Macroeconomic Model for an Inflationary Economy: Aggregate Demand and Supply

Learning Outcomes and Core Objectives

• Use the Aggregate Demand ($AD$) and Aggregate Supply ($AS$) model to explain fluctuations in real Gross Domestic Product ($Y$) and changes in the average price level ($P$).

• Analyse and assess the importance of the medium-run supply adjustment process towards a long-run, structural equilibrium and a long-run $AS$ curve.

• Compose complex chain reactions for an open economy which include effects on the price level together with real $GDP$ ($Y$).

• Evaluate these chain reactions using appropriate graphical aids.

Introduction to the AD/AS Framework

• Historical Context: In the Keynesian models covered previously, average price levels ($P$) and inflation were considered constant. This theory was developed during the Great Depression, characterized by high unemployment, thus focusing only on real income ($Y$) and unemployment.

• Evolution of Models:

  • The $IS/LM/BP$ curves illustrated the relationship between real income ($Y$) and real interest rates ($r$).

  • The $AD/AS$ curves illustrate the relationship between real income ($Y$) and average price levels ($P$) or inflation.

• Key Assumptions Relaxed: In the $AD/AS$ model, the assumption that the supply side responds effortlessly to demand changes is removed, and price levels are no longer assumed to be constant.

• Integration: The $AD/AS$ model recasts the real and monetary sectors into one diagram with the average price level ($P$) on one axis. It provides additional information regarding the behavior of firms and workers on the production (supply) side.

• Consolidation: The 45-degree diagram and the $IS/LM/BP$ diagram are collapsed into the $AD$ curve, which has a negative slope.

Definitions of Unemployment Types

• Seasonal Unemployment: Due to seasonal patterns of increased or decreased activity in specific sectors of the economy.

• Frictional Unemployment: Due to a certain number of people who are in the process of searching for new jobs or are changing jobs/careers.

• Cyclical Unemployment: Due to short-run cyclical downswings in macroeconomic activity; employment fluctuates as $GDP$ ($Y$) fluctuates.

• Structural Unemployment: Arises from the nature, location, and pattern of employment opportunities. It results from mismatches between worker skills and the skill requirements of available jobs.

• Natural Rate of Unemployment: Defined as the long-run unemployment rate.

Aggregate Demand (AD)

• Definiton: The $AD$ curve illustrates all combinations of real income ($Y$) and the average price level ($P$) at which there would be simultaneous equilibrium in the real and monetary sectors. It represents a collection of points of potential equilibrium.

• Derivation Methods:

  • From the 45-degree Diagram:

    1. Suppose the economy is at equilibrium income level $Y_0$ with associate price level $P_0$ (Equilibrium point 1: ($Y_0$, $P_0$)).

    2. Suppose prices increase ($P_1 > P_0$), leading to lower aggregate expenditure. The aggregate expenditure line shifts downwards.

    3. The new equilibrium is at ($Y_1$, $P_1$). Connecting these points forms the $AD$ curve.

  • From the IS-LM Model:

    1. Start at equilibrium ($Y_0$, $P_0$).

    2. Increase in price level ($P_1$) lowers the real money supply ($M_S / P$), shifting the $LM$ curve to the left.

    3. The new intersection of $IS$ and $LM$ occurs at a lower income ($Y_1$) and higher interest rate.

    4. This creates a new equilibrium point ($Y_1$, $P_1$) on the $AD$ curve.

The Slope and Shifts of the AD Curve

• Reasons for the Negative Slope:

  • The Interest Rate Effect: An increase in $P$ contracts the real money supply, forcing interest rates upward, decreasing investment ($I$) and total expenditure.

  • The Wealth Effect: Higher average prices diminish the real value of assets, making people feel less affluent and discouraging expenditure.

  • The Foreign Trade Effect: Higher domestic prices discourage export expenditure and encourage import expenditure, decreasing ($X - M$).

  • The Tax Effect: In periods of price increases, personal income rises, pushing taxpayers into higher tax brackets, lowering disposable income and expenditure.

