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Aggregate Demand and Supply
Note: Reading is posted under “additional materials” on course website – not under electronic course reserve.
Stable Prices
Why is inflation bad?If wages and prices move together, what is
wrong with inflation? Prices: key to allocating resources Risk: the higher the level of inflation, the more
volatile it becomes.Makes economic decisions difficultStems production of outputCan lead to unanticipated swings in output.
Stable Output
Why is volatile output bad?Creates risk for investorsInvestors demand compensation for bearing riskFirms face higher cost of borrowingLower borrowing implies lower output.
Level and Volatility of Growth
If GDP grows by 4% annuallyOutput doubles in about 18 years
If GDP grows by 2% annuallyOutput grows by about 40% in 18 years
Is Government Policy Useful?
Can government policy lower inflation? Or does policy just add extra volatility to inflation?
Can government policy reduce fluctuations in the business cycle and lower the volatility of output?
Monetariasts vs. Keynsians
Aggregate Demand
Aggregate demand: total quantity of an economy’s goods and services demanded at each price level.Single good: output or GNP
• Y=number of “goods” produced• Y=real output
Single price• P=price of one unit of Y• P*Y=nominal spending (or nominal output)• M=money supply
Aggregate Demand
Demand curve for an individual asset relates demand for the asset to the price of the asset relative to other goods.
Aggregate demand curve relates demand for output to general price level.If all prices decrease by 10%, why should
aggregate demand increase?
Aggregate Demand
When general price level decreases investors have the option of either Buying more of some good Holding more dollars
Assuming holding real goods is better than holding dollars, as price level decreases, aggregate demand increases
Real money supply – purchasing power of M =M/P When prices decrease, M/P increases holding M
constant.
Aggregate Demand
Island EconomyCurrent money supply: M=2 dollarsPrice of a gallon of milk: 2 dollarsPrice of a loaf of bread: 2 dollars
Each day:
Farmer Bakermilk
bread$2
$2
Aggregate Demand
Each day total aggregate demand = 21 loaf of bread1 gallon of milkY=2
Same $2 gets spent twice Total nominal spending = $4 = PY Velocity = (PY)/M = 4/2 = 2
Aggregate Demand
Assume money supply is constant Assume prices decrease
Bread = $1Milk=$1
Farmer can now begin day by buying more than 1 loaf of bread.
Baker can then buy more gallons of milk.
Aggregate Demand Assume
farmer buys 2 loaves of bread baker buys 2 gallons of milk
Each day total aggregate demand = 4 2 loaves of bread 2 gallons of milk Y=4
Same $2 gets spent twice Total nominal spending = $4 = PY=1*4 Velocity = (PY)/M = 4/2 = 2
Velocity
Velocity – the same dollar is spent several times within an economy.
supplymoney
spending nominal
velolcity
M
YP
V
YP
MV
M
YPV As prices decrease, Y increases
holding V and M constant.
Keynsians
Aggregate demand is determined by the sum of the parts:
demandexport
demand government
demand investment
demandconsumer
demandedoutput aggregate
NX
G
I
C
Y
NXGICYad
ad
Keynsians
Holding prices constant, a change in demand by any one sector will change aggregate demand.
Demand curve shifts right with• Increases in government spending• Decreases in taxes• Increases in money supply, M.• Business/Consumer optimism• Increase in Exports
Monetariast View
The only factor that shifts the demand curve is the money supply.
If government increases spending, why does that not increase aggregate demand?
