2.2a Aggregate Demand

• Aggregate demand (AD) is comprised of all the spending that comes to a domestic market. Aggregate demand, is a schedule, which shows the amounts of real GDP that buyers will collectively buy at given average price levels in the economy.

• Therefore we categorize the different types of demand like this:

• Consumer spending (C)• Investment (I)• Government spending (G)• Net Exports (X – M)

• The aggregate demand curve has a negative slope. Essentially the AD curve is the visual representation of the expenditure method of GDP accounting.

• The price level is measured as the average price level of final goods and services (product) in the economy and is considered a measurement of inflation.

• Why is the AD curve negatively sloped? • The first reason is called the real balances

effect. As the price level rises, the purchasing power of the public’s income or savings decreases so they can buy less as the price level rises. This factor is most closely associated with consumption (C).

• Secondly, the interest rate effect influences the slope. As prices rise, there is an increase in demand for money and the cost of borrowing money (the interest rate) will rise as well. Lenders will charge a higher rate of interest for the public to borrow money to finance household consumption or for firms to invest in productive capacity. This effect is usually most visible in investment (I).

• Finally there is the foreign purchases effect. When the price level rises, it makes the country’s exports more expensive to foreign buyers. This leads to a decrease in foreign purchases of the country’s exports. Moreover, rising domestic prices may make imported goods cheaper and result in citizens substituting imports for exports at higher price levels. This is effect is seen in net exports (X – M).

• In the diagram above, the economy is producing output Y at the price level P.

• Shifts in the AD curve are the result of changes in the components of AD or changes in the factors of the following equation:

C + I +G + (X – M) = AD

Consumption – The elements that affect consumer spending would be changes in the following:

Consumer wealth – While changes in income will clearly change consumption, so will the wealth of households. If there is a change in the value of physical (real estate) or paper (stocks and bonds) assets, then consumers will feel more or less wealthy and adjust their spending accordingly.

• Consumer expectations – If consumers believe that their real income will change in the future, they will increase or reduce expenditures based upon their expectations.

• Personal income taxes – A direct tax will affect disposable income which will have an impact upon households ability to consume.

• Household indebtedness – When households borrow to consume (or invest), the purchases bought with borrowed money will increase AD. However, when consumers pay back that debt, they will have to reduce current expenditures to pay back for previous consumption which will decrease AD.

• Interest rates – The cost of borrowing money will impact the purchase of “big ticket” items or consumer durable goods. These are goods that last longer than a year and are difficult for households to buy without borrowing moneyIf interest rates are low, then households would be willing to borrow money to buy the goods they desire, thereby increasing AD as noted above.

Investment spending – Investment is the most volatile variable in AD because it relies upon future expectations of businesses and individuals of economic activity. The elements that affect business investment would be changes in the following:

Real interest rates – Again, the cost of borrowing money can induce businesses to take or put off investing. If the real interest rate increases, then businesses will hold off borrowing to buy new plant and equipment. If real interest rates decrease, then firms would increase investment with a corresponding increase in AD.

Expected returns – If companies believe that they will be able to make a good return on investment, then they will increase their purchases and shift the AD curve to the right. If businesses believe that business conditions will improve, then they will invest in new projects.

Business taxes – Taxes will have a direct effect upon the profits that a firm expects to make from an investment. Consequently, a reduction in business taxes will increase investment and AD. An increase in such taxes will have the opposite effect.

Technology – Improvements in technology, which bring with them a corresponding increase in productivity, will increase returns to an investment. Technological change incentivizes firms to increase their investment, which then leads to an increase in AD.

Government spending – The elements that affect government spending would be changes in the following:

Changes in political priorities – If a government decides to change spending due to a perceived threat or crisis then the G variable will impact AD. An example might be a change in defense expenditures.

Changes in economic priorities – In the case of a recessionary environment, the government may increase expenditures to make up for the loss of AD or employment that occurs in a downturn. An example of this might be increasing expenditures on infrastructure such as roads.

Net Export spending would be affected by the following:

National income abroad – When trade partners incomes rise, they have a tendency to buy more imports, which could mean an increase in purchases of our exports. The opposite is true if their incomes decrease.

Exchange rates – When our country’s currency depreciates, it makes our exports cheaper to foreign buyers as it takes fewer units of their currency to pay for the goods or services we sell them. This will increase AD. Conversely, we may see the opposite effect if our currency appreciates against that of our trade partners.

