Aggregate Demand–Supply, Policy & Phillips Curve Comprehensive Notes

Short-Run Economic Fluctuations – Facts to Memorise

• Real GDP grows on average ≈ $3\%$ per year (U.S. last 50 y) → ≈ $2\%$ per-capita income growth.
• Recession = period of declining real income + rising unemployment; Depression = severe recession.
• Stylised facts (‘Business-cycle facts’):
– Fluctuations are irregular & unpredictable.
– Most macro variables (consumption, investment, wages, prices) move together but with different amplitudes.
– Output $\downarrow \Rightarrow$ unemployment $\uparrow$ (strong inverse link).
– Pro-cyclical: investment, consumption, inflation.
– A-cyclical/weak: government purchases, real wages.
– Counter-cyclical: unemployment, cyclical-unemployment gap.

Basic AD–AS Framework (Short-Run Fluctuation Model)

• Two key aggregate variables:
$Y$ = real output (real GDP) | $P$ = overall price level (CPI/GDP-deflator).
• AD curve: quantity of g&s demanded by $C + I + G + NX$ at each $P$.
• AS curve: quantity supplied by firms at each $P$.
• Use AD–AS to explain deviations of $Y$ from its long-run (natural) level $\bar Y$.

Aggregate Demand (AD) Curve

• Equation with channels:
$Y_d = C\bigl(\Omega\bigr) + I\bigl(r\bigr) + G + NX\bigl(E\bigr)$
where $\Omega=$ real wealth, $r=$ real interest rate, $E=$ real exchange rate.
• Downward slope reasons (holding (\Omega, r, E) endogenous):

1. Real-wealth effect – $P\downarrow\Rightarrow$ $\Omega=\tfrac{A}{P}\uparrow$ $\Rightarrow C\uparrow$.

2. Interest-rate effect – $P\downarrow\Rightarrow$ money demand $\downarrow$ $\Rightarrow r\downarrow$ $\Rightarrow I\uparrow$.

3. Exchange-rate effect – $P\downarrow\Rightarrow r\downarrow\Rightarrow$ capital outflow $\uparrow\Rightarrow E\downarrow$ (domestic currency depreciates) $\Rightarrow NX\uparrow$.
   • Shifters of AD (at given $P$):
   – Consumption (confidence, wealth shocks, tax changes)
   – Investment (interest-rate expectations, optimism, tech)
   – Government purchases (fiscal stance)
   – Net exports (foreign income, exchange-rate policy).

Aggregate Supply (AS)

Long-Run AS (LRAS)

• Vertical at $\bar Y$:
$Y = \bar Y = f(L, K, N, A)$ depends on labour, capital, natural resources, technology.
• LRAS shifts when natural output changes: labour (population, participation), capital (investment, human), resources, technology.

Short-Run AS (SRAS)

• Upward sloping:
$Y_s = \bar Y + a\bigl(P - P^e\bigr)$ with a>0.
• Three micro-foundations:

1. Sticky-Wage Theory – nominal wages fixed (contracts) $\Rightarrow$ P>P^e\Rightarrow real wage $\downarrow$ $\Rightarrow$ employment & output $\uparrow$.

2. Sticky-Price Theory – some firms preset prices (menu costs); unexpected $P\uparrow$ leaves them “too cheap” $\Rightarrow$ sales & output $\uparrow$.
   – Share of sticky firms $s$ ⇒ derive Lucas-like $Y = \bar Y + a(P-P^e)$ with $a = \tfrac{s}{\alpha(1-s)}$.

3. Misperceptions Theory – suppliers confuse aggregate vs relative price: if own price rises unexpectedly $\Rightarrow$ perceive high relative price $\Rightarrow$ supply more.
   • SRAS shifters: Same real factors as LRAS (L, K, N, A) plus expected price level $P^e$. ↑$P^e$ → SRAS left; ↓$P^e$ → SRAS right.

AD–AS Equilibria & Dynamic Adjustment

• Short-run equilibrium: AD intersects SRAS → gives actual $P$ and $Y$.
• Long-run equilibrium: output returns to $\bar Y$ where SRAS intersects LRAS (implies $P = P^e$).
• Negative AD shock → Y<\bar Y, unemployment ↑; over time, ↓$P^e$ shifts SRAS right until $Y$ recovers, but price level permanently lower.
• Adverse AS shock (supply shock) → SRAS left → stagflation (↓Y, ↑P).
– Policy options: wait (passive), expand AD (output stabilisation, inflation ↑), contract AD (price stabilisation, deeper recession).

