04/08/2019EC2574 D. DOULOS1 AGGREGATE DEMAND AND AGGREGATE SUPPLY

04/08/2019EC2574 D. DOULOS2 Introduction The model can be used to explain short run fluctuations in Output Prices Employment It can also be used to show the effects from macroeconomic policy

04/08/2019EC2574 D. DOULOS3 Aggregate Demand and Aggregate Supply They both describe the relationship between the overall price level and output Aggregate Supply (AS): describes for each price level the output firms are willing to supply Aggregate Demand (AD): shows all combinations of price level and output at which goods and money markets are in equilibrium The intersection shows equilibrium price level and GDP

04/08/2019EC2574 D. DOULOS4 Aggregate Supply 1. The Classical Aggregate Supply Vertical Based upon the assumptions that Labor market clears Economy at full employment Only frictional and structural unemployment Full wage and price flexibility Aggregate supply shifts in the long run Changes in potential output do not depend on prices (K and L are fixed in short run)

04/08/2019EC2574 D. DOULOS5 Aggregate Supply 2. The Keynesian Aggregate Supply Horizontal Is based on the assumptions that: Economy well below full employment AC do not increase as output increases Firms supply as much as asked at current prices Price level is not affected by current GDP in the short run Wages and prices are inflexible

04/08/2019EC2574 D. DOULOS6 IS-LM and aggregate demand  So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed.  However, a change in P would shift LM and therefore affect Y.  The aggregate demand curve captures this relationship between P and Y.

Y1Y1 Y2Y2 Deriving the AD curve Y r Y P IS LM(P 1 ) LM(P 2 ) AD P1P1 P2P2 Y2Y2 Y1Y1 r2r2 r1r1 Intuition for slope of AD curve:  P   (M/P )  LM shifts left  r r  I I  Y Y 04/08/2019EC2574 D. DOULOS7

Monetary Policy and the AD curve Y P IS LM(M 2 /P 1 ) LM(M 1 /P 1 ) AD 1 P1P1 Y1Y1 Y1Y1 Y2Y2 Y2Y2 r1r1 r2r2 The Fed can increase aggregate demand:  M  LM shifts right AD 2 Y r  r r  I I   Y at each value of P 04/08/2019EC2574 D. DOULOS8

Y2Y2 Y2Y2 r2r2 Y1Y1 Y1Y1 r1r1 Fiscal Policy and the AD curve Y r Y P IS 1 LM AD 1 P1P1 Expansionary fiscal policy (  G and/or  T ) increases agg. demand:  T   C  IS shifts right   Y at each value of P AD 2 IS 2 04/08/2019EC2574 D. DOULOS9

IS-LM and AD-AS in the short run & long run Note: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. rise fall remain constant In the short-run equilibrium, if then over time, the price level will 04/08/2019EC2574 D. DOULOS10

The SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing Y to fall. Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 04/08/2019EC2574 D. DOULOS11

The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium, 04/08/2019EC2574 D. DOULOS12

The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium, Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down 04/08/2019EC2574 D. DOULOS13

AD 2 The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 SRAS 2 P2P2 LM(P 2 ) Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down Over time, P gradually falls, causing: SRAS to move down M/P to increase, which causes LM to move down 04/08/2019EC2574 D. DOULOS14

AD 2 SRAS 2 P2P2 LM(P 2 ) The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 This process continues until economy reaches a long-run equilibrium with 04/08/2019EC2574 D. DOULOS15

Analyze SR & LR effects of  M Suppose Fed increases M. Show the short-run effects on your graphs. Show what happens in the transition from the short run to the long run. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y r Y P LRAS IS SRAS 1 P1P1 LM(M 1 /P 1 ) AD 1 04/08/2019EC2574 D. DOULOS16

Short-run effects of  M LM and AD shift right. r falls, Y rises above Y r Y P LRAS IS SRAS P1P1 LM( M 1 /P 1 ) AD 1 LM( M 2 /P 1 ) AD 2 Y2Y2 Y2Y2 r2r2 r1r1 04/08/2019EC2574 D. DOULOS17

