1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-1 Chapter 5 Aggregate Supply and Demand

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-2 Objectives Develop the aggregate supply and aggregate demand model to explain how output and price are determined Explain how the slope of the aggregate supply curve reflects the economy’s price adjustment mechanism Consider different interpretations of the behaviour of aggregate supply and aggregate demand Link output to employment and unemployment

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-3 Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand under Alternative Supply Assumptions 5.4Supply-Side Economics 5.5Putting Aggregate Supply and Aggregate Demand Together in the Long Run 5.6Linking Output to Employment and Unemployment

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-4 Aggregate Supply and Aggregate Demand The aggregate supply–aggregate demand (AS–AD) model is the basic tool for studying output fluctuations and the determination of price levels. The model describes the relationship between overall prices (GDP deflator) and output (real GDP). Shifts in either aggregate supply or aggregate demand cause the price level and the level of output to change. The amount by which the price level changes (as AD shifts) depends of the slope of the AS curve and the extent to which AD shifts.

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-5 The Aggregate Supply Curve

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-6 The Classical AS Curve The classical AS curve: –Is vertical, indicating that the same amount of goods will be supplied whatever the price level. Assumption –The labour market is in equilibrium at full employment and all factors of production are fully utilised. Implication –Increases in AD do not increase output but merely raise prices.

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-7 The Classical AS Curve The level of output corresponding to full employment is called ‘potential GDP’. Potential GDP grows over time as the economy accumulates resources and new technologies. This shifts the AS curve to the right over time.

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-8 The Keynesian AS Curve The Keynesian AS curve: –Is horizontal, indicating firms will supply whatever amount of goods is demanded at the existing price. Assumption –There is unemployment, so firms may obtain as much labour as they want at the current wage. Implication –AD determines the level of output, with prices ‘sticky’ in the short run.

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-9 Vertical or Horizontal? Potential output (GDP) is the level of output corresponding to full employment of the labour force. The effect of changes in AD on output and prices depends on the level of actual output relative to potential output. At levels of output below potential, the AS is quite flat, as there is little tendency for prices of goods and factors to fall. At levels of output above potential, the AS curve is steep and prices tend to rise continuously.

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-10 Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand under Alternative Supply Assumptions 5.4Supply-Side Economics 5.5Putting Aggregate Supply and Aggregate Demand Together in the Long Run 5.6Linking Output to Employment and Unemployment

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-11 5.2 The Aggregate Demand Curve The AD curve: –Shows the combinations of the price and output level at which the goods and money markets are in equilibrium. –AD downward sloping because, for a given level of nominal money, higher prices reduce the value of the real money supply, which reduces the demand for output.

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-12 The Aggregate Demand Curve The AD relationship between price and output: –Is dependent upon the real money supply –Real money supply is nominal money supply (M) deflated by the price level (P) –That is: M/P –When P falls, the real money supply rises, interest rates fall and investment rises, causing AD to increase.

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-13 The Aggregate Demand Curve The quantity theory of money provides a simple analysis of the AD curve. M  V = P  Y(5.1) Where M is the nominal money supply and V is the velocity of money. P  Y equates to nominal GDP. If we assume that V and M are constant, then an increase in output (Y) must be offset by a decrease in prices (P).

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-14 Chapter Organisation Introduction 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand under Alternative Supply Assumptions 5.4Supply-Side Economics 5.5Putting Aggregate Supply and Aggregate Demand Together in the Long Run 5.6Linking Output to Employment and Unemployment

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-15 5.3 AD under Alternative Supply Assumptions

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-16 The Keynesian Case In Figure 5.7: –Initial equilibrium is at E, where AD and AS intersect (goods and assets market equilibrium). –Assume an increase in AD, which shifts AD to AD'. –The new equilibrium point is E' where output has increased. –Firms are willing to supply any amount of output at that level of price.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-17 The Classical Case

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-18 The Classical Case In Figure 5.8: –Equilibrium is at E. –Assume an increase in AD. –At the initial level of prices, spending has increased and the economy would tend to move towards point E'. –However, firms cannot obtain more labour, as the economy is at full employment. –Wages are bid up which increases the costs of production. –The increase in costs is passed on as higher prices.

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-19 The Classical Case –The increase in prices reduces real money stock and decreases spending. –The economy moves up along AD' until spending has decreased to the level consistent with full employment output at E''. –Increases in AD only lead to higher prices, not increases in output.

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-20 Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand under Alternative Supply Assumptions 5.4Supply-Side Economics 5.5Putting Aggregate Supply and Aggregate Demand Together in the Long Run 5.6Linking Output to Employment and Unemployment

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-21 5.4 Supply-Side Economics Shifting the AS to the right is increases potential GDP. There is debate about how best to achieve this increase in AS. Supply-side economics argue: –Cutting taxes will significantly increase AS. –This increase will be so large that total tax revenue will rise. However, cutting taxes has an effect on both aggregate supply and aggregate demand.

