Aggregate Demand & Aggregate Supply Notes

Aggregate Demand & Aggregate Supply

Overview

• The lecture focuses on understanding the aggregate demand (AD) and aggregate supply (AS) curves.
• It differentiates between short-run and long-run aggregate supply curves.
• The AD-AS model is used to analyze economic fluctuations, highlighting why the income-expenditure model is insufficient. This model illustrates how monetary and fiscal policies can stabilize the economy.

Aggregate Supply and Demand

• The behavior of the economy can be explained, predicted, and potentially manipulated by examining the relationship between:
  • Aggregate (total) demand.
  • Aggregate (total) supply.
• Studying changes in aggregate supply and/or aggregate demand can explain:
  1. What causes recessions.
  2. Why inflation is high in some recessions but not others.

Aggregate Demand

• A higher aggregate price level causes lower aggregate output.
• The aggregate demand curve slopes downward due to:
  1. Wealth effect:
     • As prices rise, the purchasing power of wealth falls, thus reducing consumption.
  2. Export price effect:
     • As prices rise, exports become more expensive and drop.
  3. Interest rate effect:
     • As prices rise, people hold more money, pushing interest rates higher, which reduces business investment.
• Movements along the AD curve vs. shifts of the AD curve depend on the source of change in wealth.
  • If it’s a change in the price level affecting wealth, it’s a movement along the AD curve.
    • Example: Rapid inflation decreases wealth, moving the economy along the AD curve.
  • If it’s a change in something else affecting wealth, it’s a shift in the AD curve.
    • Example: A housing market crash shifts the AD curve.
• Factors that shift the entire AD curve:
  • Consumer spending
  • Investment
  • Government spending
  • Net exports
  • If foreign income rises, net exports increase

Aggregate Supply

• Short-Run Aggregate Supply (SRAS):
  • SRAS is positively sloped because input costs are slow to change (sticky).
  • A movement down the SRAS curve leads to deflation and lower aggregate output.

Short-Run Aggregate Supply

• In the short run, the aggregate supply curve is upward sloping because:
  • Some input prices (such as wages) are slow to change; they are sticky.
  • When prices rise but input prices are sticky, profits increase, and firms produce more, leading to a short-run increase in aggregate output.
• $Profit \, per \, unit = Price - Production \, Costs$

Sticky Wages & SRAS

• Nominal wages are often determined by contracts signed some time ago, or through informal agreements.
• Evidence suggests that wages fail to fall even during periods of high unemployment.
• The determinants of the SRAS curve are:
  1. Changes in input prices:
     • Commodity prices, wages
  2. Technology and productivity.
  3. Taxes and regulation.
  4. Market power of firms.
  5. Inflationary expectations.
  • Higher inflation expectations by businesses, workers, or consumers will decrease SRAS.
• A negative supply shock leads to lower aggregate output and a higher aggregate price level (stagflation).
• Rising productivity increases profits and increases short-run aggregate supply.
• Taxes and regulations add to the costs of business, decreasing the SRAS curve.
• As industries become more concentrated (firms have more market power), SRAS decreases.

Shifts of the SRAS Curve

• The SRAS curve shifts to the right when productivity rises.
• Negative Supply Shocks + Inflation = stagflation (inflation + falling aggregate output).
• Demand shocks are more common than negative supply shocks.

Movement Along vs. Shift of the AD Curve

1. A rise in the interest rate caused by a change in monetary policy.
   • Shifts left: A decrease in the quantity of money increases the interest rate because people have less on hand and will therefore borrow more (and lend less).
   • A higher interest rate leads to less investment and consumer spending at any given aggregate price level.
2. A fall in the real value of money due to a higher aggregate price level.
   • Movement (up) along: This is the interest rate effect of a change in the aggregate price level.
   • As the value of money falls, people want to hold more money (borrow more, lend less) which increases the interest rate and a reduction in consumer and investment spending.
3. Expectations of a worse-than-expected job market next year.
   • Shifts left: Expectations of a poor job market (and therefore lower average disposable incomes) will reduce people’s consumer spending today at any given aggregate price level.
4. A fall in tax rates.
   • Shifts right: A fall in tax rates raises people’s disposable income. At any given aggregate price level, consumer spending is now higher.
5. A rise in the real value of assets in the economy due to a lower aggregate price level.
   • Movement (down) along: As the aggregate price level falls, the real value of assets rises. This is the wealth effect of a change in the aggregate price level: as the value of assets rises, people will increase their consumption plans.
6. A rise in the real value of assets in the economy due to a surge in real estate values.
   • Shifts right: A rise in the real value of assets in the economy due to a surge in real estate values raises consumer spending at any given aggregate price level.

Long-Run Aggregate Supply (LRAS)

• In the long run, the aggregate supply curve is vertical.
• The long run = the time it takes for all prices (including nominal wages) to adjust.
• There is no change to profits simply because prices have changed.
• In the long run, the economy will gravitate toward full employment.
• The position of the LRAS curve depends on the economy’s capacity, amount of available resources, the quality of the labor force, and available technology.
• Full employment occurs at the natural rate of unemployment.
• Rightward shifts in LRAS occur when:
  • Technology improves: automation, digitalization.
  • Labor quality is enhanced; more people pursue higher education.
  • Trade and globalization increase.

Macroeconomic Equilibrium

• Short-run macroeconomic equilibrium occurs where AD and SRAS intersect.
• Long-run macroeconomic equilibrium occurs where AD and LRAS intersect.
• Stabilization policy = the use of government policy to reduce the severity of recessions and control excessively strong expansions.

SR vs. LR Effects of a Positive/Negative Demand Shock

• The economy may correct itself in the LR if wages and prices fully adjust.
• An initial positive demand shock increases the aggregate price level and aggregate output, decreasing unemployment in the SR, until an increase in nominal wages in the LR reduces SRAS and moves the economy back to potential output.
• An initial negative demand shock reduces the aggregate price level and aggregate output and leads to higher unemployment in the short run, until a fall in nominal wages in the long run increases SRAS and moves the economy back to potential output.

Responding to Supply Shocks

• Negative supply shocks pose a policy dilemma:
  • To stabilize aggregate output, aggregate demand has to rise, which will lead to inflation.
  • On the other hand, stabilizing prices requires reducing aggregate demand, which will deepen the output slump.

The Multiplier & AD/AS

• When short-run equilibrium is below full employment, the spending multiplier magnifies new spending, shifting AD toward long-run equilibrium.

The Great Depression, 1929–1933

• During the Great Depression, short-run equilibrium output was far below full employment.
• Real GDP fell by nearly 40%.
• Unemployment reached 25%.
• AD shifted far to the left.
• It took a sharp rise in government spending on World War II to shift AD back to long-run equilibrium.

Demand-Pull Inflation

• A positive demand shock expands the economy beyond full employment output.
• Rising input prices eventually push SRAS to the left, back to long-run equilibrium but at a higher price level.
• Examples include the U.S. in the 1960s and Japan from 1985 to 1995.

Cost-Push Inflation

• A negative supply shock reduces output and raises prices.
• Increasing AD will push output back to full employment but at even higher prices.
• Alternatively, decreasing AD will reduce inflation but increase unemployment.
• The 1973–1975 oil shock caused long lines, higher prices, and a shift of the SRAS curve to the left.