AGGREGATE DEMAND 8 AND CHAPTER AGGREGATE SUPPLY
A Way to View the Economy We can think of an economy as consisting of two major activities: buying and producing. When economists speak about aggregate demand, they are speaking about the buying side of the economy. When economists speak about aggregate supply, they are speaking about the producing side of the economy.
A Way to View the Economy
A Way to View the Economy The framework of analysis we use is called aggregate demand aggregate supply (AD AS). That framework of analysis has three parts: 1. Aggregate demand (AD) 2. Short-run aggregate supply (SRAS) 3. Long-run aggregate supply (LRAS)
Aggregate Demand Recall from the last chapter that households, firms, governments and the rest of the world buy domestic goods and services. Aggregate demand is the quantity demanded of these goods and services, or the quantity demanded of Real GDP, at various price levels, ceteris paribus. For example, the following whole set of data represents aggregate demand:
Aggregate Demand An aggregate demand (AD) curve is the graphical representation of aggregate demand. AD is downward sloping As the price level falls, the quantity demanded of Real GDP rises. As the price level rises, the quantity demanded of Real GDP falls
Aggregate Demand Why Does the Aggregate Demand Curve Slope Downward? This inverse relationship and the resulting downward slope of the AD curve are explained by: (1) The real balance effect (2) The interest rate effect (3) The international trade effect
Aggregate Demand Real Balance Effect When price level goes up, the real value of monetary wealth or the value of a person s monetary assets goes down. This means that purchasing power of monetary assets go down, that is, the quantity of goods and services that can be purchased with a unit of money decreases. As a result, ceteris paribus, people demand less. In summary, a rise in the price level causes purchasing power to fall, which decreases a person s monetary wealth. As people become less wealthy, the quantity demanded of Real GDP falls.
Aggregate Demand Interest Rate Effect The inverse relationship between the price level and the quantity demanded of Real GDP is established through changes in the part of household and business spending that is sensitive to changes in interest rates. As the price level rises, the purchasing power of the person s money decreases. With less purchasing power (per unit of money), she cannot purchase her fixed bundle of goods with the same amount of money.
Aggregate Demand Interest Rate Effect If she wants to continue to buy the goods, she needs to acquire more money. To do that, she goes to a bank and requests a loan. In terms of simple supply-and demand analysis, the demand for credit increases. Consequently, the interest rate rises. As the interest rate rises, households borrow less to finance, say, automobile purchases, and firms borrow less to finance new capital goods spending. Thus, the quantity demanded of Real GDP falls.
Aggregate Demand International Trade Effect The international trade effect takes place through changes in foreign sector spending due to changes in price level. As the price level in Bangladesh rises, Bangladeshi goods become relatively more expensive than foreign goods. As a result, both Bangladeshis and foreigners buy fewer Bangladeshi goods and more foreign goods, i.e. exports fall and imports rise implying a fall in net exports. The quantity demanded of Real GDP falls.
Aggregate Demand An Important Word on the Three Effects Keep in mind that what caused these three effects is a change in the price level. When discussing, say, the interest rate effect, we are talking about the interest rate effect of a change in the price level. Why is this point important? The interest rate can change due to things other than the price level changing. Other things that change the interest rate lead to a shift in the AD curve instead of a movement along the AD curve.
Aggregate Demand A Change in Quantity Demanded of Real GDP vs. a Change in Aggregate Demand A change in the price level brings about a change in the quantity demanded of Real GDP. As the price level falls, the quantity demanded of Real GDP rises, ceteris paribus. When the aggregate demand curve shifts, the quantity demanded of Real GDP changes even though the price level remains constant.
Aggregate Demand
Aggregate Demand Changes in Aggregate Demand: Shifts in the AD Curve What can change aggregate demand? What can cause aggregate demand to rise, and what can cause it to fall? The simple answer is, if: Spending increases at a given price level AD rises Spending decreases at a given price level AD falls
Aggregate Demand How Spending Components Affect Aggregate Demand At a given price level if:
Aggregate Demand Why Is There More Total Spending? True or false? The price level falls and total spending rises. As a result of total spending rising, aggregate demand in the economy rises, and the AD curve shifts rightward.
Aggregate Demand Why Is There More Total Spending? The answers is: FALSE Aggregate demand curve shifts to the right only if total spending rises at a given price level. Total spending can rise for one of two reasons. The first deals with a decline in prices and leads to a movement along a given AD curve. The second deals with a change in some factor other than prices and leads to a shift in the AD curve.