  • The Real Income Effect: Higher price levels lower the real value of income and the capacity to spend.

• Shifting Factors:

  • Any factor other than $P$ or $Y$ (due to $P$) that affects aggregate expenditure shifts the curve.

  • Stimulating Factors: Shift $AD$ to the right.

  • Contracting Factors: Shift $AD$ to the left.

  • Note: Any shift in the $IS$ or $LM$ curves not caused by price changes results in an $AD$ shift.

Aggregate Supply (AS)

• Definition: The $AS$ curve shows, for each price level ($P$), the aggregate level of real output ($Y$) that producers are willing or able to supply.

• Determining Factors:

  • Size of the labour force ($N$).

  • Productivity of labour ($A$).

  • Labour skills (education/training).

  • Cost of labour (wages).

  • Availability and cost of raw materials.

  • Availability, cost, and technology of capital goods ($K$).

  • Cost of financial capital (interest rates).

  • Exchange rates (affecting imported input costs).

  • Actual and expected prices ($P^e$).

• Time Horizons:

  • Long-run (3–7 years): Sufficient time for mistaken price expectations to be corrected. Expected price equals actual price ($P^e = P$).

  • Short-run (1–3 years): Expected price level does not equal actual price level ($P^e \neq P$).

The Relationship Between Production and Price Level

• In the Short term (Positive Relationship):

  1. Rigid Input Prices: Input prices (contracts/expectations) do not adapt quickly. If actual $P$ is higher than expected, inputs are relatively cheaper, and production increases.

  2. Declining Productivity of Inputs: Based on the production function $Y = f(K, N, A)$. As production increases, marginal productivity decreases, raising average costs. Producers only increase supply if compensated by higher output prices.

  3. Relative Scarcity of Inputs: Increased production makes inputs scarcer, driving up their prices. Compensation via higher output prices is required.

• Short-run AS (ASSR) Shape:

  • Far below capacity: $AS_{SR}$ is flatter (more horizontal) as inputs are eager for employment.

  • Near maximum capacity ($Y_{MAX}$): $AS_{SR}$ is steep (more vertical) due to input scarcity.

  • Past maximum capacity: $AS_{SR}$ becomes vertical; no increase in production is possible regardless of price.

• Long-run AS (ASLR): A vertical curve at the maximum potential level of output ($Y_S$), representing structural equilibrium or saturated market employment.

Shifts in AS Curves

• Factors Shifting both ASSR and ASLR:

  • Natural disasters/Drought (Left).

  • Trade sanctions (Left).

  • Exchange rate depreciation (Left, due to higher input costs).

  • Increase in Productivity/Technology (Right).

  • Changes in Capital Stock ($K$) or Labour Force ($N$) (Right if increasing).

• Factors Shifting ONLY ASSR:

  • Changes in price expectations ($P^e$). If $P^e$ increases, $AS_{SR}$ shifts left. If $P^e$ decreases, $AS_{SR}$ shifts right.

Macroeconomic Equilibrium and Adjustment Processes

• Short-run Equilibrium: Intersection of $AD$ and $AS_{SR}$.

• Long-run Equilibrium: Intersection of $AD$ and $AS_{LR}$. This is the structural equilibrium where expected price equals actual price.

• Medium-Term Supply-Side Adjustment:

  • If $AD$ increases, firms increase production and prices rise from $P_0$ to $P_1$.

  • Short-run output exceeds $Y_S$.

  • Workers eventually realize prices have risen and negotiate higher nominal wages to adjust expectations.

  • Higher wages increase production costs, causing $AS_{SR}$ to shift left until output returns to $Y_S$ at a higher price level $P_2$.

• Demand Contraction:

  • If $AD$ decreases, actual prices fall below expected prices. Inputs become cheaper than expected.

  • $AS_{SR}$ eventually shifts right until equilibrium returns to $Y_S$ at a lower price level.

