along the AD curve. Silence is vastly better than confusion. You can pull this rabbit out of the hat when you get to Chapter 25 if you’re covering the material in the order presented in the textbook.

Aggregate Demand The AD curve (drawn against P) slopes downward because when prices rise Wealth effect: real value of wealth decreases. Intertemporal substitution effects: interest rates rise International substitution effects: Exports fall, imports rise

Aggregate Demand Changes in Aggregate Demand Expectations Future income, future profits, future inflation Fiscal policy Net Taxes (taxes –transfers) Government purchases Monetary policy Interest rates affect investment, consumption. The world economy. Exports and imports

Macroeconomic Equilibrium Short-Run Macroeconomic Equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SRAS curve. Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—when the economy is on its LRAS curve. Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend. Describe the convergence process using the mechanism laid out on page 138 of the textbook. In that process, firms always produce the profit-maximizing quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower prices and cut production. Similarly, they can’t keep up with sales and inventories are falling, firms raise prices and increase production. These adjustment processes continues until firms are selling their profit-maximizing output. Emphasize also that with a fixed (sticky) money wage rate, this short-run equilibrium can be at, below, or above potential GDP.

Macroeconomic Equilibrium LR equilibrium occurs where the AD and LRAS curves intersect results when the money wage has adjusted to put the SRAS curve through the long-run equilibrium point.

Macroeconomic Equilibrium The Business Cycle The business cycle occurs because AD and SRAS fluctuate but the money wage does not change rapidly enough to keep real GDP at potential GDP.

Macroeconomic Equilibrium A long-run equilibrium is an equilibrium in which potential GDP equals real GDP. Unempl=natural rate No pressure on real wages P LRAS SRAS AD Real GDP

Macroeconomic Equilibrium Equilibrium below full employment potential GDP exceeds real GDP. Recessionary gap Unempl>natural rate Downward pressure on real wages SRAS will eventually shift right P LRAS SRAS AD Real GDP

Macroeconomic Equilibrium Equilibrium above full employment real GDP exceeds potential GDP. Inflationary gap Unempl < natural rate Upward pressure on real wages SRAS will eventually shift left P LRAS SRAS AD Real GDP

Fluctuations in Aggregate Demand An increase in aggregate demand shifts the AD curve rightward. SR effect on Prices Real GDP Real wages Unemployment

Fluctuations in Aggregate Demand In LR, upward pressure on real wages causes money wage to rise and shifts SAS leftward until return to LR equilibrium. As move from A to B, effect on: Prices Real wages Unemployment Real GDP B A

Macroeconomic Equilibrium Fluctuations in Aggregate Supply Starting at LR equilibrium, a rise in the price of oil decreases short-run aggregate supply and the SRAS curve shifts leftward.

U.S. Economic Growth, Inflation, and Cycles Changes in real GDP and the price level each year from 1963 to 2003 in terms of shifting AD, SAS, and LAS curves. Putting the AS-AD model to work. Don’t neglect the predictions of the model. This is the payoff for the student. With this simple model, we can now say quite a lot about growth, inflation, and the cycle. The price level doesn’t fall, and real GDP rarely falls. The AS-AD model predicts a fall in the price level when either aggregate demand decreases or aggregate supply increases. And the model predicts that real GDP decreases when either aggregate supply or aggregate demand decreases. Students are sometimes bothered by this apparent mismatch between the predictions of the model and the observed economy. The best way to handle this issue is to emphasize that in our actual economy, AS and AD almost always are increasing. When we use the model to simulate the effects of a decrease in either AS or AD, we’re studying what happens relative to the trends in real GDP and the price level. A fall in the price level in the model translates into a lower price level than would otherwise have occurred and a slowing of inflation. The story is similar for real GDP.

Using the AS/AD model Starting from a LR equilibrium, examine the SR and LR effect of Tax cut Increase in government spending Fed cuts interest rates Consumer confidence rises Temporary supply shock Assume NO EFFECT on LRAS (to be considered later) Variables to consider: price, real wage, real GDP, unemployment.