Aggregate Demand Factors That Can Change C, I, G, and NX and Therefore Can Shift the AD Curve Consumption: C Four factors can affect consumption: 1.Wealth 2.Expectations about future prices and income 3.Interest rate 4.Income taxes
Aggregate Demand Factors That Can Change C and Therefore Can Shift the AD Curve 1. Wealth Individuals consume not only on the basis of their present income but also on the basis of their wealth. Greater wealth makes individuals feel financially more secure and thus more willing to spend. Wealth C AD Wealth C AD
Aggregate Demand Factors That Can Change C and Therefore Can Shift the AD Curve 2. Expectations About Future Prices and Income Individuals expectations of future prices can increase or decrease aggregate demand: Expect higher future prices C AD Expect lower future prices C AD Similarly, expectations regarding income can affect aggregate demand: Expect higher future income C AD Expect lower future income C AD
Aggregate Demand Factors That Can Change C and Therefore Can Shift the AD Curve 3. Interest Rate Current empirical work shows that spending on consumer durables is sensitive to the interest rate. Buyers often pay for these items by borrowing; so an increase in the interest rate increases the monthly payment amounts linked to the purchase of durables and thereby reduces their consumption. The reduction in consumption leads to a decline in aggregate demand. Interest rate C AD Interest rate C AD
Aggregate Demand Factors That Can Change C and Therefore Can Shift the AD Curve 4. Income Taxes As income taxes rise, disposable income decreases. When people have less take-home pay to spend, consumption falls. Consequently, aggregate demand decreases. A decrease in income taxes has the opposite effect; it raises disposable income. When people have more take-home pay to spend, consumption rises and aggregate demand increases. Income taxes C AD Income taxes C AD
Aggregate Demand Factors That Can Change I and Therefore Can Shift the AD Curve Investments: I Three factors can change investment: 1. The interest rate 2. Expectations about future sales 3. Business taxes
Aggregate Demand Factors That Can Change I and Therefore Can Shift the AD Curve 1. Interest Rate As the interest rate rises, the cost of an investment project rises and businesses invest less. As investment decreases, aggregate demand decreases. As the interest rate falls, the cost of an investment project falls and businesses invest more. Consequently, aggregate demand increases. Interest rate I AD Interest rate I AD
Aggregate Demand Factors That Can Change I and Therefore Can Shift the AD Curve 2. Expectations About Future Sales If businesses become optimistic about future sales, investment spending grows and aggregate demand increases. If businesses become pessimistic about future sales, investment spending contracts and aggregate demand decreases. Businesses become optimistic about future sales I AD Businesses become pessimistic about future sales I AD
Aggregate Demand Factors That Can Change I and Therefore Can Shift the AD Curve 3. Business taxes An increase in business taxes lowers expected profitability. With less profit expected, businesses invest less. As investment spending declines, so does aggregate demand. A decrease in business taxes, on the other hand, raises expected profitability and investment spending. This increases aggregate demand. Business taxes I AD Business taxes I AD
Aggregate Demand Factors That Can Change G and Therefore Can Shift the AD Curve Government Expenditure: G Government expenditure usually rises due to expansionary Fiscal policy designed to reduce unemployment. Government expenditure usually falls due to contractionary Fiscal policy designed to reduce inflation. Expansionary Fiscal Policy G AD Contractionary Fiscal Policy G AD
Aggregate Demand Factors That Can Change NX and Therefore Can Shift the AD Curve Net Exports: NX Two factors can change net exports: 1. Foreign real national income 2. The exchange rate
Aggregate Demand Factors That Can Change NX and Therefore Can Shift the AD Curve 1. Foreign real national income As foreign real national income rises, foreigners buy more Bangladeshi goods and services. Thus, exports rise. As exports rise, net exports rise, ceteris paribus. As net exports rise, aggregate demand increases. This process works in reverse. As foreign real national income falls, foreigners buy fewer Bangladeshi goods and exports fall. This lowers net exports, reducing aggregate demand. Foreign real national income BD exports BD net exports AD Foreign real national income BD exports BD net exports AD
Aggregate Demand Factors That Can Change NX and Therefore Can Shift the AD Curve 2. Exchange Rate As the Taka depreciates, Bangladeshi goods become cheaper and foreign goods become more expensive. Bangladeshis cut back on imported goods, and foreigners increase their purchases of Bangladeshi exported goods. If exports rise and imports fall, net exports increase and aggregate demand increases. As Taka appreciates, Bangladeshi goods become more expensive and foreign goods become cheaper, Bangladeshis increase their purchases of imported goods, and foreigners cut back on their purchases of Bangladeshi exported goods. If exports fall and imports rise, net exports decrease, thus lowering aggregate demand. Taka depreciates BD exports and BD imports BD net exports AD Taka appreciates BD exports and BD imports BD net exports AD
Aggregate Demand Can a Change in the Money Supply Change Aggregate Demand? Most economists would say that it does, but they differ on how. One way to explain the effect is as follows: 1. A change in the money supply affects interest rates. 2.A change in interest rates changes consumption and investment. 3.A change in consumption and investment affects aggregate demand.
