Aggregate Demand and Supply Study Notes

Aggregate Demand and Aggregate Supply (AD/AS) Overview

Key Questions

  • What causes short-run fluctuations in the economy, and how can these be identified through various economic indicators?

  • Can public policy effectively prevent periods of falling income and increasing unemployment?

  • In what ways can public policy be employed to mitigate the severity and duration of recessions or depressions?

  • The primary focus is on short-run fluctuations that occur around long-run economic trends, impacting both consumer behavior and business operations.

Economic Context

United States Business Activity Since 1914

  • Major events inducing economic fluctuations in the U.S. economy include:

    • World War II: Increased economic activity due to war production (+60), significantly boosting GDP and employment levels.

    • Korean War: Similar to WWII, the military conflict led to spikes in government spending and production (+40).

    • Vietnam War: Continued military engagement contributed to economic volatility (+20).

    • Great Depression: A severe economic downturn that contracted the economy sharply (-60) resulting in widespread unemployment and business failures.

Understanding Short Run Fluctuations

Business Cycle

  • The business cycle is characterized by fluctuations that are not regular or predictable; it includes periods of expansion and contraction, influenced by various external and internal factors.

Macroeconomic Quantities Fluctuate Together

  • Key indicators linked to the monitoring of real GDP (RGDP) to observe short-run changes include:

    • Income: Fluctuations in wages and employment levels impact overall consumer spending capacity.

    • Corporate profits: Changes in profit levels affect business investment decisions and stock market performance.

    • Consumer spending: Direct correlation with overall economic health, as consumer confidence influences purchase decisions.

    • Investment spending: Refers to business investments in capital goods, which are influenced by interest rates and economic conditions.

    • Industrial production, retail sales, home sales, and auto sales: These indicators provide insights into specific sectors of the economy, highlighting the performance of manufacturing and retail industries.

Relationship Between Output and Unemployment

  • There exists an inverse relationship where, as output of goods and services falls, unemployment rates rise due to layoffs and reduced hiring practices in response to lower demand.

Explaining Short Run Economic Fluctuations

Classical Dichotomy, Monetary Neutrality

  • Although mentioned, these concepts are yet to be elaborated upon. However, they convey the idea that in the long run, real variables are unaffected by nominal variables such as money supply.

Short Run Model Focus

  • Focus on economy’s output (RGDP) and price level, utilizing tools such as the Consumer Price Index (CPI) or GDP deflator to gauge price stability.

Aggregate Demand (AD)

Definition

  • The aggregate demand curve represents the total quantities of goods and services that the entire economy desires to purchase at various price levels.

  • It is represented as AD = GDP = C + I + G + Nx, where:

    • C = Consumption

    • I = Investment

    • G = Government spending

    • Nx = Net exports (exports minus imports).

Comparison with Micro Demand Curve

  • The aggregate demand curve differs from the micro demand curve as it aggregates consumer behavior across the entire market, rather than focusing on individual choices for a single good.

  • Unlike micro-economics, income effects (normal/inferior) or substitution effects cannot be fully applied within this macroeconomic context.

  • Mirrors the Law of Demand: an inverse relationship exists such that a lower price level correlates with a larger real GDP, while a higher price level is associated with a smaller real GDP.

Downward Sloping AD

  1. Wealth Effect

    • An increase in the price level (PL) leads to a decrease in real wealth as consumers find their purchasing power diminished. Conversely, a decrease in PL increases real wealth, motivating consumers to spend more due to enhanced perceptions of wealth.

  2. Interest Rate Effect

    • A decrease in PL reduces the demand for money, resulting in lower interest rates. This encourages borrowing and investment in areas such as housing, which subsequently increases overall demand for goods and services.

    • Simplified, this can be expressed as: - PL down = Interest Rates down = More AD (movement down along the AD curve).

  3. Exchange Rate Effect

    • A decrease in domestic PL can lead to reduced interest rates, prompting U.S. investors to seek higher returns abroad, resulting in a depreciation of the dollar. This depreciation makes U.S. exports cheaper for foreign buyers while making imports more expensive, thus increasing net exports (Nx).

