Chapter 11: The Aggregate Demand/Supply Model

Macroeconomic Perspectives on Demand and Supply

• Foundational Perspectives: Macroeconomists are frequently categorized into two schools of thought regarding the primary drivers of economic size:     - Supply-Side Priority: The belief that supply is the most significant determinant of the macroeconomy's size, with demand naturally following.     - Demand-Side Priority: The belief that demand is the most important factor, with supply adjusting accordingly.
• Synthesis of Approaches: A successful macroeconomic framework must integrate both supply and demand factors to accurately describe the economy.
• Say’s Law:     - Definition: Summarized as "Supply creates its own demand."     - Logic: Every time a good or service is produced and sold, the proceeds represent income to someone (labor, capital owners, etc.), which theoretically provides the means to purchase other goods.     - Neoclassical Economists: These are economists who emphasize the role of aggregate supply in determining the size of the macroeconomy, particularly over the long run.     - Time Horizon: Say's Law serves as a robust approximation for the long run. Over decades, as an economy's productive capacity increases, total demand tends to grow at roughly the same pace.     - Short-Run Limitations: Say's Law does not account for shorter periods (months or a few years) where recessions or depressions occur due to a collective lack of demand for products.
• Keynes’ Law:     - Definition: Summarized as "Demand creates its own supply."     - Logic: The level of $GDP$ is not primarily determined by productive potential but by the total amount of demand in the economy.     - Time Horizon: Keynes’ law applies effectively in the short run (months to years). It explains scenarios where firms face a drop in demand during recessions or excessive demand during economic booms that exceeds production capacity.     - Limitations: If demand were the only factor, governments could infinitely expand the economy through spending or tax cuts. However, economies face genuine physical and institutional limits on production capacity.

Building the Aggregate Demand and Aggregate Supply Model

• The AD/AS Model: A macroeconomic model used to determine total supply and total demand for an economy and illustrate how they interact.
• Aggregate Supply ($AS$): The total quantity of output (Real $GDP$) that firms are willing and able to produce and sell.
• Aggregate Supply ($AS$) Curve: A graphical representation showing the relationship between the price level and the total quantity of output firms will produce and sell, holding input prices fixed.
• Slope of the $AS$ Curve: The curve slopes upward. As the price level for outputs rises while input prices remain fixed, firms have a higher profit incentive to increase production.
• Potential $GDP$: The maximum quantity an economy can produce given full employment of labor, physical capital, technology, and institutions.
• Full-employment $GDP$: An alternative name for Potential $GDP$. This occurs when the economy operates at its potential and the unemployment rate is at the natural rate of unemployment.
• Aggregate Demand ($AD$): The total amount of spending on domestic goods and services within an economy.
• Components of $AD$: Includes four distinct elements:     - Consumption ($C$)     - Investment ($I$)     - Government Spending ($G$)     - Net Exports ($X - M$), where $X$ is exports and $M$ is imports.
• Aggregate Demand ($AD$) Curve: A graphical representation showing total spending on domestic goods and services at each price level.
• Slope of the $AD$ Curve: The curve slopes downward. As the price level rises, total spending on domestic goods and services declines due to three specific reasons:     1. Wealth Effect: Higher price levels reduce the real value of wealth (like savings), leading to lower consumption.     2. Interest Rate Effect: Higher price levels increase the demand for money, driving up interest rates, which reduces investment and interest-sensitive consumption.     3. Foreign Price Effect: Higher domestic price levels make exports relatively more expensive and imports cheaper, reducing net exports.

Equilibrium and Interpretation of the AD/AS Model

• Equilibrium: The point where the $AS$ and $AD$ curves intersect. This intersection identifies the equilibrium price level and the equilibrium level of Real $GDP$.
• Numerical Example 1 (Slide 10):     - Equilibrium Price Level: $90$     - Equilibrium Output (Real $GDP$): $8,800$
• Numerical Example 2 (Hypothetical - Slide 11):     - Equilibrium Price Level: $130$     - Equilibrium Real $GDP$: $680$
• Defining Time Horizons in Supply:     - Short Run Aggregate Supply ($SRAS$): Represents the positive relationship between price level and Real $GDP$ when input prices are fixed.     - Long Run Aggregate Supply ($LRAS$): A vertical line located at Potential $GDP$. In the long run, the price level does not affect the level of Real $GDP$, as the economy is limited by its factors of production.