Aggregate Demand If One Component of Aggregate Spending Rises, Does Some Other Spending Component Have to Decline? Let s say that the money supply in the economy is Tk. 1 and that Tk. 1 is currently in the hands of Shakib. Shakib takes the Tk. 1 and buys good X from Tamim. Later, Tamim takes the Tk. 1 and buys good Y from Mushfique. Still later, Mushfique takes the Tk.1 and buys good Z from Mashrafe. We started with a money supply of just Tk. 1, and that 1 Taka changed hands three times. The average number of times a Taka changes hands (or is spent) to buy final goods and services is what economists call velocity. In our simple example, velocity is 3. The product of our money supply (Tk. 1) and velocity (3) is Tk. 3, which represents the total amount of spending in the economy.
Aggregate Demand From our example, two things are obvious: First, total spending in the economy can be a greater dollar amount than the money supply. Proof: In our example, the money supply was Tk. 1, but total spending equaled Tk. 3. Second, total spending depends on the money supply and velocity. Proof: Total spending in our example was the product of the money supply times velocity. Now, say out of this Tk. 3, Tk. 1 is spent on C, Tk. 1 is spent on I and Tk. 1 is spent on G. If, say, government expenditure rises to Tk. 2, must some other spending component decline? The answer is yes if neither the money supply nor velocity changes. But the answer is no if either the money supply or velocity rises.
Aggregate Demand So, to summarize: If both the money supply and velocity are constant, a rise in one spending component (such as government expenditure) necessitates a decline in one or more other spending components. If either the money supply or velocity rises, one spending component can rise without requiring other spending components to decline.
Short-Run Aggregate Supply Aggregate demand is one side of the economy; aggregate supply is the other. Aggregate supply is the quantity supplied of all goods Aggregate supply is the quantity supplied of all goods and services (Real GDP) at various price levels, ceteris paribus. Aggregate supply includes both short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).
Short-Run Aggregate Supply Short-Run Aggregate Supply Curve: What It Is A short-run aggregate supply (SRAS) curve shows the quantity supplied of all goods and services (Real GDP or output) at different price levels, ceteris paribus. the SRAS curve is upward sloping: As the price level rises, firms increase the quantity supplied of goods and services; as the price level drops, firms decrease the quantity supplied of goods and services.
Short-Run Aggregate Supply Short-Run Aggregate Supply Curve: Why It Is Upward Sloping Why is the SRAS curve upward sloping? Two Explanations: 1. Sticky wages 2. Worker misperceptions
Short-Run Aggregate Supply Short-Run Aggregate Supply Curve: Why It Is Upward Sloping 1. Sticky wages Some economists believe that wages are sticky, or inflexible. This may be because wages are locked in for a few years due to labor contracts that workers and management enter into. Both labor and management may see this as in their best interest. Management has some idea of what its labor costs will be during the time of the contract. Workers may have a sense of security knowing that their wages can t be lowered.
Short-Run Aggregate Supply
Short-Run Aggregate Supply Short-Run Aggregate Supply Curve: Why It Is Upward Sloping The quantity demanded of labor is inversely related to the real wage: As the real wage rises, the quantity demanded of labor falls As the real wage falls, the quantity demanded of labor rises. Firms will employ more workers because it is cheaper to hire them. Now, suppose that the price index falls. As a result, real wage rises. What will firms do? At higher real wages, firms will cut back on its labor. With fewer workers working, less output is produced.
Short-Run Aggregate Supply Short-Run Aggregate Supply Curve: Why It Is Upward Sloping So, if nominal wages are sticky, a decrease in the price level (which pushes real wages up) will result in a decrease in output. This is what an upward-sloping SRAS curve represents: As the price level falls, the quantity supplied of goods and services declines.