Levels of protectionism – If there is increased protectionism (import tariffs or quotas) practiced by trade partners, this can reduce exports and thereby AD.

2.2b Aggregate supply

• Aggregate supply (AS) is a schedule of real domestic output that is produced at each possible price level.

• Unlike aggregate demand, aggregate supply is more complex in its measurement. This is due to the fact that producers cannot adjust quickly to changes in the average price level.

• The short run is defined as the timeframe in which wages and input prices cannot adjust to changes in the average price level.

• The long run is considered to be the time in which wages and input prices can adjust to changes in the average price level.

Movements along the SRAS curve –

• Due to what we call a recognition lag, wages and factor input costs do not respond immediately to changes in the price level so it takes time for these prices to adjust.

• While an increase in the price level might allow a firm to increase its product prices, the factor input costs will respond much more slowly.

• Remember that the largest cost for most firms is labor and so the nominal wage rate plays a dominant role in firms’ operations.

• Wage rate changes often lag changes in the price level in an economy as it takes time for workers to realize that their purchasing power has declined.

• When the price level rises, firms are able to increase their final goods prices and make larger profits as their wage bill remains unchanged.

• Subsequently, a firm will increase its output when the price level is rising to capture more profits.

• Consequently, the firms increase output and can push the economy beyond full employment as they hire unemployed workers and encourage employees to work overtime or to move to full time work.

• The situation is illustrated in the diagram below at point b in which the Y’ level of RGDP at the P’ price level demonstrates a rise up along the SRAS curve.

• Firms respond to falls in the price level by lowering their final goods prices as they attempt to clear inventory.

• This reduction in sales revenues will reduce profits and put firms in a position to decrease production or even lay off workers. The increase in unemployment will correspond to a decrease in SRAS.

• This condition corresponds to the Y” level of RGDP at the P” price level or at point c on the diagram below.

• The movements along the SRAS curve described above originate at point a.

• Production costs are the primary factor in changes in AS. However, there are several determinants of AS:

• Resource costs – All factor input prices will play a role in the final product price, consequently any change in resource costs will shift the curve. If for example, there is a decrease in the price of oil, then the AS curve will shift out to the right as we can produce more output with the same expenditure as before the price change. Conversely, a rise in wages will push the curve up and to the left.

• Resource costs are not just domestic in nature. While labor is a domestic expense, some raw materials are imported. As a result, exchange rates and control over the supply of the needed resource can complicate prices firms.

• If one particular trade partner has inordinate market power over a commodity, then it can increase the price and thereby impact our AS due to our use of the input in our production. Furthermore, if our exchange rate depreciates, we will have to pay more for imports of a critical factor input.

• Productivity – Improvements in productivity will increase output at all price levels and push the AS out and to the right.

• By improving the quality of factor inputs, either in the case of new machines or increasing the skill level of workers, we can produce more output at current prices and shift out the AS curve.

Business Environment – This addresses many variables such as:

• Business taxes – Higher direct and indirect taxes increase costs in the short run and can lead to a reduction in output at every price level with a corresponding leftward shift in the AS curve.

• Subsidies – Payments by the government to firms to encourage the production of specific goods can lower production costs and encourage companies to expand their output.

• Regulation - The costs associated with complying with government regulations can divert funds from production and decrease output for firms. An increase in government regulation may shift the AS curve to the left.

2.2c Controversy over aggregate supply

Aggregate supply is a source of debate among different schools of economic thought. Most economists agree that the long run AS (LRAS) curve is vertical and that it represents the full employment/potential level of output.

• Neo- Classical economists (Friedrich Hayek and Milton Friedman) argue that production levels are determined through the efficient operation of markets. Therefore, there is no SRAS as the economy is always just at full employment operating on or near the LRAS curve.

• If there is a temporary downturn, then laid off workers will quickly adjust their wage demands or change their location and be reemployed very soon. There is no need for the government to intervene

• Neo-classical economists believe that any policy to address instability in the economy will interfere with the self-correcting mechanism of markets and result in price distortions (inflation).

• In essence, the neo-classical perspective believes that AS in the long run is independent of prices as markets will act to push the economy back towards equilibrium.

• The neo-classical school is often associated with non-interventionist and market based policies. By reducing the role of government in the economy and regulating the rate of growth in the money supply (more on this later), markets will self-correct and the economy will grow more effectively.

• Consequently, neo-classical economists focus on the long run and as a result they will push for supply-side policies which reduce impediments to competition as well as reduce government intervention in the economy.

