The Aggregate Demand/Aggregate Supply Model

Transcription

1 CHAPTER 27 The Aggregate Demand/Aggregate Supply Model The Theory of Economics... is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions. J. M. Keynes McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2 CLASSICAL VS. KEYNESIAN McGraw-Hill/Irwin Colander, Economics 2

3 The Development of Macro The Great Depression: deep recession that began in 1929 and lasted for 10 years Output fell by 30% Unemployment rose to 25% It was a defining event that undermined people s faith in markets Led to emphasis on the short-run and the demand side of the economy and the development of macroeconomic theory separate from microeconomics 27-3

4 Classical Economists These are earlier economists who focused on long-run issues Believed markets were self-regulating through the invisible hand The economy would always return to its potential output and target rate of unemployment in the long run 27-4

5 Classical Economists Favored a laissez-faire approach Blamed the Depression on labor unions and government policies that prevented prices from falling McGraw-Hill/Irwin Colander, Economics 5

6 Keynesian Economics First outlined in 1936 by John Maynard Keynes Looked at the short run The Depression caused the development of this approach Dealt with adjustment of wages and price level to changes in expenditures If people stopped buying, this decreased aggregate demand and would decrease production 27-6

7 Keynesian Economics Distinguished the adjustment process for a single market (micro issue) from the adjustment process for the aggregate economy (macro issue) Keynesians argued that, in times of recession, spending is a public good that benefits everyone McGraw-Hill/Irwin Colander, Economics 7

8 Keynesian Economics The aggregate economy's short-run adjustment process can lead the economy away from its potential income A falling price level can have a negative effect on aggregate demand This could lead to a cycle of falling output and prices 27-8

9 Keynesian Economics In the short-run equilibrium income is not fixed at the economy s long run potential income it fluctuates For Keynes, there is a difference between equilibrium income and potential income Equilibrium income: the level of income toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing McGraw-Hill/Irwin production Colander, Economics 9

10 Keynesian Economics Potential income: the level of income that the economy technically is capable of producing without generating accelerating inflation Market forces may not be strong enough to get the economy out of a recession McGraw-Hill/Irwin Colander, Economics 10

11 Paradox of thrift Keynesian Economics In the long run, saving leads to investment and growth In the short run, saving may lead to a decrease in spending, output, and employment The paradox of thrift is different from the classical growth model which focuses on saving to achieve economic growth 27-11

12 THE AS/AD MODEL McGraw-Hill/Irwin Colander, Economics 12

13 The AS/AD Model Consists of 3 curves: SRAS (Short Run Aggregate Supply) AD (Aggregate Demand) LRAS (Long Run Aggregate Supply) McGraw-Hill/Irwin Colander, Economics 13

14 Price Level Draw the Graph: AS/AD Graph LRAS SRAS P 1 Long-run equilibrium Real GDP AD McGraw-Hill/Irwin 14 Y P

15 The AS/AD Model This is different from micro when we discussed S and D In macro, we are talking about the price level of ALL goods not just one good On the horizontal axis we look at aggregate output, not just the output of a single good McGraw-Hill/Irwin Colander, Economics 15

16 Components of the AS/AD Model Aggregate Demand (AD) is all the goods and services (real GDP) that buyers are willing and able to purchase at different prices 27-16

17 Components of the AS/AD Model Aggregate Demand Curve (AD) Is a curve that shows how a change in the price level will change aggregate expenditures on all goods and services in an economy Remember, AD is a sum of aggregate expenditures: C + I + G+ (X n ) McGraw-Hill/Irwin Colander, Economics 17

18 Components of the AS/AD Model Short-Run Aggregate Supply Curve (SRAS) Shows how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant McGraw-Hill/Irwin Colander, Economics 18

19 Components of the AS/AD Model Long-Run Aggregate Supply Curve (LRAS) Shows the long-run relationship between output and the price level McGraw-Hill/Irwin Colander, Economics 19

20 AGGREGATE DEMAND McGraw-Hill/Irwin Colander, Economics 20

21 The Slope of the AD Curve The AD curve is downward sloping because of: Interest rate effect: when the price level increases, lenders need to charge higher interest rates to get a real return on their loans Higher interest rates discourage consumer spending and business investment 27-21