Short-Run Aggregate Supply Short-Run Aggregate Supply Curve: Why It Is Upward Sloping 2. Worker misperceptions Another explanation for the upward-sloping SRAS curve holds that workers may misperceive real wage changes. Suppose that the nominal wage is $30 an hour and price level is $1.50. So, real wage = $30 / $1.50 = $20 Now suppose the nominal wage falls to $25 and the price level falls to $1.25. The real wage is still $20 ($25 / $1.25 = $20) but workers may not know this. They know their nominal wage has fallen (i.e., they are earning $25 an hour instead of $30).They also may know that the price level is lower, but they may not know initially how much lower the price level is.
Short-Run Aggregate Supply Short-Run Aggregate Supply Curve: Why It Is Upward Sloping For example, suppose they mistakenly believe the price level has fallen from 1.50 to 1.39. They will then think that their real wage has actually fallen from $20 ($30 / $1.50) to $17.98 ($25 / $1.39). In response to the misperceived falling real wage, workers reduce the quantity of labor they are willing to supply. With fewer workers (resources), firms produce less. So, if workers misperceive real wage changes, then a fall in the price level will bring about a decline in output, which is illustrative of an upward-sloping SRAS curve.
Short-Run Aggregate Supply Issues with these two labor market based explanations Take the first explanation. We have discussed the upward sloping SRAS curve when price falls. What about when price rises? Then, given sticky wages, real wage falls. So, the argument would be that because real wage falls, employers will hire more workers which will in turn lead to more production. However, what about the workers? Will they be willing to supply more labor at lower real wages? When real wage rises, it s reasonable to argue that employers will hire less workers. Because even if the workers want to supply more, it s really the employers prerogative to decide how many workers they are willing to hire. But when real wage falls, and workers do not want to supply more labor, it s hard to justify a scenario whereby employers are forcing workers to work.
Short-Run Aggregate Supply Issues with these two labor market based explanations Take the second explanation. We have discussed the upward sloping SRAS curve when workers underestimate the decline in price. But what if they overestimate the price decline? Then, they will think that real wage has actually gone up. Then they will be willing to supply more labor. More labor implies more production. In that case a fall in price would actually result in higher supply! Of course, assuming that employers agree to hire more workers. If they don t, then there will be no change in production. Either way, the direct/positive relationship between price and quantity supplied breaks down. Also, why only assume that the workers misperceive real wage changes? What happens if employers also have misperceptions?
Short-Run Aggregate Supply To avoid these problems, we can think about the upward sloping SRAS curve in the following way. Think about an individual firm: firm A. It s fair to assume that in the short run the money wage rate and the prices of nonlabor inputs remain unchanged. Now, if price of the good that firm A produces rises with no change in these costs, then firm A can increase profit by increasing production. Since any firm usually is in business to maximize its profit, firm A will increase production. Similarly, if price of the good produced by firm A falls while the money wage rate and the prices of nonlabor inputs remain unchanged, then firm A can reduce its losses (or profit reductions) by decreasing production.
Short-Run Aggregate Supply What s true for firm A is true for the producers of all goods and services. When all prices rise, the price level rises. If the price level rises and the money wage rate and other factor prices remain constant, all firms increase production and the quantity of real GDP supplied increases. A fall in the price level has the opposite effect and decreases the quantity of real GDP supplied.
Short-Run Aggregate Supply What Puts the Short Run in the SRAS Curve? According to most macroeconomists, the SRAS curve slopes upward because of the reasons explained in the previous slides (including sticky wages and worker misperceptions). No matter what the explanation, things are likely to change over time. Wages will not be sticky forever (labor contracts will expire), and workers will figure out that they misperceived real wage changes. Factor costs will also not remain constant. Only for a period of time identified as the short run are these issues likely to be relevant.
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve The factors that can shift the SRAS curve are: 1. Wage rates 2. Prices of nonlabor inputs 3. Productivity 4. Supply shocks 5. Expected price level
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve 1. Wage rates Changes in wage rates have a major impact on the position of the SRAS curve because wage costs are usually a firm s major cost item. The impact of a rise or fall in equilibrium wage rates can be understood in terms of the following equation: Profit per unit = Price per unit - Cost per unit
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve Higher wage rates mean higher costs and, at constant prices, translate into lower profits and a reduction in the number of units (of a given good) that firms will want to produce. Lower wage rates mean lower costs and, at constant prices, translate into higher profits and an increase in the number of units (of a given good) firms will decide to produce.
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve 2. Prices of nonlabor inputs There are other inputs to the production process besides labor. Changes in the prices of nonlabor inputs affect the SRAS curve in the same way as changes in wage rates do. An increase in the price of a nonlabor input (e.g., oil) shifts the SRAS curve leftward; a decrease in their price shifts the SRAS curve rightward.