• Neo-classical attitudes are connected to mostly right leaning political parties. Policies promoted in Ireland in the period after the 2009 financial crisis which reduced government spending and encouraged austerity in general, could be considered to be neo-classical in nature.

• However, Keynesian economists believe that markets are imperfect and that macroeconomic instability is the result of different forms of market failure.

• Consequently, the Keynesians believe in the AS curve which has three regions.

• They believe that output can fall at such as rate that it falls into the horizontal range of the AS curve. This means that there could be a decrease in output with no change in the price level.

• This is due to the belief that resource costs and final product prices are “sticky downwards”. This perspective is rooted in the belief that workers do not adjust their wage demands as rapidly as they will attempt to find employment at their previous income.

• Moreover, from this perspective, producers do not adjust their product prices until absolutely necessary to clear inventory.

• When both of these scenarios are in play, there is plenty of spare capacity for the economy to put back to work without putting upward pressure on the price level.

• Horizontal range – this is substantially below full employment implies that the economy is in recession or worse, a depression. There are plenty of unemployed resources and there is upward pressure on prices. This is characterized by a flat portion of the AS curve.

• Intermediate range – as the economy starts to grow, there is increased demand for labor and other resources. This results in upward pressure on factor input prices and requires firms to increase their product prices to maintain profitability. There will begin to be shortages of resources, which will further drive up prices. This region is where most of the short run analysis is done and is upward sloping.

• Vertical range – when the economy reaches its potential output or full employment, the curve becomes vertical. This is because the economy is at full capacity. Any efforts by firms to increase output will only bid resources away from other firms and drive up prices in the process. This is due to the finite resources in the economy.

• Keynesian economists believe that markets are imperfect and that macroeconomic instability is the result of different forms of market failure.

• They believe that output can fall at such as rate that it falls into the horizontal range of the AS curve. This means that there could be a decrease in output with no change in the price level.

• This is due to the belief that resource costs and final product prices are “sticky downwards”. This perspective is rooted in the belief that workers do not adjust their wage demands as rapidly as they will attempt to find employment at their previous income.

• Moreover, producers do not adjust their product prices until absolutely necessary to clear inventory.

• When both of these scenarios are in play, there is plenty of spare capacity for the economy to put back to work without putting upward pressure on the price level.

• Keynesian policies to address economic instability are often a mix of fiscal (government driven) and monetary (central bank directed) policies. These policies often affect the economy through the demand or AD side.

• These tactics can be interventionist as in increasing government spending to make up for a decrease in AD or cutting taxes to increase investment. Or the central bank could increase the money supply to lower interest rates to promote investment.

• Unfortunately, both of these policies often result in inflation, which we will discuss in more detail in the future.

• An example of such Keynesian government driven policies was the $819 billion stimulus package of increased spending and continuation of tax cuts passed by Congress in the U.S. in 2009.

2.2d Long run aggregate supply

• Despite their differences, both Keynesians and neo-classical economists agree on the LRAS being vertical at the potential output of the economy and the goal of shifting the LRAS to the right.

• The LRAS corresponds to the full-employment output (Yfe) of the economy. This is basically when the economy is operating at its potential.

• Another way of saying this is that the economy is operating at the natural rate of unemployment (NRU). This point occurs when the number of job applicants is equal to the number of vacancies.

• The economy can operate below the NRU or at time beyond the NRU. How the economy adjusts to these two conditions is the subject of much controversy and we will discuss this dispute in more detail in section 2.3.

• Shifting the LRAS is another way of demonstrating economic growth through expanding the potential or full employment output of the economy.

• In this case it is very similar to the how the PPC operates.

Notice how the PPC is pushed out demonstrating economic growth and how this matches the increase from Yfe to Yfe’ in the LRAS on the AD/AS model on the right.

• Two sources of expansion of the LRAS are increasing the quantity and quality of factor inputs.

• If there is an increase in the factors of production we can shift the potential of full employment output.

• For example, we can add more to our labor force via population growth or increase labor force participation. By having formerly unemployed workers or more women enter the labor force, we have increased our potential output.

• If we increase our stock of physical capital through investment, we have pushed out our potential. When firms put in place more machinery, it will increase the productivity of labor and consequently potential output.

• A new natural resources discovery will push the LRAS to the right reflecting an increase in land as a factor of production. An example of this might be Brazil’s oil discovery in 2006, which added to its potential GDP.

