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

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.

Aggregate Demand

Aggregate Output Demanded, Y

P

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

Long-Run Aggregate Supply

Aggregate Output, Y

P

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

P

Aggregate Output Supplied=Y

Short-run supply curve shiftsleft as costs of productionincrease.

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

Aggregate Output, Y

P

Government spending shifts demand to right

1.

2.

3.

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

Aggregate Output, Y

P

1.

2.

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

Monetariast View

Aggregate Output, Y

P

1.2.

3.

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

Aggregate Output, Y

P

1.

2.

3.

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

Aggregate Output, Y

P

1.2.

3.

Original equilibrium

With no intervention

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

Aggregate Output, Y

P

1.

2.Original equilibrium

With no intervention

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.