Aggregate Supply and Demand

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Aggregate = ?

• aggregate = total, so…

• Aggregate Demand (AD) = the total demand for all goods and services, and

• Aggregate Supply (AS) = the total supply of all goods and services.

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P and Q axis?

• How do we measure P and Q for the entire economy?

• Q = the quantity of all goods and services produced, without any change in prices, so we use Real GDP. Most economists use Y rather than Q (Y stands for income)

• P = the average price level for all goods and services, so we use the GDP Deflator

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Aggregate Demand

• AD = total demand by consumers (C) + firms (I) + government (G) – the parts of C, I, and G that are for imported goods and services (M) + foreign demand for US goods and services (X)

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AD is complicated• The amount of demand must balance

income and spending (spending comes from income and income comes from spending).

• More income will lead to more spending, which will create more income, which will lead to more spending…

• At some level of GDP, all income will be spent, which then equals the total demand for goods and services.

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Downward sloping AD

• The demand for chicken is downward sloping because the prices of all other goods are held constant. When the price of chicken goes up, people buy more of other goods instead. Why is this different for AD?

• Income is also held constant, so when the price goes up people cannot afford to buy as much. Why is this different for AD?

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Wealth Effect

• When all prices change, the value of some assets will not change, such as bonds, checking deposits, and dollar bills.

• With higher prices, the actual value (purchasing power) of these assets will decrease. With less wealth, people will spend less, causing the aggregate quantity demanded to decrease.

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The problem

• As usual in economics, it is a bit more complicated than that.

• A bond is an IOU, or contract for the borrower to pay back the lender.

• If the real value of the IOU decreases, the lender is worse off (and will spend less) but the borrower is better off (and will spend more).

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The solution

• What if the borrower is the US Treasury or the Fed (Federal Reserve Bank)? Their spending will not change. Only the spending of the lender (that is us) will change.

• So, if all prices increase, the real value of the $100 bond that we bought from the US government will decrease. With less real wealth we will spend less.

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Interest Rate Effect

• If prices rise then we will need more money to buy goods and services.

• To get more money, people will sell some other assets, such as bonds.

• This will cause the interest rate to increase.

• Which will cause consumers and firms to borrow and spend less.

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Money, bonds, and loans

• Each person chooses how much of their wealth to hold as money (which they will use to buy goods and services) and assets such as bonds (which earn interest).

• Bonds are a type of loan, so if people want to hold fewer bonds they are willing to make fewer loans.

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Open Economy Effect

• Prices in the rest of the world ARE held constant.

• If all prices in the US increase, foreign demand for US goods and services (X) will decrease and US demand for foreign goods and services (M) will increase. They buy less from us and more of our spending is for foreign products (so less for US products).

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Shifts in AD

• Remember that a change in price causes movement along a demand curve (change in quantity demanded), while a change in all other factors will shift to a new demand curve (change in demand).

• Other than prices, what can change the demand by consumers, firms, government, and people outside this country?

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Shift in C

• Change in consumer confidence

• Change in wealth (e.g., stock market or housing prices)

• Change in tax rates

• Which are you more likely to spend, a temporary tax cut or a permanent cut?

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Shift in I

• Change in business confidence

• Change in the money supply by the Fed, which will affect the interest rate

• Changes in taxes, such as a lower tax rate on capital gains

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Shift in G

• Changes in defense spending due to war

• Changes in public works spending (e.g., new roads or buildings)

• Changes in social programs (e.g., universal health care)

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Shifts in X and M

• Changes in economic conditions in other countries

• What would happen to US exports if Canada had a recession?

• Changes in exchange rates (e.g., how many yen it takes to buy a dollar)

• This affects the prices of US goods in Japan

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Spending multiplier

• Any change in spending will have a multiplied effect on total demand.

• As noted earlier, more spending by one person will cause someone’s income to rise. With more income, that person will spend more, which will cause someone else’s income to rise, and so on.

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Aggregate Supply

• The shape of the AS curve is different in the short run and long run.

• In the long run, all prices, including the wage rate (the price of labor) will change.

• In the short run, some prices do not change.

• For example, some prices are fixed for the life of a contact.

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Long Run AS (LRAS)

• If all prices, including wage rates, rise by the same amount, how will firms react?

• They can charge more but their cost of production has also increased. Nothing has really changed, so they will produce and sell the same quantity.

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Slope of LRAS

• If an increase in the price level has no effect on the quantity produced, then the supply curve is a vertical line.