Monetary Policy – Keynes’ Liquidity Preference

• Money supply $M<em>s$ fixed by central bank via reserve req., open-market ops, discount/fed-funds rate. • Money demand $M</em>d=L(r, Y, P)$; in very short run expect constant inflation ⇒ nominal = real rates.
• Equilibrium $M<em>s = M</em>d$ pins down interest rate $r$.
• Central bank increases $M<em>s$ ⇒ $r\downarrow$ ⇒ AD shifts right. • Decreases $M</em>s$ ⇒ $r\uparrow$ ⇒ AD shifts left.
• Modern practice: set target rate (e.g.
federal funds); required $M_s$ adjusts endogenously.
– One degree of freedom: expand AD ⇒ cut target $r$ & supply more $M$; contract AD ⇒ raise $r$ & drain $M$.

Fiscal Policy & AD

• Government controls $G$ and taxes $T$.
• Direct AD shift: Δ$G$ enters expenditure directly.

Government-Purchases Multiplier

$\text{Multiplier}=\frac{\Delta Y}{\Delta G}=\frac{1}{1-\text{MPC}}$.
Example: $\text{MPC}=0.75$ ⇒ multiplier $=4$ ⇒ $\$20\text{ billion}$ rise in $G$ → $\$80\text{ billion}$ ↑$Y$.

Tax Multiplier

$\frac{\Delta Y}{\Delta T}= -\frac{\text{MPC}}{1-\text{MPC}}$ (Haavelmo theorem: spending+tax multipliers sum to 1).

Crowding-Out Effect

• Δ$G$ financed by borrowing → $r\uparrow$ → $I\downarrow$ → offsets multiplier (AD shift smaller).
• Net fiscal impact = multiplier minus crowding-out; size depends on interest-sensitivity of money demand & investment.

Stabilisation Debate

• Case FOR: prevent/wash out private shocks; Employment Act (US) mandates.
• Case AGAINST: info & implementation lags may destabilise; recommend passive rules.
• Automatic stabilisers: progressive taxes, unemployment insurance ⇒ AD support without new legislation.

Phillips Curve (PC)

Definition & Basic Data

• Short-run negative relation between inflation $\pi$ and unemployment $u$.
• Observed 1960s: downward-sloping PC; broke down in 1970s (stagflation).

AD–AS Connection

• Movement along SRAS from AD shocks traces PC: AD ↑ → $P$ ↑ (inflation) & $Y$ ↑ → $u$ ↓.

Expectations-Augmented PC

$u = u<em>n - a(\pi - \pi^e)$ – $u</em>n$ natural unemployment, $\pi^e$ expected inflation, a>0 slope parameter.
– In long run $\pi = \pi^e$ ⇒ $u = u_n$ ⇒ vertical long-run PC (LRPC).

Supply Shocks & PC Shifts

• Adverse AS shock (oil, pandemic) raises $P$ at every $Y$ ⇒ SRPC shifts right: higher $\pi$ for any $u$.
• Policymakers face worse trade-off (stagflation).

Disinflation & Sacrifice Ratio

• Reducing $\pi$ via contractionary $M$-policy shifts AD left. Short run: move down SRPC → $u$ ↑, output ↓.
• Sacrifice ratio ≈ 5: need cumulative output loss of $5\%$ per 1 pp fall in inflation.
• Rational Expectations critique (Friedman, Lucas): if policy is credible, $\pi^e$ falls quickly ⇒ SRPC shifts left immediately ⇒ costless (or low-cost) disinflation.

Historical Episodes (US)

• 1960s: Stable PC; policymakers exploited trade-off.
• 1970s Oil Shocks: AS↓; stagflation; PC shifted right.
• Volcker (1979–87): aggressive $M$ tightening; inflation ↓10→4 pp; unemployment peaked ≈10%.
• Greenspan (1987–2006): favourable AS (oil glut, IT), low $\pi$ & $u$.
• Bernanke (2006–14): housing bust & financial crisis; AD collapse; policy used QE + fiscal stimulus; $\pi$ low, $u$ high then fell. Credibility kept $\pi^e$ near $2\%$.
• Yellen (2014–18): gradual normalisation, continued recovery, $u$ ↓, $\pi$ < target.
• Powell (2018– ): Pandemic shock → sharp AD/AS shocks; 2021-22 inflation surge; Fed tightening 2022-24 to fight $\pi$.