• By improving the quality of inputs, we can push the LRAS outward as well. This is usually associated with improvements in training and education for labor to increase productivity. Highly trained labor can be more capable of suggesting cost saving ideas to increase output.

• Technological advances associated with capital equipment will make labor more productive and thereby push the LRAS out as well. For example, new machines in a metal fabrication plant, which use raw materials more efficiently, will increase potential output.

• Finally, we can improve our allocative efficiency by more effectively organizing our productive resources. Companies endeavor to do this by continually examining production processes to decrease wasted movements or procedures.

2.2e SRAS/AD equilibrium

• Similar to equilibrium in microeconomics, macroeconomic equilibrium occurs when AD and the SRAS behave in a manner to move towards equilibrium in which:

P level = AD = SRAS

Real Output Demanded (AD)

Price level (Index Number)

Real Output Supplied (AS)

440 110 453

443 105 450

447 100 447

450 95 444

453 90 441

The table makes evident that macroeconomic equilibrium will occur at a price level of 100 with a real output of $447 billion. Let’s look at a diagram.

As the diagram makes clear, the equilibrium level of output is at $447 billion at the price index of 100.

• Arriving at a new equilibrium in the short run can be achieved through the demand side or the supply side. Let’s examine the demand side first.

• Whenever one of the determinants of aggregate demand (C+I+G+(X-M)) changes, the result will be a shift in the AD curve.

• The increase in investment described above will lead to an increase in aggregate demand from AD to AD’. This results in a new equilibrium level of output Y’ at a higher price level of P’.

• While the economy experiences higher output, the challenge here is that there is a rise in the price level, which is associated with demand pull inflation.

• Suffice it to say, if we see a decline in any of the AD variables, the new equilibrium would be at a lower output and a lower price level (all things being equal).

• Drops in various components of AD may be the result of higher interest rates resulting in businesses reducing Investment or Consumers income stagnating so they buy fewer goods and services.

• One final note here is that a natural or man-made event can reduce Consumption (as well as Investment) due to the disruption in people’s lives. An example of this might be the terrorist attacks in Spain in 2004 and in England in 2005 leading to less train travel by citizens or a decline in consumption due to the earthquake in Haiti in 2010.

• Do you think that you can draw the correct diagram for a decline in AD?

• Decreases in SRAS are usually associated with supply shocks. These events are often the result of the disruption of a segment in the supply chain due to a natural or man-made disaster.

• The 2011 earthquake and tsunami in Japan lead to a decrease in the SRAS in Japan as well as impacting the supply chain of firms in other countries.

• The classic explanation of a supply shock is an increase in oil prices that is so dramatic as to make every unit of output that much more expensive to produce that the economy creates less output at a higher price.

• In the 1970’s when oil prices tripled in a very short period of time, the U.S. economy in particular, production costs soared and the result was what is called cost push inflation.

The lower output was at a higher price and the diagram below illustrates the conundrum.

• With an increase in factor input costs (such as oil in this case), producers can make fewer goods and services for a given budget.

• The scenario leads to a shift in the SRAS curve to SRAS’.

• This results in a decrease in output form Y to Y’, yet with prices increasing from P to P’ accounting for the corresponding increase of resource costs.

•

• There are occasions when the both AD increases and the SRAS curve shifts out as well. This results in low inflation and strong economic growth.

• Unfortunately, this sort of benign environment is not always seen in the real economy…the U.S. experienced this scenario between 1996 and 2000.

• The diagram below will illustrate this favorable environment.

• As the diagram makes evident, the growing economy shows a shift in the AD curve from AD to AD’. The new equilibrium shows a corresponding output of Y’ at the price level P’.

• However, as a result of increased worker productivity, the SRAS curve shifts out to SRAS’. The shift in the SRAS curve increases output even further to Y” at a lower price level of P”.

2.2f LRAS-SRAS-AD equilibrium

• Short run and long run equilibrium can come together at full employment.

• Remember that the full employment level of output corresponds to the LRAS. This is because nominal wages adjust in response to changes in the price level over time.

• In the long run, the SRAS goes through a series of adjustments to changes in the price level.

• As we will see shortly, these adjustments can lead to a recessionary or inflationary gap in the short run.

• Corrections can result in AD-SRAS-LRAS equilibrium, as demonstrated by the diagram below.

• In the scenario above, the economy starts in a recessionary environment at Y output at the P price level. Now suppose that prices have fallen far enough to induce firms to invest in new machinery and hire workers to operate the machinery.