• The only question is, at what quantity of real GDP?

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Location of LRAS

• If all prices, including wages, are free to adjust, then markets should be in equilibrium, including the labor market.

• This means that there is no shortage and no surplus of labor, so that everyone who wants a job has a job, except for those people who are taking time to find the best job (frictional unemployment) or lack the right skills (structural unemployment)

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Location of LRAS

• If the labor market is at equilibrium, then we can determine the amount of output produced using that quantity of labor (roughly 95% of the labor force, assuming the natural rate of unemployment is 5%)

• The output that is produced when we have full employment is called the potential output for the economy, or Yp

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Changes in Yp

• Yp, or the full-employment output for the economy, is based on the amount of other resources available, including capital.

• It also depends on technology available and how many people want to work.

• The willingness to work is determined in part by tax rates.

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Short Run AS (SRAS)

• In a short period of time, not all prices are able to adjust because…

• some prices are set by contracts which are in effect for months or years

• changes in price, particularly wages, may require costly negotiations and it does not make sense to renegotiate constantly

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Sticky prices

• Another reason why prices may not adjust quickly is that firms lack perfect information. If you are not sure what the new price should be do not change it right away.

• There are also costs to changing prices, such as printing new catalogs and upset customers (when prices go up).

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Shape of SRAS

• If most prices increase but wages (the price of labor) does not, then how will firms react? Does it make sense to hire more workers temporarily or fewer workers?

• What if most prices decrease?

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Upward-sloping SRAS

• If prices go up but wages do not, then real wages go down. If labor is cheaper, hire more workers until the contract expires and you have to pay them more. Total output goes up (higher P means higher Y)

• If prices go down but wages do not, then real wages go up and firms will decide to hire were workers. Total output goes down.

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Shifts in SRAS

• SRAS will shift when the “stuck” prices, such as wages for some workers, get unstuck.

• It can also shift when the availability and prices of other resources change, such as the price of oil or employer-paid healthcare benefits.

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Changes in AD

• Assume that the economy starts at full equilibrium, that is, where AD and LRAS intersect.

• What happens in the short run if AD decreases? in the long run?

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Decrease in AD

LRASSRAS

AD

AD'

Yp (full employment!real GDP)

Y (real GDP)

P (GDP Deflator)

•

•

!

"

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Decrease in AD

• The economy starts in equilibrium at point ➀, where AD, LRAS, and SRAS intersect.

• When AD decreases, this creates a surplus of goods and services.

• The price level will decrease and the economy moves along the AD and SRAS curves to reach a new temporary equilibrium at point ➁.

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Recessionary Gap

• The economy is temporarily (in the short run) at an equilibrium which is below the full-employment output. This is called a recessionary gap and can be measured by the difference between current Y and Yp.

• What will happen in the long run?

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Long run

• With lower prices, eventually wage contracts will expire and wage will decrease.

• A decrease in wage rates will cause SRAS to increase (lower wages = hire more workers and produce more)

• The SRAS will shift until the economy returns to full equilibrium and Y =Yp at ➂.

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New LR EquilibriumLRAS

SRAS

SRAS'

AD'

YpY

P

•

•!

"

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Government action?

• The policy options for the government are

• Do nothing in the short run and wait for the economy to recover in the long run, so ➀ to ➁ (short run) to ➂ (long run).

• Use expansionary monetary or fiscal policy to increase AD in the short run, so ➀ to ➁ to ➀ (short run).

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Do nothing?

• If the short run is really short, then let the economy recover on its own.

• If you try to fix the problem (not enough demand) by increasing demand, you may create too much demand if the economy recovers before the policy has an effect.

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Why policy is slow

• Recognition lag = determining that the economy has entered a recession

• Implementation lag = deciding what to do and doing it; longer for fiscal policy

• Impact lag = a change in policy will take time to have an effect, such as the time between announcing a tax cut and an increase in spending

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Do something?

• However, the short run may last a long time.

• “In the long run we are all dead.” ~ John Maynard Keynes

• While the economy will eventually recover, there could be great harm to many people from persistent high unemployment.

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What changes?

• If consumers or firms spend less (AD falls), and the government decides to increase its spending (AD rises) to keep total real GDP from decreasing, the composition of AD will change.

• There will be less private spending (C and I) and more public spending (G). Can this be a problem for the economy?

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What if AD increases?

• What will happen to P and Y in the short run? What happens to the real wage rate and employment?

• What will happen to P and Y in the long run?

• What should the government do?

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