Key Equations & Numbers to Know

• SRAS/Lucas supply: $Y = \bar Y + a(P - P^e)$.
• Liquidity preference money market equilibrium: $M/P = L(r,Y)$.
• Government spending multiplier: $\dfrac{1}{1-\text{MPC}}$.
• Tax multiplier: $-\dfrac{\text{MPC}}{1-\text{MPC}}$.
• Haavelmo theorem: spending multiplier +$ tax multiplier =1$. <br>• Expectations-augmented PC:$u = un - a(\pi - \pi^e)$. • Sacrifice ratio ≈ 5 (empirical). • Crowding-out: Δ$G$→ Δ$r$→ Δ$I$: strength depends on slope of$Md & interest elasticity of I.

Ethical, Practical & Philosophical Implications

• Stabilisation policy involves trade-offs between current unemployment and future price stability; distributional impacts must be weighed.
• Credibility & communication of central bank crucial (expectations management).
• Fiscal activism raises inter-temporal equity issues via debt burden; automatic stabilisers mitigate political implementation lags.
• Supply shocks (energy, pandemics) show limits of demand-management alone; structural policies (energy diversification, labour-market reforms) complement macro tools.

Short-Run Economic Fluctuations – Facts to Memorise

• Real GDP grows on average approximately 3\%$per year (U.S. last 50 years), which translates to approximately$2\%$per-capita income growth annually. This average growth reflects the long-run productive capacity of the economy.</p><p>• Recession = a significant decline in economic activity spread across the economy, typically visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. This period is characterised by declining real income and rising unemployment. Depression = a severe and prolonged recession, marked by an extremely large decline in output and employment, such as the Great Depression of the 1930s.</p><p>• Stylised facts (‘Business-cycle facts’):</p><p>– Fluctuations are irregular and unpredictable: Economic expansions and contractions do not follow a fixed pattern or precise timing, making them difficult to forecast accurately.</p><p>– Most macro variables (consumption, investment, wages, prices) move together but with different amplitudes: This means that during an expansion, most economic indicators rise, and during a contraction, most fall. However, the magnitude of their response (amplitude) can vary significantly; for instance, investment is often much more volatile than consumption.</p><p>– Output$\downarrow \Rightarrow$unemployment$\uparrow$(strong inverse link): When the economy produces less (GDP falls), firms require fewer workers, leading to an increase in the unemployment rate. This relationship is often described by Okun's Law.</p><p>– Pro-cyclical: variables that move in the same direction as real GDP. Examples include investment, consumption, and inflation. During economic expansions, these variables typically rise, and during contractions, they fall.</p><p>– A-cyclical/weak: variables that show little or no consistent relationship with the business cycle or have very small fluctuations. Examples include government purchases and real wages, which tend to be more stable regardless of the economic phase.</p><p>– Counter-cyclical: variables that move in the opposite direction to real GDP. Examples include unemployment and the cyclical-unemployment gap; when output falls, unemployment rises, and vice-versa.</p><h5 id="850c247c-6da1-4352-9888-7695364ce5bb" data-toc-id="850c247c-6da1-4352-9888-7695364ce5bb" collapsed="false" seolevelmigrated="true">Basic AD–AS Framework (Short-Run Fluctuation Model)</h5><p>• This framework is designed to explain short-run fluctuations in real output and the overall price level around their long-run equilibrium values. It integrates aggregate demand and aggregate supply to illustrate how these forces interact to determine an economy's short-run macroeconomic equilibrium.</p><p>• Two key aggregate variables:</p><p>$Y$= real output (real GDP), representing the total quantity of goods and services produced in the economy.</p><p>$P$= overall price level (measured by CPI/GDP-deflator), representing the average level of prices for all goods and services.</p><p>• AD curve: Represents the total quantity of goods and services demanded by households, firms, the government, and foreign consumers ($C + I + G + NX$) at each possible overall price level ($P$).</p><p>• AS curve: Represents the total quantity of goods and services that firms are willing and able to supply at each possible overall price level ($P$).</p><p>• We use the AD–AS model to explain deviations of$Y$from its long-run (natural) level$ar Y$. The natural level of output, also known as potential output, is the level of real GDP an economy achieves when all resources (labor, capital, natural resources, technology) are fully employed at their natural rates.</p><h5 id="9936fd1b-bd1f-45f3-9232-ba49d7d21830" data-toc-id="9936fd1b-bd1f-45f3-9232-ba49d7d21830" collapsed="false" seolevelmigrated="true">Aggregate Demand (AD) Curve</h5><p>• Equation with channels for aggregate demand ($Y_d$):</p><p>$Y_d = C\bigl(\Omega\bigr) + I\bigl(r\bigr) + G + NX\bigl(E\bigr)$</p><p>where$\Omega$= real wealth (nominal assets divided by price level),$r$= real interest rate,$E$= real exchange rate. Each component reflects different aspects of spending within the economy.</p><p>• Downward slope reasons (assuming$\Omega, r, E$are endogenous and adjust to changes in$P$):</p><ol><li><p><strong>Real-wealth effect (or Pigou effect)</strong> – As the price level ($P$) decreases, the real value of consumers' nominal money holdings and other nominal assets ($\Omega = A/P$) increases, making them feel wealthier. This increased wealth encourages greater consumer spending ($C\uparrow$), thereby increasing the quantity of goods and services demanded.</p></li><li><p><strong>Interest-rate effect (or Keynes effect)</strong> – A lower price level ($P\downarrow$) reduces the amount of money households and firms need to hold for transactions. This reduced money demand leads to an excess supply of money in financial markets, which in turn drives down the equilibrium real interest rate ($r\downarrow$). A lower real interest rate reduces the cost of borrowing, stimulating investment spending ($I\uparrow$) by firms (for new equipment, factories) and households (for new homes).</p></li><li><p><strong>Exchange-rate effect (or Mundell-Fleming effect)</strong> – As the price level ($P\downarrow$) falls, the real interest rate ($r\downarrow$) also falls (due to the interest-rate effect). This lower domestic real interest rate makes domestic assets less attractive relative to foreign assets, prompting a capital outflow (investors seek higher returns abroad). An increase in capital outflow increases the supply of domestic currency in the foreign exchange market, causing the real exchange rate ($E\downarrow$) to depreciate. A depreciated domestic currency makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic consumers, thus increasing net exports ($NX\uparrow$).</p></li></ol><p>• Shifters of AD (at a given$P$): Factors that change the quantity demanded at every price level will shift the entire AD curve.</p><p>– <strong>Consumption</strong> (C): Changes in consumer confidence (optimism/pessimism about future income), significant wealth shocks (e.g., stock market boom/bust), or changes in tax policy (e.g., tax cuts leaving more disposable income) can shift AD.</p><p>– <strong>Investment</strong> (I): Changes in firms' expectations about future profitability, shifts in interest-rate expectations (independent of current$P), technological advancements (increasing expected returns on new capital), or changes in investment tax credits can shift AD.