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve 3. Productivity Productivity is the output produced per unit of input employed over some period of time. Let s consider the labor input. An increase in labor productivity means businesses will produce more output with the same amount of labor, causing the SRAS curve to shift rightward. A decrease in labor productivity means businesses will produce less output with the same amount of labor, causing the SRAS curve to shift leftward.
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve Many factors lead to increased labor productivity. Some examples: A more educated labor force A larger stock of capital goods Technological advancements
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve 4. Supply shocks Major natural or institutional changes that affect aggregate supply are referred to as supply shocks. Supply shocks are of two varieties. Adverse supply shocks shift the SRAS curve leftward. A long drought can have severe impact on the production of paddy in Bangladesh. A major cutback in the supply of oil coming to the United States from the Middle East.
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve Beneficial supply shocks shift the SRAS curve rightward. A major oil discovery or unusually good weather leading to increased production of a food staple These supply shocks can be reflected in resource or input prices.
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve 5. Expected price level A change in expected price level can lead to a shift in the SRAS curve. Suppose individuals expect the price level to decline. Thus they expect their real wages to rise and will work more. Working more produces more output; so the SRAS curve shifts rightward. Suppose individuals expect the price level to rise. Thus they expect their real wage to decline and will work less. Working less produces less output; so the SRAS curve shifts leftward.
Short-Run Aggregate Supply Changes in Short-Run Aggregate Supply: Shifts in the SRAS Curve
Putting AD and SRAS Together: Short- Run Equilibrium
Putting AD and SRAS Together: Short- Run Equilibrium Changes in Short-Run Equilibrium in the Economy
Putting AD and SRAS Together: Short- Run Equilibrium In Dollars and in Oil In November 2007 the barrel price of oil was rising. On November 1, 2007, it had risen to $96 a barrel. In the same month the value of the dollar was falling in foreign exchange markets. In fact, the value of the dollar had been falling for some time. Although the value of $1 was 0.83 in January 2006, it had fallen to 0.69 by November 1, 2007. How would Real GDP and Price change?
Putting AD and SRAS Together: Short- Run Equilibrium In Dollars and in Oil We know that the falling value of the dollar would lead to greater U.S. exports, and this is exactly what was happening at the time. As a result, U.S. net exports were rising, pushing the AD curve in the economy to the right. But because oil prices were rising, the SRAS curve in the economy was shifting to the left. How would these two changes affect Real GDP?
Putting AD and SRAS Together: Short- Run Equilibrium In Dollars and in Oil The answer depends on the relative shifts of the AD and SRAS curves. There are the three possibilities: 1. If the AD curve shifted rightward more than the SRAS curve shifted leftward, then Real GDP will rise. 2. If the AD curve shifted rightward by less than the SRAS curve shifted leftward, then Real GDP would fall. 3. If the AD curve shifted rightward by the same amount as the SRAS curve shifted leftward, then Real GDP would remain unchanged. In all three cases, though, the price level would increase. Rising aggregate demand, combined with falling short-run aggregate supply, always results in a rising price level.
An Important Exhibit Expected Price Level 1. Expansionary Fiscal Policy 2. Contractionary Fiscal Policy
Long-Run Aggregate Supply
Long-Run Aggregate Supply
Long-Run Aggregate Supply
Long-Run Aggregate Supply
Long-Run Aggregate Supply Short-Run Equilibrium, Long-Run Equilibrium, and Disequilibrium In both short-run and long-run equilibrium, the quantity supplied of Real GDP equals the quantity demanded. So what is the difference between short-run equilibrium and long-run equilibrium? In long-run equilibrium, the quantities supplied and demanded of Real GDP equal Natural Real GDP. But in short-run equilibrium, the quantities supplied and demanded of Real GDP are either more or less than Natural Real GDP.
Long-Run Aggregate Supply
Long-Run Aggregate Supply Short-Run Equilibrium, Long-Run Equilibrium, and Disequilibrium When the economy is in neither short-run nor long-run equilibrium, it is said to be in disequilibrium. Essentially, disequilibrium is the state of the economy as it moves from one short-run equilibrium to another or from short-run equilibrium to long-run equilibrium. In disequilibrium, the quantity supplied and the quantity demanded of Real GDP are not equal.
Practice Question Do in Class: Question: Suppose wealth rises and at the same time, the price of nonlabor inputs rises. What is the effect of these changes on the price level and Real GDP? Answer: See page 219 of the textbook under the title Reality Can Be Messy, and Correct Predictions Can Be Difficult to Make