Transition from short run to long run Over time,  P rises  SRAS moves upward  M/P falls  LM moves leftward New long-run equilibrium  P higher  all real variables back at their initial values Money is neutral in the long run. Y r Y P LRAS IS SRAS P1P1 LM( M 1 /P 1 ) AD 1 LM( M 2 /P 1 ) AD 2 Y2Y2 Y2Y2 r2r2 r1r1 LM( M 2 /P 3 ) SRAS P3P3 r3 =r3 = 04/08/2019EC2574 D. DOULOS18

The Great Depression Unemployment (right scale) Real GNP (left scale) billions of 1958 dollars percent of labor force 04/08/2019EC2574 D. DOULOS19

THE SPENDING HYPOTHESIS: Shocks to the IS curve Asserts the Depression was largely due to an exogenous fall in the demand for goods & services — a leftward shift of the IS curve. Evidence: output and interest rates both fell, which is what a leftward IS shift would cause. 04/08/2019EC2574 D. DOULOS20

THE SPENDING HYPOTHESIS: Reasons for the IS shift Stock market crash  exogenous  C Oct 1929–Dec 1929: S&P 500 fell 17% Oct 1929–Dec 1933: S&P 500 fell 71% Drop in investment Correction after overbuilding in the 1920s. Widespread bank failures made it harder to obtain financing for investment. Contractionary fiscal policy Politicians raised tax rates and cut spending to combat increasing deficits. 04/08/2019EC2574 D. DOULOS21

THE MONEY HYPOTHESIS: A shock to the LM curve Asserts that the Depression was largely due to huge fall in the money supply. Evidence: M1 fell 25% during 1929–33. But, two problems with this hypothesis: P fell even more, so M/P actually rose slightly during 1929–31. nominal interest rates fell, which is the opposite of what a leftward LM shift would cause. 04/08/2019EC2574 D. DOULOS22

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices Asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929–33. This deflation was probably caused by the fall in M, so perhaps money played an important role after all. In what ways does a deflation affect the economy? 04/08/2019EC2574 D. DOULOS23

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The stabilizing effects of deflation:  P   (M/P )  LM shifts right   Y Pigou effect: P  (M/P )P  (M/P )  consumers’ wealth   C C  IS shifts right  Y Y 04/08/2019EC2574 D. DOULOS24

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of expected deflation:  E   r  for each value of i  I  because I = I (r )  planned expenditure & agg. demand   income & output  04/08/2019EC2574 D. DOULOS25

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of unexpected deflation: debt-deflation theory  P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls 04/08/2019EC2574 D. DOULOS26

Why another Depression is unlikely? Policymakers (or their advisers) now know much more about macroeconomics: The Fed knows better than to let M fall so much, especially during a contraction. Fiscal policymakers know better than to raise taxes or cut spending during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic stabilizers make fiscal policy expansionary during an economic downturn. 04/08/2019EC2574 D. DOULOS27

04/08/2019EC2574 D. DOULOS28 The 2008–09 financial crisis & recession 2009: Real GDP fell, u-rate approached 10% Important factors in the crisis: early 2000s Federal Reserve interest rate policy subprime mortgage crisis bursting of house price bubble, rising foreclosure rates falling stock prices failing financial institutions declining consumer confidence, drop in spending on consumer durables and investment goods

04/08/2019EC2574 D. DOULOS29 Interest rates and house prices

04/08/2019EC2574 D. DOULOS30 Change in U.S. house price index and rate of new foreclosures, 1999–2009

04/08/2019EC2574 D. DOULOS31 U.S. bank failures by year, 2000–2011

04/08/2019EC2574 D. DOULOS32 Major U.S. stock indexes (% change from 52 weeks earlier)

04/08/2019EC2574 D. DOULOS33 Real GDP growth and unemployment