– Government purchases (G): Deliberate changes in government spending on goods and services (e.g., increased infrastructure projects or defence spending), representing a shift in fiscal stance, directly shift AD.

– Net exports (NX): Changes in foreign national income (higher foreign income means more demand for domestic exports), changes in trade policies, or shifts in the real exchange rate due to non-price level factors (e.g., government currency intervention) can shift AD.

Aggregate Supply (AS)

Long-Run AS (LRAS)

• The LRAS curve is vertical at the natural rate of output ($\bar Y$), meaning that in the long run, the economy's total production of goods and services is determined by its supply of resources and technology, not by the overall price level.

Y = \bar Y = f(L, K, N, A)$where$L$represents the quantity and quality of labour,$K$represents the stock of physical capital (e.g., factories, machinery),$N$represents natural resources, and$A$represents the level of technology and productivity. These factors determine the economy's potential output over time.</p><p>• LRAS shifts when natural output changes: Any factor that changes the economy's productive capacity in the long run will shift the LRAS curve. This includes changes in the labour force (e.g., population growth, changes in labour force participation rates), changes in the capital stock (e.g., through investment or human capital development), discovery of new natural resources or depletion of existing ones, and advancements in technology (e.g., innovations that make production more efficient).</p><h6 id="52a73887-7a62-45e2-82e0-8aafee8637a7" data-toc-id="52a73887-7a62-45e2-82e0-8aafee8637a7" collapsed="false" seolevelmigrated="true">Short-Run AS (SRAS)</h6><p>• The SRAS curve is upward sloping, indicating that in the short run, an increase in the overall price level leads to an increase in the quantity of goods and services supplied.</p><p>$Ys = \bar Y + a\bigl(P - P^e\bigr)$with$a>0$. This equation suggests that output ($Ys) deviates from its natural level ($\bar Y$) when the actual price level (P$) deviates from the expected price level ($P^e$). A positive '$a$' indicates an upward slope.</p><p>• Three micro-foundations explain the upward slope of the SRAS curve:</p><ol><li><p><strong>Sticky-Wage Theory</strong> – This theory posits that nominal wages adjust slowly to changes in the price level due to long-term contracts, social norms, and slow information dissemination. If the actual price level ($P$) unexpectedly rises above the expected price level ($P^e$), nominal wages are fixed in the short run, meaning real wages ($W/P$) fall. Lower real wages reduce firms' labour costs, making production more profitable. In response, firms hire more workers and increase output ($Y\uparrow$$).