AGGREGATE SUPPLY AND AGGREGATE DEMAND CHAPTER 12 AGGREGATE SUPPLY AND AGGREGATE DEMAND

1. Supply and Demand in Micro and Macro In micro-economics: the law of demand provides the foundation for the demand curve, and the law of diminishing returns provides the foundation for the supply curve. In macro-economics: aggregate supply and demand plays a similar role, but their curve shapes are based on entirely different principles. On the vertical axis – the aggregate price level On horizontal axis – the total output of the economy or real GDP

2. Classical and Keynesian Economics 2.1 Two different views Classical Economics Originated in 1900, by classical economists Belief: macro-economy has strong self-stabilizing forces that keep it at or near full employment (no required government intervention).

2. Classical and Keynesian Economics 2.1 Two different views – cont. Originated in the late 1930’s, by John Maynard Keynes Belief: macro-economy is inherently unstable; if left to its own devices, it can get stuck at high levels of unemployment, producing a real GDP below potential.

2.2 Classical model Real GDP was determined by the supply of resources and their productivity. David Ricardo, David Hume, and Jean Baptiste Say believed that economies would operate at or near full employment. Say’s law states that whatever aggregate output is produced will be demanded. Because the interest rate adjust so that desired aggregate expenditures equal actual output.

2.3 Keynesian revolution Laissez-faire means a hands-off, minimal role for government in economic affairs. The Great Depression of 1930s shook the belief in the classical model. Unemployment rose from 3.2% in 1929 to 24.9% in 1933 and was still 17.2% in 1939. Between 1929 and 1933: real investment dropped by 75% while real consumption fell by 20%.

2.3 Keynesian revolution – cont. The Great Depression caused Keynes to formulate a new theory of macro-economics. He rejected the laissez-faire approach as too slow and costly, he felt government intervention is needed to ensure full employment.

3. Aggregate Supply and Demand Aggregate supply and demand are the most powerful analytical tools of macro-economy. At the macro level it is the price level and the economy’s total output that are determined by the interaction of aggregate supply and aggregate demand. Because total output determines the amount of employment and unemployment, movements in them (employment) are also explained by aggregate supply and demand.

3.1 Aggregate Supply and Demand Defined The aggregate demand curve shows the quantities of total output agents are prepared to buy demand (buy) at different price levels. The aggregate supply curve shows the quantities of total output all firms in the economy are willing to supply at different price levels.

3.2 Macro-economic Equilibrium Macro-economic equilibrium occurs at that level at which the aggregate quantity demanded equals the aggregate quantity supplied. If the economy attempted to settle at a macro-economic equilibrium at a price level below P, where the aggregate quantity demanded exceeded aggregate quantity supplied: the price level would rise, the quantity demanded would fall, and the quantity supplied would increase.

3.3 Shifts in Aggregate Supply and Aggregate Demand This equilibrium determines the price level and how much output, and, at the same time, how much employment and unemployment the economy produce. Shifts in aggregate supply and demand curves determine whether output and employment are increasing or decreasing; or price level is rising or falling. To understand the determinant of inflation and unemployment, we must understand the determinants of aggregate supply and aggregate demand.

4. Aggregate Demand Aggregate demand schedules reveal how aggregate demand responds to changes in the general price level. (Law of demand applies to individual commodities and not to aggregate demand) As the general price level rises, prices and wages are generally rising. For a higher price level to elicit a smaller aggregate quantity demanded, higher prices must cause economic agents to reduce their expenditures.

4. Aggregate Demand – cont. The real balance effect states that at higher price levels households will purchase less real consumption because their wealth will purchase less. The interest rate effect is higher prices raising interest rates and thereby discouraging investment. The foreign trade effect occurs when a rise in the domestic price level (holding foreign prices and the exchange rate constant) lowers the aggregate quantity demanded by pushing down net exports (X-M)

5. Aggregate Supply Economists have different views about the shape of the aggregate supply curve. The aggregate supply curve shows the quantities of real output all firms in the economy are prepared to supply at different price levels. The aggregate supply curve considers why economic agents in the economy might supply more goods and services at a higher price level.

5.1 The Classical Aggregate Supply Curve The classical aggregate supply curve is vertical because it assumes no money illusion. Money illusion could cause economic agents to think that a change in the price level is actually a change in real wages or relative prices and so change their production and employment decisions. Economic agents may respond to changes in real wages and relative prices, but for the economy as a whole, they will recognize that inflation does not cause real wages and relative prices to rise; therefore the supply of G&S are not affected by inflation.

5.2 The Keynesian Aggregate Supply Curve The aggregate supply curve has a backward L-shape. The flat part characterizes an economy with substantial unemployment that cannot be removed by lower wages because wages are not falling. When full employment is reached , the supply curve becomes vertical.

5.3 Short-Run Aggregate Supply Modern economics use a blend of classical and Keynesian economics to describe the behavior of aggregate supply. In the short run, an increase in the price level could cause firms to supply more real output. Multi-year wage contracts reduce the flexibility of the economy to adjust wages and prices to changes in business conditions.

5.3 Short-Run Aggregate Supply – cont. Short-run aggregate supply (SRAS) is the schedule of the real GDP’s that firms are prepared to supply at different price levels, holding the expected price level constant. Short-run aggregate supply shows what happens to output when the price level changes unexpectedly. The short-run aggregate supply is positively sloped because unanticipated increases in the price level lower real wages and raise selling prices relative to cost.

6. Shifts in Aggregate Supply and Demand Curves 6.1 Demand shock Any factor that causes C, I, G, or X-M: to increase independently of the price level will shift the aggregate demand curve to the right (an increase in AD). to decrease independently of the price level will shift the aggregate demand curve to the left (a decrease in AD).

6.1.1 The Classical Model In this model with a vertical supply curve, increases in aggregate demand do not raise output, only prices. In an economy with flexible wages and prices, the economy operates at full employment (yn), therefore , increases in aggregate demand translate to higher prices, not more output.

6.1.2 The Keynesian Model The Keynesian supply curve is horizontal below full-employment output (yn). If the initial equilibrium is below full-employment, increases in aggregate demand curve cause more output and employment without driving up prices. In the Keynesian high-unemployment model, demand increases do only good! They increases output and do not raise prices. When full employment is reached (the vertical section of the aggregate supply curve), further increases in aggregate demand only cause higher prices.

6.1.3 The Short-Run Aggregate Supply Model When inflation is unanticipated, an increase in aggregate demand raises both process and output in the short run. SRAS is upward sloping. The new equilibrium is established at a higher price level and a higher real GDP.

6.2 Supply Shocks OPEC’s acquisitions of control over crude-oil exports, poor harvest, etc. reduce aggregate supply. A supply shock is a shift in aggregate supply caused by some external factor that causes costs of production to change. Supply shocks can be either adverse or beneficial:

6.2 Supply Shocks – cont. An adverse supply shock raises costs, so the short-run aggregate supply curve shifts to the left. A beneficial supply shock occurs when costs fall so that the short-run aggregate supply curve shifts to the right. Adverse supply shocks create inflation and unemployment.

6.3 The Long-Run, Self- Correcting Mechanism Can the economy automatically return to full employment if, for some reason, it is operating above or below full employment? In the long run, the economy produces at the natural level of GDP because of the self-correcting mechanism.

6.4 Policy implications of the Self-Correcting Mechanism The tendency of the economy to return to (yn) means that the economy’s long-run output and employment cannot be controlled. How long must the economy wait for self-correcting actions to restore the economy to the natural rate? Evidence of a Self-Correcting Mechanism Example