• The increase in I, leads to a shift in the AD curve to AD’ at the P’ price level and Yfe level of output. This happened to be in long run equilibrium for the economy.

•

• The neo-classical school believes that the economy always self-corrects, so therefore we only need to worry about policies that push out the LRAS.

• The neo-classical analysis shown below starts at full employment output (Yfe) at the price level Y or point a.

• If there is an unanticipated increase in aggregate demand shown by the shift in the AD curve from AD to AD’, then this will push equilibrium beyond the full employment level of output corresponding to Y’ at point b.

• However, owners of resources/factor inputs are quick to realize that the price level has increased and they will demand higher prices or wages to restore lost purchasing power.

• As per unit production costs increase, aggregate supply will decrease leading to a shift in the curve from AS to AS’. Hence the economy self-corrects to point c back at the full employment output (Yfe) but at a higher price level (P”).

• Neo-classical economists believe that people behave rationally and therefore take action rapidly to protect their self-interest.

• Even though the economy will slip out of long run equilibrium, individuals and firms interacting in the market place will automatically push it back to Yfe.

• For these reasons, there is no need for the government to invoke any changes in fiscal policy or for the central bank to take monetary action…let the markets work.

• Keynesian economists have a different perspective on how an economy falls into, and for how long the economy can be in, disequilibrium.

• The basic belief here is that the economy is in equilibrium wherever AS = AD…whether at full employment or not.

• The Keynesian school of thought focuses on the role that aggregate demand plays in economic instability.

• Rapid changes in any of the variables of AD will lead to the economy reaching a new equilibrium often above or below full employment.

• Remember that another key to the Keynes perspective is that individuals and firms take a longer time to recognize and adjust their wage and price demands.

• For example, a dramatic drop in Consumption in an economy where consumption plays a large role can push the economy into recession.

• However, the most destabilizing variable is wide swings in Investment.

• Due to investment relying upon real interest rates and expected rates of return, optimism (or pessimism) can lead to big booms (or busts) in investment.

2.2g Keynesian perspective on equilibrium.

• A recessionary gap is defined as a level of macroeconomic equilibrium below the full employment level of output as show in the diagram of the Malaysian economy below.

• This gap corresponds to the point when actual economic growth falls below potential economic growth in the business cycle.

• The result of this decline is unemployed resources whether it be labor or capital in the form of plant and machinery being idle.

• In the Keynesian system, the economy can experience long periods of recession due to the downward rigidity in wages and prices. In this view, individuals do not adjust their wage demands as rapidly as they will attempt to find employment at their previous income.

• As noted earlier, from this perspective, producers do not adjust their product prices until absolutely necessary to clear inventory.

• An equation for this might be:

AD = AS < LRAS/Yfe

• This diagram of the Malaysian economy shows a recessionary gap where equilibrium is reached at a price level of 100 equaling a RGDP of $447 billion.

• However, this point is below the full employment level of potential output at $450 billion.

• This model also allows for an inflationary gap to occur in which the economy reaches equilibrium beyond full employment.

• In this case, we might be able to write this as

an equation:AD = SRAS > LRAS/Yfe

• If an economy starts to grow rapidly and overheat, there can be a reduction in spare manufacturing capacity and very tight labor markets.

• Wage rates will be bid up as firms try to secure scarce labor to meet the growing demand for their output.

• Natural resource and other factor input prices will increase as firms continue to compete for scarce resources as most producers of natural resources cannot quickly increase supply to meet growing demand.

• These input price increases will lead to higher final goods and services prices as shown below.

• In this scenario it is evident that the Malaysian economy is overheating reaching equilibrium at a price level of 105 with RGDP beyond full employment at $453 billion.

• Finally, unlike neo-classical economists, Keynes did not believe that increases in AD had to be inflationary.

• It is a core belief of the Keynesians that the economy can operate for long periods of time in the horizontal range of the Keynesian AS curve.

• Because of the large amount of unused resources (labor, capital or natural resources), there are plenty of factor inputs available for production.

• These unemployed resources can be engaged without worry for bottlenecks or shortages leading to wage and price increases.

• Therefore, increases in AD can result in growth and output can be increased with little or no upward pressure on the overall price level.

• In the economy above, equilibrium is deep in the horizontal zone of the AS curve and there is enough excess capacity and surplus labor that AD can increase to AD’ with no impact upon the overall price level as RGDP moves from Y to Y’.