22 The Slope of the AD Curve International effect: as the price level falls (assuming the exchange rate does not change), net exports will rise When the U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods Exports fall and imports rise causing real GDP demanded to fall McGraw-Hill/Irwin Colander, Economics 22

23 The Slope of the AD Curve Money Wealth Effect/Real Balance Effect: A decrease in the price level increases the purchasing power of money People have more money and save more money Banks can then loan out more money and interest rates decrease Higher price levels reduce purchasing McGraw-Hill/Irwin power Colander, Economics 23

24 The Slope of the AD Curve The multiplier effect: the amplification of initial changes in expenditures (more in CH 28) Basically, a change that causes other repercussions in the economy could be reducing purchases of U.S. goods, an increase in unemployment, etc. McGraw-Hill/Irwin Colander, Economics 24

25 Shifts in the AD Curve A shift in the AD curve means that at every price level, total expenditures have changed. Five important shift factors are: 1. Foreign income 2. Exchange rates 3. Distribution of income 4. Expectations 5. Monetary and fiscal policy 27-25

26 Shifts in the AD Curve: Foreign Income & Exchange Rates When foreign income decreases, the AD curve for U.S. goods shifts to the left (decrease) When foreign income increases, the AD curve shifts to the right (increases) When a country's currency gains value the AD curve shifts in the opposite direction McGraw-Hill/Irwin Colander, Economics 26

27 Shifts in the AD Curve: Distribution of Income & Expectations When real wages decrease the AD curve shifts to the left When real wages increase the AD curve shifts to the right McGraw-Hill/Irwin Colander, Economics 27

28 Shifts in the AD Curve: Distribution of Income & Expectations When consumers expect the economy to do well they spend more this causes the AD curve to shift to the right If consumers expect the price of a good to rise this also causes the AD curve to shift to the right McGraw-Hill/Irwin Colander, Economics 28

29 Shifts in the AD Curve: Fiscal Policy If the government spends money and does not increase taxes, this shifts the AD curve to the right (expansionary fiscal policy) If the government holds spending constant and raises taxes, this shifts the AD curve to the left (contractionary fiscal policy) McGraw-Hill/Irwin Colander, Economics 29

30 Shifts in the AD Curve: Monetary Policy If the Fed expands the money supply (expansionary monetary policy) it can offer lower interest rates this shifts the AD curve to the right If the Fed contracts the money supply (contractionary monetary policy) this shifts the AD curve to the left McGraw-Hill/Irwin Colander, Economics 30

31 AGGREGATE SUPPLY McGraw-Hill/Irwin Colander, Economics 31

32 Aggregate Supply Aggregate supply: the amount of goods and services (real GDP) that firms will produce in an economy at different price levels The supply for everything by all firms Aggregate supply differentiates between short run and long-run and has two different curves McGraw-Hill/Irwin Colander, Economics 32

33 Aggregate Supply Short-run Aggregate Supply (SRAS) Wages and resource prices will not increase as price level increases Long-run Aggregate Supply Wages and resource prices will increase as price level increases McGraw-Hill/Irwin Colander, Economics 33

34 Shifters of Aggregate Supply Change in Inflationary Expectations If an increase in AD leads people to expect higher prices in the future This increases labor and resource costs and decreases AS Change in Resource Prices Prices of domestic and imported resources McGraw-Hill/Irwin Colander, Economics 34

35 Shifters of Aggregate Supply Change in Actions of the Government (NOT Government Spending) Taxes on producers Subsidies for domestic producers Government regulations Changes in Productivity Technology McGraw-Hill/Irwin Colander, Economics 35

36 The Slope of the SRAS Curve The SRAS curve is upward sloping because of: Auction markets: markets represented by the supply and demand models Price is determined by the interaction between buyers and sellers 27-36

37 The Slope of the SRAS Curve Posted price markets (also called quantityadjusting markets) Markets in which firms respond to changes in demand by changing production instead of changing their prices Firms tend to increase their markup when demand increases McGraw-Hill/Irwin Colander, Economics 37

