1. Aggregate Demand and Supply Note: Reading is posted under “additional materials” on course website – not under electronic course reserve.

2. Stable Prices Why is inflation bad? If wages and prices move together, what is wrong with inflation? Prices: key to allocating resources Risk: the higher the level of inflation, the more volatile it becomes. Makes economic decisions difficult Stems production of output Can lead to unanticipated swings in output.

3. Stable Output Why is volatile output bad? Creates risk for investors Investors demand compensation for bearing risk Firms face higher cost of borrowing Lower borrowing implies lower output.

4. Level and Volatility of Growth

5. If GDP grows by 4% annually Output doubles in about 18 years If GDP grows by 2% annually Output grows by about 40% in 18 years

6. Is Government Policy Useful? Can government policy lower inflation? Or does policy just add extra volatility to inflation? Can government policy reduce fluctuations in the business cycle and lower the volatility of output? Monetariasts vs. Keynsians

7. Aggregate Demand Aggregate demand: total quantity of an economy’s goods and services demanded at each price level. Single good: output or GNP Y=number of “goods” produced Y=real output Single price P=price of one unit of Y P*Y=nominal spending (or nominal output) M=money supply

8. Aggregate Demand Demand curve for an individual asset relates demand for the asset to the price of the asset relative to other goods. Aggregate demand curve relates demand for output to general price level. If all prices decrease by 10%, why should aggregate demand increase?

9. Aggregate Demand When general price level decreases investors have the option of either Buying more of some good Holding more dollars Assuming holding real goods is better than holding dollars, as price level decreases, aggregate demand increases Real money supply – purchasing power of M =M/P When prices decrease, M/P increases holding M constant.

10. Aggregate Demand Island Economy Current money supply: M=2 dollars Price of a gallon of milk: 2 dollars Price of a loaf of bread: 2 dollars Each day: Farmer Baker milk bread $2

11. Aggregate Demand Each day total aggregate demand = 2 1 loaf of bread 1 gallon of milk Y=2 Same $2 gets spent twice Total nominal spending = $4 = P  Y Velocity = (P  Y)/M = 4/2 = 2

12. Aggregate Demand Assume money supply is constant Assume prices decrease Bread = $1 Milk=$1 Farmer can now begin day by buying more than 1 loaf of bread. Baker can then buy more gallons of milk.

13. Aggregate Demand Assume farmer buys 2 loaves of bread baker buys 2 gallons of milk Each day total aggregate demand = 4 2 loaves of bread 2 gallons of milk Y=4 Same $2 gets spent twice Total nominal spending = $4 = P  Y=1*4 Velocity = (P  Y)/M = 4/2 = 2

14. Velocity Velocity – the same dollar is spent several times within an economy. As prices decrease, Y increases holding V and M constant.

15. Aggregate Demand Aggregate Output Demanded, Y P

16. Keynsians Aggregate demand is determined by the sum of the parts:

17. Keynsians Holding prices constant, a change in demand by any one sector will change aggregate demand. Demand curve shifts right with Increases in government spending Decreases in taxes Increases in money supply, M. Business/Consumer optimism Increase in Exports

18. Monetariast View The only factor that shifts the demand curve is the money supply. If government increases spending, why does that not increase aggregate demand? Monetariast answer: complete crowding out. To buy more, government must issue bonds Shifts supply of bonds to the right Increases yield Consumers cannot afford to borrow Consumer demand declines

19. Long Run Aggregate Supply LRS Determined by The amount of capital The amount of labor (natural rate of unemployment) Available technology In the long run, the farmer and baker don’t have the ability to continually produce 2 loaves of bread and 2 gallons of milk. Prices rise Output decreases

20. Long-Run Aggregate Supply Aggregate Output, Y P

21. Short Run Aggregate Supply SRS Firms are seeking to maximize profits Face increasing marginal cost Produce where price=marginal cost As prices increase firms are willing to produce more

22. Short Run Aggregate Supply SRS Example: Firm produces widgets Price at which they can sell: $10 To produceCostProfit 1st $3 $7 2 nd $5 $5 3 rd $9.99 $.01