Examples of Chain Reactions (Open Economy)

Example 1: Increase in Repo Rate (Contractionary Monetary Policy)

1. Primary Effect: Money supply ($M_S / P$) decreases $\rightarrow$ interest rates ($r$) increase $\rightarrow$ Investment ($I$) decreases $\rightarrow$ Aggregate Expenditure ($E$) decreases $\rightarrow$ $AD$ shifts left $\rightarrow$ output ($Y$) decreases.

2. BoP Effects: Decrease in $Y$ leads to lower imports ($M$), creating a Current Account ($CA$) surplus. Increase in $r$ attracts foreign capital, creating a Financial Account ($FA$) surplus. Overall $BoP$ surplus develops.

3. Short-run Secondary Effect (Demand side): Decrease in $Y$ lowers money demand ($M_d / P$), slightly lowering $r$ and slowing the primary effect.

4. BoP Adjustment (Money Supply): Inflow of foreign currency increases $M_S$, lowering $r$ and shifting $AD$ slightly back to the right.

5. BoP Adjustment (Exchange Rate): Demand for currency increases, Rand appreciates, exports ($X$) decrease and imports ($M$) increase, shifting $AD$ left again.

6. Medium-run (Supply side): Expected price ($P^0$) > actual price ($P^3$). Wages decrease, production costs fall, and $AS_{SR}$ shifts right until $Y = Y_S$.

Example 2: Increase in Government Expenditure ($G$)

1. Primary Effect: $G$ increases $\rightarrow$ $E$ increases $\rightarrow$ $AD$ shifts right $\rightarrow$ $Y$ increases.

2. BoP Effects: Increase in $Y$ increases imports ($M$), causing a $CA$ deficit.

3. Short-run Secondary Effect: Increase in $Y$ raises $M_d / P$, increasing $r$. Higher $r$ creates a $FA$ surplus. If capital mobility is high, a $BoP$ surplus develops.

4. Medium-run (Supply side): Actual price ($P$) > expected price ($P^e$). Workers negotiate higher wages. Production costs rise, shifting $AS_{SR}$ left until output returns to $Y_S$ at a permanently higher price level.

Supply-Side Disturbances and Stagflation

• Drought Example:

  • Phase 1: Supply shock shifts both $AS_{SR}$ and $AS_{LR}$ to the left. Actual prices ($P_1$) > expected prices ($P_0$).

  • Phase 2: Adjustment process. Workers negotiate higher wages due to price increases, shifting $AS_{SR}$ further left until expectations match reality at $Y_{S2}$.

  • Net Effect: Higher prices and lower income ($GDP$), a condition known as Stagflation.

• Oil Price Increase: Similar to a drought, but also shifts $AD$ left due to a rising import bill. The result remains higher prices and lower income.

• Expansionary Policy during Supply Shocks: If government tries to "accommodate" a drought by increasing $G$ to shift $AD$ right, it only results in even higher price levels (inflation) without restoring the original long-run output level.

• Investment-Led Growth: Increase in investment shifts $AD$ right and also increases productive capacity, shifting $AS_{LR}$ and $AS_{SR}$ right. This allows the economy to grow ($Y$ increase) while minimizing the inflation penalty compared to pure consumption spending.

Lessons for Policymakers

• Continual increases in expenditure growth to keep output above structural levels lead to increasing inflation.

• Reducing unemployment below the structural rate permanently is only possible at the cost of continually increasing inflation.

• Expenditure should be designed to stimulate the supply side (infrastructure, skills) rather than just the demand side (tax cuts, lower interest rates) to minimize the inflation penalty of growth.

The Comprehensive Macroeconomic Model

• Monetary Sector Link: Changes are transmitted to the real sector via interest rates and investment (left-to-right causality).

• Real Sector Link: Includes aggregate income ($Y$) and price levels ($P$).

• Feedback Mechanism: Changes in the real sector ($Y, P$) impact the monetary sector via money demand (right-to-left, indirect causality).

• Policy Impacts: Monetary policy hits the monetary sector first; Fiscal policy hits the real sector first.