38 The Slope of the SRAS Curve In the short run, an increase in output is accompanied by a rise in the price level In the short run, wages and the price of resources will not increase as the price level increases McGraw-Hill/Irwin Colander, Economics 38

39 Aggregate Supply: Sticky Wages and Prices Sticky prices: when prices do not change when there is a change in AD (short run) Sticky wages: when wages do not change when there is a change in AD (short run) Generally, prices and wages are not downwardly flexible Example: if a business increases prices of its goods and becomes more profitable, it will not lower its prices McGraw-Hill/Irwin Colander, Economics 39

40 Aggregate Supply: Sticky Wages and Prices The Ratchet Effect: prices can easily move up but not down If prices were to fall, the cost of resources must fall or firms would go out of business McGraw-Hill/Irwin Colander, Economics 40

41 Aggregate Supply: Sticky Wages and Prices The cost of resources (especially labor) rarely fall because: Labor Contracts (unions) Wage decrease results in poor worker morale Firms must pay to change prices Example: repricing items in inventory, advertising new prices to consumers, etc.) McGraw-Hill/Irwin Colander, Economics 41

42 Shifts in the SRAS Shifts in the SRAS are caused by changes in: Input prices Productivity Import prices Sales and excise taxes In general: %Δ in price level = %Δ in wages %Δ in productivity McGraw-Hill/Irwin Colander, Economics 42

43 Shifts in the SRAS Curve If input prices rise, the SRAS shifts left (decrease) If input prices fall, the SRAS shifts right (increase) An increase in productivity shifts the SRAS right (increase) A fall in productivity shifts the SRAS left (decrease) McGraw-Hill/Irwin Colander, Economics 43

44 Shifts in the SRAS Curve An increase in import prices shifts the SRAS left (decrease) A decrease in import prices shifts the SRAS right (increase) Higher sales taxes shift the SRAS left (decrease) Lower sales taxes shift the SRAS right (increase) McGraw-Hill/Irwin Colander, Economics 44

45 The LRAS Curve The long run aggregate supply curve shows the long-run relationship between output and the price level In the long run, the price of wages and resources will increase as the price level increases 27-45

46 The LRAS Curve The position of the LRAS curve is determined by the potential output, which is the amount of goods and services an economy can produce at full employment The LRAS curve is vertical because potential output is unaffected by the price level McGraw-Hill/Irwin Colander, Economics 46

47 Price level LRAS 1 Y P The LRAS Curve Real GDP Increases in the LRAS are caused by increases in: Capital Resources Growth-compatible institutions Technology Entrepreneurship 27-47

48 Short-Run Equilibrium in the AS/AD Model Price level P 1 E P 0 AD 1 F SRAS AD 0 Short-run equilibrium is where the SRAS and AD curves intersect Point E is short-run equilibrium A shift in the aggregate demand curve to the right changes equilibrium from E to F, increasing output from Y 0 to Y 1 and increasing price level from P 0 to P 1 Y 0 Y 1 Real GDP 27-48

49 Short-Run Equilibrium in the AS/AD Model Price level P 1 P 0 G E SRAS 1 SRAS 0 A shift up in the short-run aggregate supply curve changes equilibrium from E to G, decreasing output from Y 0 to Y 1 and increasing price level from P 0 to P 1 AD Y 1 Y 0 Real GDP 27-49

50 Long-Run Equilibrium in the AS/AD Model Price level LRAS Long-run equilibrium is where the LRAS and AD curves intersect P 1 P 0 E AD 1 AD 0 H A shift in the aggregate demand curve changes equilibrium from E to H, increasing the price level from P 0 to P 1 but leaving output unchanged Y P Real GDP 27-50

51 Long-Run Equilibrium in the AS/AD Model Price level P 0 LRAS E SRAS AD The economy is in both short-run and long-run equilibrium when all three curves intersect at the same point (E) AD grows at the same rate as potential output, so that unemployment and inflation are very low Y P Real GDP 27-51

52 Draw the Graph: An Inflationary Gap in the AS/AD Model The Aggregate Demand/ Price level LRAS SRAS 1 An inflationary gap is the amount by which equilibrium output is above potential output P 1 P 2 Gap AD 2 AD 1 To get rid of the gap, AD needs to shift to the left to return to long run equilibrium Y F Y 1 Real GDP 27-52