23. Short Run Aggregate Supply SRS As prices increase firms are willing to produce more to maximize profits Is short run, production (labor) costs do not change. Wages are set by long-term contracts (about 70% of production costs) Raw materials bought in advance SRS curve slopes up Holding price constant, an increase in production costs shifts supply curve to the left An increase in the cost of the “factors of production”

24. SRS P Aggregate Output Supplied=Y Short-run supply curve shifts left as costs of production increase.

25. SRS Factors that can shift SRS curve to left: Increasing wages Increasing expected inflation Inflation erodes purchasing power of wages. Workers will demand higher wages. Strikes Increasing production costs other than wages. Natural disasters Increases in price of oil

26. Equilibrium Aggregate Output, Y P Long Run Aggregate Supply Determined by natural rate of unemployment Labor market is tight Large demand for workers Upward pressure on wages Labor market is loose Low demand for workers Downward pressure on wages

27. Equilibrium Keynsians: Wages are sticky. Short-run aggregate supply is slow to shift, particularly when unemployment is high. Government is needed to restore economy to equilibrium. Government spending Lowering taxes

28. Keynsian View Aggregate Output, Y P Government spending shifts demand to right 1. 2. 3.

29. Keynsian View Increased government spending can increase aggregate demand and lower unemployment. Wages are slow to adjust, so the economy stays out of equilibrium for several years. Eventually wages increase and short-run supply shifts left. The long-run effect is just inflation.

30. Keynsian View Aggregate Output, Y P 1. 2.

31. Keynsian View If economy is initially out of equilibrium Wages are slow to adjust, so the economy can stay out of equilibrium for several years. Increased government spending can increase aggregate demand. Lower unemployment at the cost of inflation. Keynsian view is benefit outweighs costs

32. Monetariast View Aggregate Output, Y P 1. 2. 3.

33. Non-Activist Monetary View Assume short-run supply shifts left Economy gets kicked out of equilibrium Government can shift demand curve right by increasing the money supply But before this happens, SRS shifts back right, since wages adjust fast When demand curve shifts right, economy gets kicked out of equilibrium again SRS shifts back left

34. Monetariast View Result of policy: Increases volatility of output Increases inflation Conclusions: The Fed does more harm than good when it tries to tinker with money supply.

35. Non-activist Argument Data Lag – it takes time for policy makers to obtain the data that tell them what’s going on. Data on quarterly GDP not available for several months until after the quarter. Recognition lag – it takes time for policy makers to realize what the data is saying about the future. NBER won’t classify the economy in a recession until 6 months after it determines one might have begun. Effectiveness lag – Once money supply has changed, it can take time for effects to be carried out

36. Deflation Nearly all economists agree deflation is at least as bad as inflation With deflation, greater defaults on loans Greater bank failure Capital cannot be channeled to good investments Real output declines May have long run effects

37. Monetariast View To prevent deflation, grow money supply at a small constant rate. Result will be moderate inflation from year to year, but benefit will be a hedge against deflation.

38. Keynsian View Aggregate Output, Y P 1. 2. 3.

39. Keynsian View Assume short-run supply shifts left Economy gets kicked out of equilibrium Government can shift demand curve right by increasing the money supply Wages are not perfectly flexible Demand curve shifts right before supply curve shifts back right. Result of intervention is Faster return to long run output level at cost of moderate inflation Activist view is that benefits outweigh costs.

40. Keynsian View Aggregate Output, Y P 1. 2. 3. Original equilibrium With no intervention

41. Keynsian View Assume demand curve shifts right (irrational exuberance) Economy gets kicked out of equilibrium Government can shift demand curve left by decreasing the money supply Demand curve shifts left before supply curve shifts left. Result of intervention is Faster return to long run output level at cost of moderate inflation Lower and less volatile inflation

42. Keynsian View Aggregate Output, Y P 1. 2. Original equilibrium With no intervention

43. Keynsian View Assume demand curve shifts left (irrational pessimism) Economy gets kicked out of equilibrium Government can shift demand curve right by increasing the money supply Hopefully economy never gets to point 1. Argument in favor of increasing money supply at small rate –that may vary over time according to business optimism/pessimism. Result of intervention is No deflation at cost of some moderate inflation Activist view is that benefit outweighs cost.