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-22 Supply-Side Economics

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-23 Supply-Side Economics Refer to Figure 5.9. The initial tax cut shifts AD to the right. The AS also shifts to the right over time because lower tax rates increase the incentive to work. However, the AD curve shifts by more than the AS curve, since consumer spending increases by more than the increase in potential GDP.

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-24 Supply-Side Economics In the short run: –GDP has increased substantially (from E to E'). –This is primarily due to the AD effect. In the long run: –The economy moves to E''. –GDP has only increased by a small amount, total tax collection falls, the government’s budget deficit rises, and prices are permanently higher.

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-25 Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand under Alternative Supply Assumptions 5.4Supply-Side Economics 5.5Putting Aggregate Supply and Aggregate Demand Together in the Long Run 5.6Linking Output to Employment and Unemployment

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-26 5.5 Putting Aggregate Supply and Aggregate Demand Together in the Long Run Long-run aggregate supply shifts to the right over time at a steady rate. Shifts in aggregate demand over time can be either large or small depending on movements in the money supply and interest rates. Over long periods of time, output is determined by aggregate supply. Prices are determined by the movement of aggregate demand relative to the movement in aggregate supply.

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-27 Putting Aggregate Supply and Aggregate Demand Together in the Long Run

28. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-28 Putting Aggregate Supply and Aggregate Demand Together in the Long Run Refer to Figure 5.10. Output has risen as the aggregate supply and aggregate demand curves move to the right. Larger shifts were evident in the 1960s and 1990s than in the 1970s and 1980s. There were large vertical moves in aggregate demand in the 1970s. This was associated with larger increases in prices.

29. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-29 Chapter Organisation 5.1The Aggregate Supply Curve 5.2The Aggregate Demand Curve 5.3Aggregate Demand under Alternative Supply Assumptions 5.4Supply-Side Economics 5.5Putting Aggregate Supply and Aggregate Demand Together in the Long Run 5.6Linking Output to Employment and Unemployment

30. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-30 5.6Linking Output to Employment and Unemployment The production function indicates the relationship between the quantity of factor inputs and output. If labour is assumed to be the only variable factor of production in the short run, the production function is: Y = F(N,…)(5.2)

31. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-31 Linking Output to Employment and Unemployment

32. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-32 Linking Output to Employment and Unemployment Refer to Figure 5.11. The contribution to output of additional units of labour is called the ‘marginal product of labour’. The decision to employ extra units of labour depends on the marginal product of labour and the marginal cost. The marginal cost of labour is the real wage rate W/P. Firms will employ labour up to the point where: MPN(N) = W/P(5.3)

33. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-33 Linking Output to Employment and Unemployment The comparison of the MPN and the real wage rate determines the demand for labour. The demand for labour curve is represented by the marginal product of labour schedule. The demand for labour is downward sloping, indicating that at lower real wage rates more labour will be employed.

34. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-34 Linking Output to Employment and Unemployment

35. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-35 The Neoclassical Model of the Labour Market The supply of labour curve is upward-sloping, indicating that rises in real wages will provide an incentive for workers to work more. In the neoclassical model it is assumed that markets behave competitively. This allows the forces of supply and demand to determine the equilibrium level of employment. This model of the labour market underlies the classical aggregate supply curve. Unemployment is largely seen as voluntary.

36. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-36 Cyclical Adjustment in the Labour Market Unemployment may occur if aggregate demand falls. This type of unemployment is involuntary. It is also known as ‘cyclical unemployment’, because it results from variations in the trade cycle.

37. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-37 Cyclical Adjustment in the Labour Market The neoclassical framework suggests that situations of involuntary unemployment will not continue, as the labour market will adjust to ensure the demand for labour equates to the supply of labour. A breakdown in the neoclassical adjustment process can explain why cyclical unemployment has been observed to continue over long periods of time.

38. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-38 Linking Output to Employment and Unemployment Even at full employment levels of output, some unemployment exists. This may be: –Frictional unemployment  Unemployment due to individuals shifting between jobs and looking for new jobs –Structural unemployment  Unemployment due to a mismatch between the skills of the labour force and the skills demanded by firms  Unemployment is a consequence of technological improvements.

39. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-39 Linking Output to Employment and Unemployment The natural rate of unemployment (NRU): –The frictional and structural unemployment associated with the full employment level of output –Current estimates of the NRU in Australia are about 5.5%.

40. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 5-40 Okun’s Law — Linking Output to Unemployment Unemployment and output are closely related in the short run. This relationship can be expressed in Okun’s Law. Okun’s law shows the relationship between unemployment and output (Equation (5.4)). When  = 2, then for every 1% output is above potential output, unemployment will fall by 0.5%.