53 Draw the Graph: A Recessionary Gap in the AS/AD Model The Aggregate Demand/ Price level P 2 P 1 Gap Y 1 Y P LRAS SRAS 1 Real GDP AD 1 AD 2 A recessionary gap is the amount by which equilibrium output is below potential output To get rid of the gap, AD needs to shift to the right to return to long run equilibrium 27-53

54 Aggregate Demand Policy Monetary and/or fiscal policy also affect the AD curve Monetary policy involves the Federal Reserve Bank changing the money supply and interest rates Fiscal policy is the deliberate change in either government spending or taxes to stimulate, or slow down, the economy 27-54

55 Contractionary Fiscal/Monetary Policy in the AS/AD Model Price level LRAS If the economy is point B, there is an inflationary gap Y 1 Y P P 1 B The appropriate fiscal policy is to decrease government spending and/or increase taxes P 2 AD 1 E The appropriate monetary policy would be to decrease the money supply Y P Gap Y 1 AD 2 Real GDP AD shifts to the left and output returns to potential output Y P and inflation is prevented 27-55

56 Expansionary Fiscal/Monetary Policy in the AS/AD Model Price level LRAS If the economy is at point A, there is a recessionary gap equal to Y P Y 1 P 2 A P 1 AD 2 E Gap Y 1 Y P AD 1 Real GDP The appropriate fiscal policy is to increase government spending and/or decrease taxes The appropriate monetary policy would be to increase the money supply AD shifts to the right and output returns to potential output Y P and prices increase to P

57 Why Macro Policy Is More Complicated than the AS/AD Model Makes It Look 1. Implementing fiscal policy through changing taxes and government spending is a slow legislative process There is no guarantee that the government will do what economists say is necessary 2. Potential output (the level of output that the economy is capable of producing without generating inflation) is difficult to estimate We do have ways to get a rough idea of where it is 3. There are many other possible interrelationships in the economy that the model does not take into account 27-57

58 Why Macro Policy Is More Complicated than the AS/AD Model Makes It Look There are two ways to think about the effectiveness of fiscal policy: in the model and in reality The effectiveness of fiscal policy depends on the government s ability to perceive and to react appropriately to a problem 27-58

59 Why Macro Policy Is More Complicated than the AS/AD Model Makes It Look Countercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycle Fine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or potential level of income McGraw-Hill/Irwin Colander, Economics 59

60 Chapter Summary The Classical economists long-run focus and laissez-faire approach was incapable of solving the problems of the Great Depression in the 1930s Keynesian economic theory, which emphasizes short-run fluctuations and advocates an activist government policy, developed solutions to the Depression The Keynesian AD/AS model is composed of the AD, SRAS, and the LRAS curves The AD curve has a negative slope because of the wealth, interest rate, international, and multiplier effects 27-60

61 Chapter Summary The AD curve shifts when there are changes in foreign income, exchange rates, expectations, distribution of income, or monetary and fiscal policy The SRAS curve has a positive slope because some firms adjust quantity and some adjust price when AD changes The LRAS curve is vertical at potential output The LRAS curve shifts out if there is an increase in available resources, capital, labor, technology, or growth compatible institutions Short-run equilibrium is where AD = SRAS 27-61

62 Chapter Summary Long-run equilibrium is at potential output (Y P ) where AD = LRAS The economy may be at short-run equilibrium, but not longrun equilibrium If short-run equilibrium is above Y P, there is an inflationary gap and SRAS eventually shifts up to return the economy to Y P at a higher price level If short-run equilibrium is below Y P, there is a recessionary gap and SRAS eventually shifts down to return the economy to Y P at a lower price level 27-62

63 Chapter Summary Aggregate demand management policy is the government s use of economic policy to control the level of aggregate spending Fiscal policy involves changing government spending and/or taxes to change aggregate demand To eliminate a recessionary gap, fiscal policy should increase government spending and/or decrease taxes To eliminate an inflationary gap, fiscal policy should decrease government spending and/or increase taxes 27-63