Shifts in Aggregate Supply

• Primary Drivers of $AS$ Shifts:     1. Productivity Growth: Improvements in how efficiently inputs are converted to outputs move the curve to the right.     2. Changes in Input Prices: For example, changes in the cost of labor or energy (like oil).
• General Rule for Supply Shifts:     - Factors affecting production costs typically affect the $SRAS$.     - Improvements in the quantity or quality of factors of production shift both $LRAS$ and $SRAS$.
• Unexpected Shocks: Shocks can shift the $AS$ curve suddenly. Examples include:     - Large-scale weather events (e.g., droughts affecting crops).     - Overseas wars that remove people from the labor force to fight.
• Stagflation: A condition where the economy experiences stagnant growth (reduced output) and high inflation simultaneously. This is often caused by a leftward shift of the $SRAS$ curve.
• Directional Impact (Graphic Analysis):     - Rightward Shift ($SRAS_0$ to $SRAS_1$): Caused by productivity gains. Results in a higher level of output and downward pressure on the price level ($E_0 \rightarrow E_1 \rightarrow E_2$).     - Leftward Shift ($SRAS_0$ to $SRAS_1$): Caused by higher input prices. Results in a lower quantity of output and a higher price level (inflationary pressure).

Shifts in Aggregate Demand

• Mechanism of Shift: A rightward shift indicates at least one component of demand ($C$, $I$, $G$, or $X-M$) increased at every price level. A leftward shift indicates a decrease in one or more components.
• Confidence Factors:     - Consumer Confidence: When consumers feel optimistic about the future, they spend more, shifting $AD$ right. If confidence drops, spending falls, shifting $AD$ left.     - Business Confidence: High confidence leads firms to increase investment spending in anticipation of future payoffs, shifting $AD$ right.
• Government Policy Impacts:     - Spending: Increases in government spending shift $AD$ right; decreases shift it left.     - Taxation: Tax cuts for individuals increase consumption. Tax increases diminish it. Specific corporate tax cuts can stimulate investment demand.
• Recessionary Policy: During recessions characterized by high unemployment and low profits, the U.S. government often passes tax cuts to stimulate $AD$.
• Directional Impact (Graphic Analysis):     - AD Right ($AD_0$ to $AD_1$): Results in a new equilibrium ($E_1$) with higher output and a higher price level. Equilibrium moves closer to Potential $GDP$.     - AD Left ($AD_0$ to $AD_1$): Results in a new equilibrium ($E_1$) with lower output and a lower price level. Equilibrium moves farther below Potential $GDP$.

Growth, Unemployment, and Inflation in the AD/AS Model

• Long-Run Economic Growth: Represented by the gradual rightward shift of both the $AS$ and the vertical Potential $GDP$ (or full-employment) line over time, driven by productivity increases.
• Recession Representation: Illustrated when the equilibrium point of Real $GDP$ is substantially below the Potential $GDP$ line (the $LRAS$).
• Unemployment in the Model:     - Cyclical Unemployment: Short-run variations caused by the business cycle. In the AD/AS model, this is shown by how far the equilibrium output is from Potential $GDP$.     - High Cyclical Unemployment: Occurs when output is substantially to the left of Potential $GDP$.     - Low Cyclical Unemployment: Occurs when output is close to Potential $GDP$.     - Long-Run Baseline: In a healthy U.S. economy, the long-run unemployment rate typically hovers around $5\%$.
• Inflationary Pressures:     - Inflation is short-run fluctuation; high rates typically follow economic booms, while rates fall during recessions.     - Demand-Pull Inflation: Occurs if $AD$ continues to shift right when the economy is already near Potential $GDP$, pushing the equilibrium into the steep portion of the $AS$ curve.     - Cost-Push Inflation: Results from a rise in input prices (e.g., labor or oil) that shifts the $AS$ curve to the left.

Diagnostic Zones of the SRAS Curve

• The Keynesian Zone:     - Characteristics: The portion of the $SRAS$ curve where $GDP$ is far below potential; the curve is relatively flat.     - Implications: The economy is in a recession, cyclical unemployment is high, and there is very little worry about inflationary price pressure from demand shifts.
• The Neoclassical Zone:     - Characteristics: The portion of the $SRAS$ curve where $GDP$ is at or near potential; the curve is very steep.     - Implications: Cyclical unemployment is low (though structural unemployment may persist). To increase Real $GDP$, $AS$ must shift right. Increases in $AD$ primarily result in higher price levels rather than more output.
• The Intermediate Zone:     - Characteristics: The portion of the curve where $GDP$ is below potential but not extremely so; the curve is upward-sloping but not vertical.     - Implications: Unemployment and inflation move in opposite directions.     - Shift AD Right: Reduces unemployment but increases the price level and inflation pressure.     - Shift AD Left: Increases unemployment but lowers the price level and inflation pressure.

Questions & Discussion

• Discussion Question (Slide 7): How can the $AS$ curve cross Potential $GDP$?
• Discussion Question (Slide 11): Using a hypothetical equilibrium where the price level is at $130$ and real $GDP$ is at $\$680$, what information can we infer about the state of this country’s economy?     - Is this country risking inflationary pressures or facing high unemployment?     - How can you tell?