Determinants of Aggregate Demand Shifts

  • Factors that drive shifts in aggregate demand have similarities to factors affecting micro demand:

    • Consumption (C): Includes shifts in consumer saving intentions, changes in wealth due to market fluctuations, and alterations in taxation.

    • Investment (I): Influenced by technological advancements, overall business outlook, and incentives provided by tax policies.

    • Government (G): Changes in federal or state government spending play a critical role in influencing aggregate demand.

    • Net Exports (Nx): Driven by the economic conditions of foreign partners and fluctuations in currency values.

Key Determinants Summary
Factors that Shift Aggregate Demand Curve

  • Changes in consumer spending

  • Changes in investment spending

  • Changes in government spending (fiscal policy measures)

  • Changes in net export spending

  • Variations in interest rates

  • Changes in disposable income levels

  • Fluctuations in consumer wealth and expectations

  • Tax policy changes (e.g., personal income taxes)

  • Business conditions and expected returns on investments

  • Degree of excess capacity regarding existing capital stock

  • Corporate taxes impacting business operations

  • Changes in national income levels abroad

  • Fluctuation in exchange rates influencing trade advantages.

Aggregate Supply (AS)

Long-Run Aggregate Supply (LRAS)

  • The LRAS is a vertical representation indicating the economy’s potential growth level.

  • In the long run, output is determined by input factors, such as labor, capital, natural resources, and technology, none of which are directly affected by the price levels.

  • Maximum output can be sustained only through significant investments in capital and workforce development.

Short-Run Aggregate Supply (SRAS)

  • The SRAS curve is typically upward sloping for two main reasons:

  1. An increase in the Price Level (PL) typically results in an increase in the quantity of goods and services supplied due to enhanced profitability and incentives for production.

  2. Several theories highlight why SRAS slopes upward, noting that short-term deviations from the long-run output levels occur as PL changes unexpectedly:

    • A higher-than-expected PL can lead businesses to produce more, while a lower-than-expected PL discourages output.

Theories Explaining Short-Run AS Slope

  1. Sticky Wage Theory

    • Nominal wages do not adjust immediately due to existing contracts, resulting in increased costs when PL falls unexpectedly while real wages rise, leading to higher unemployment and decreased production.

  2. Sticky Price Theory

    • Firms may not immediately adjust prices in response to falling PL due to costs associated with recalibrating pricing (menu costs, etc.) and pre-existing contracts, leading to decreased sales and production.

  3. Misperceptions Theory

    • Suppliers may misinterpret a sudden PL decrease as a relative price drop affecting only their business, causing them to reduce supply in light of perceived losses.

Equilibrium in the AD-AS Model

Short-Run and Long-Run Equilibrium

  • Short-run equilibrium in the AD-AS model occurs at the intersection of the Aggregate Demand (AD) curve and the Short-Run Aggregate Supply (SRAS) curve. A long-run equilibrium is reached where the AD curve intersects with the Long-Run Aggregate Supply (LRAS) at full employment output level.

  • Gaps can develop, illustrated by the relationship between output and employment levels:

    • Inflationary Gap: Characterized by production above full employment Yf, resulting in unemployment rates dipping below the Natural Rate of Unemployment (NRU).

    • Recessionary Gap: Occurs when production levels are below full employment Yf, leading to rising unemployment rates above NRU.

Historical Context of AD/AS Model

  • The AD-AS model evolved in response to the economic turmoil of the Great Depression, representing a critical reevaluation of classical economic theories which were deemed inadequate during severe economic crises.

  • Influential economist John Maynard Keynes championed the need for active government intervention to stimulate aggregate demand through initiatives like public works spending, emphasizing the need for fiscal policy refinements to counteract economic downturns.

  • His critique of classical theory is succinctly captured in his remark: “In the long run, we are all dead,” highlighting the importance of timely policy action.

Conclusion

  • The AD/AS model serves as a crucial analytical tool for understanding short-run economic fluctuations and illustrates the ways in which policy interventions can shape demand and supply dynamics.

  • Through this framework, one can explore the interplay between demand and supply, consider the effects of sticky wages and prices, and analyze the broader economic environment influencing fluctuations.