Monetariast answer: complete crowding out. To buy more, government must issue bonds Shifts supply of bonds to the right Increases yield Consumers cannot afford to borrow Consumer demand declines
Long Run Aggregate SupplyLRS
Determined by The amount of capital The amount of labor (natural rate of unemployment) Available technology
In the long run, the farmer and baker don’t have the ability to continually produce 2 loaves of bread and 2 gallons of milk. Prices rise Output decreases
Short Run Aggregate SupplySRS
Firms are seeking to maximize profitsFace increasing marginal costProduce where price=marginal cost
As prices increase firms are willing to produce more
Short Run Aggregate SupplySRS
Example: Firm produces widgetsPrice at which they can sell: $10
To produce Cost Profit
1st $3 $7
2nd $5 $5
3rd $9.99 $.01
Short Run Aggregate SupplySRS
As prices increase firms are willing to produce more to maximize profits
Is short run, production (labor) costs do not change. Wages are set by long-term contracts
(about 70% of production costs) Raw materials bought in advance
SRS curve slopes up
Holding price constant, an increase in production costs shifts supply curve to the left An increase in the cost of the “factors of production”
SRS
Factors that can shift SRS curve to left:Increasing wagesIncreasing expected inflation
• Inflation erodes purchasing power of wages. Workers will demand higher wages.
StrikesIncreasing production costs other than wages.
• Natural disasters• Increases in price of oil
Equilibrium
Aggregate Output, Y
P
Long Run Aggregate SupplyDetermined by natural rate of unemployment
Labor market is tightLarge demand for workersUpward pressure on wages
Labor market is looseLow demand for workersDownward pressure on wages
Equilibrium
Keynsians: Wages are sticky. Short-run aggregate supply is slow to shift,
particularly when unemployment is high.Government is needed to restore economy
to equilibrium.• Government spending• Lowering taxes
Keynsian View
Increased government spending can increase aggregate demand and lower unemployment.
Wages are slow to adjust, so the economy stays out of equilibrium for several years.
Eventually wages increase and short-run supply shifts left.
The long-run effect is just inflation.
Keynsian View
If economy is initially out of equilibrium
Wages are slow to adjust, so the economy can stay out of equilibrium for several years.
Increased government spending can increase aggregate demand.
Lower unemployment at the cost of inflation. Keynsian view is benefit outweighs costs
Non-Activist Monetary View
Assume short-run supply shifts left Economy gets kicked out of equilibrium Government can shift demand curve right by
increasing the money supply But before this happens, SRS shifts back
right, since wages adjust fast When demand curve shifts right, economy
gets kicked out of equilibrium again SRS shifts back left
Monetariast View
Result of policy:Increases volatility of outputIncreases inflation
Conclusions: The Fed does more harm than good when it tries to tinker with money supply.
Non-activist Argument
Data Lag – it takes time for policy makers to obtain the data that tell them what’s going on. Data on quarterly GDP not available for several
months until after the quarter.
Recognition lag – it takes time for policy makers to realize what the data is saying about the future. NBER won’t classify the economy in a recession until 6
months after it determines one might have begun.
Effectiveness lag – Once money supply has changed, it can take time for effects to be carried out
Deflation
Nearly all economists agree deflation is at least as bad as inflationWith deflation, greater defaults on loansGreater bank failureCapital cannot be channeled to good
investments Real output declinesMay have long run effects
Monetariast View
To prevent deflation, grow money supply at a small constant rate.
Result will be moderate inflation from year to year, but benefit will be a hedge against deflation.
Keynsian View
Assume short-run supply shifts left Economy gets kicked out of equilibrium Government can shift demand curve right by
increasing the money supply Wages are not perfectly flexible Demand curve shifts right before supply curve
shifts back right. Result of intervention is
Faster return to long run output level at cost of moderate inflation
Activist view is that benefits outweigh costs.
Keynsian View
Assume demand curve shifts right (irrational exuberance)
Economy gets kicked out of equilibrium Government can shift demand curve left by decreasing
the money supply Demand curve shifts left before supply curve shifts left. Result of intervention is
Faster return to long run output level at cost of moderate inflation
Lower and less volatile inflation
Keynsian View
Assume demand curve shifts left (irrational pessimism) Economy gets kicked out of equilibrium Government can shift demand curve right by increasing
the money supply Hopefully economy never gets to point 1. Argument in favor of increasing money supply at small
rate –that may vary over time according to business optimism/pessimism.
Result of intervention is No deflation at cost of some moderate inflation Activist view is that benefit outweighs cost.
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