Aggregate Demand and Aggregate Supply ECO 120 Macroeconomics Week 4 Aggregate Demand and Aggregate Supply Lecturer Dr. Rod Duncan

Topics Aggregate demand (AD) curve Aggregate supply curve (AS)- the short-run and long-run curves Equilibrium in the AD-AS model

Aggregate demand The aggregate demand (AD) curve shows the relationship between the aggregate price level, P, and the equilibrium level of GDP, Y. We are thinking of the level of Y depending on the price level, P. Much like in Micro, where demand for a good depends on its price. We could represent this relationship as a graph of AD, as a table of values or as an equation Y = AD(P). So what is the relationship between aggregate prices and equilibrium output?

Aggregate demand We know from our previous lectures that we can calculate equilibrium GDP, Y*: Y* = AE = C(Y* - T) + I + G + NX Or we can use a table or a graph. Y AE Y* Y* Y

Deriving the AD curve But in this way we are calculating Y* for a fixed level of our exogenous variables, I, G, NX and also for a other factors, such as: Weather or natural disasters Aggregate price level If a change in P affects C, I or NX, it will also change the equilibrium level of Y. So how can a change in P affect the level of C, I and NX? We take each of these in turn.

Real balances effect (P→C) We assumed before that households make consumption decisions based on their disposable incomes, so C depends on Y – T. But people also take into account their wealth: Equity in their home Retirement accounts Money in the bank Savings bonds, corporate bonds, stockmarket investments Future income (also called “human capital”)

Real balances effect (P→C) We would expect that a person with the same income but greater wealth would consume more than a person with lesser wealth. You inherit $500,000 from your aunt. You stay in your old job. Do you consume the same things as you did yesterday? Or your house doubles in value. Or you win the lottery. So C depends both on disposable income, Y – T, and on household wealth.

Real balances effect (P→C) A lot of household wealth is held in the form of bonds and other types of “fixed income securities”. A bond or “fixed income security” is a piece of paper (a contract) that says something like: The Australian Treasury (or Ford Motor Company or …) promises to pay the holder of this bond $100 in 2006. If the average level of prices rise between 2005 and 2006, then this bond is worth less than it would be at lower prices in 2006. Worth less is real terms- in which it can buy.

Real balances effect (P→C) As P rises, the real value of bonds and other fixed income securities falls. So as P rises, household wealth falls. As household wealth falls, we would expect C to drop. So the real balances effect predicts that a rise in P should lead to a fall in C.

Interest-rate effect (P→I) A second channel through which P might affect Y* is through the effect of P on investment, I. We can imagine at least 2 paths for this effect: A rise in prices means that people will need more money to make their purchases- driving up the demand for money. An increase in the demand for money will raise the “price” of money- the nominal interest rate, i. We will spend more time on this in the lecture on monetary policy.

Interest-rate effect (P→I) 2. An greater increase in prices than expected is a rise in expected inflation. Inflation is a cost for people who save, as inflation means prices of goods in the future are higher, so money saved is worth less. The rise in expected inflation will push up nominal interest rates- to compensate savers for higher future prices. So both of these channels would suggest that higher P leads to higher nominal interest rates, i.

Interest-rate effect (P→I) Higher P leads to higher i. But higher i will lead to lower levels of investment, I, as some investment projects that were profitable at lower i are unprofitable at a higher i. We will be going into this effect in more detail in the next lecture. Higher P should lead to a fall in I.

Foreign-purchases effect (P→NX) A third channel through which P can affect Y is through the effect of higher P on NX. A higher P means that (all else held constant, such as currency exchange rates) Australian goods are more expensive relative to foreign goods. If Australian goods are more expensive, we would expect fewer foreign purchases of our goods- our exports, X, drop. If Australian goods are more expensive, we would expect Australians to buy more goods from overseas- our imports, M, rise.

Foreign-purchases effect (P→NX) If the price of our cars go up, we would expect fewer foreigners to buy our cars, and more Australians to buy foreign cars. We will be going into these topics in a lot more detail in lectures on international trade. A high level of P should lead to a fall in NX, as: NX↓ = X↓ - M↑

Deriving AD So as P↑, we expect: The AE curve shifts down. C↓ (real balances) I↓ (interest rate) NX↓ (foreign-purchases) AE = C↓ + I↓ + G + NX↓ The AE curve shifts down. Equilibrium Y* falls.

Deriving aggregate demand How do average prices affect demand for goods and services? Real balances effect: higher prices means our assets have less value so people are poorer and consume less. Interest-rate effect: higher prices drive up the demand for money and so drive up interest rates, at higher interest rates, investment falls (see later) Foreign-purchases exports: at higher Australian prices, foreign goods are cheaper, so net exports falls (see later) As the average price level rises, demand for goods and services should fall, with all else held constant.

Aggregate demand We would like to have a relationship between the demand for goods and services and the price level. We call this the “aggregate demand” (AD) curve. The AD curve is downward-sloping in aggregate price. P0 P1 AD Y0 Y1 Y

Shifts of the AD curve Factors that affect the AE curve will affect the AD curve. For example, if household wealth rose, then C would increase for all levels of disposable income. Demand would be higher for all levels of prices, so the AD curve shifts to the right. C: household wealth, household expectations about the future I: interest rates, business expectation about the future, technology G and T: changes in fiscal policy NX: the currency exchange rate, change in output in foreign countries

Shifts of the AD curve Any change in these factors will produce a shift of the whole AD curve. If G↑ then the AE↑, so the AD curve shifts to the right. Likewise if T↓ then the AE↑, so the AD curve shifts to the right. G↑ or T↓ P0 AD1 AD0 Y0 Y1 Y

AD and the multiplier A change in G or I or NX will shift the AE curve up. This will produce a shift to the right of the AD curve. The shift in the AD curve will be the change in I times the multiplier.

Aggregate supply The aggregate demand curve showed the relationship between goods demand and the average level of prices. The aggregate supply (AS) curve shows the relationship between goods supply and the average level of prices. By goods supply, we are thinking about all of the goods and services provided by all the producers in the economy. How does the aggregate price level affect the aggregate level of goods and services supply?

Deriving the AS curve We will differentiate between goods supply in the short-run (SR) and in the long-run (LR). The crucial difference between the two time periods is that we will assume that nominal wages for employees are fixed in the SR. Workers’ money wages do not change in the SR. But workers’ wages are free to move in the LR. So we will have two different AS curves- the SR AS and the LR AS curves.

Fixed nominal wages How can we defend the assumption that wages are fixed in the SR? All wages in a modern economy are set either via contracts between employers and employees or via a labour agreement between unions and employers. These contracts specify well in advance (a few months to several years) what the wages of a worker will be in nominal terms. These contracts are usually very difficult to change.

Supply of an individual firm So what effect will this assumption of fixed wages have? To think about this, we will think about the supply of a small firm in our economy. Intuition: If the output price for a firm rises, but the cost of labour stays the same, a firm will want to increase profits by producing more output. But if the output price and the cost of labour both rise by the same amount, a firm will not increase output.

Supply of an individual firm Imagine we have a firm that buys labour, L, at a wage cost, W per unit, and sells output, Q, at a price, P per unit. Imagine our firm needs a certain amount of labour to produce output: L = f(Q) Profits = Revenues – Costs Revenues = Sales = PQ Costs = Labour Costs = WL Firm profits = PQ – WL or PQ – Wf(Q)

Supply of an individual firm The firm’s supply problem is to choose Q* to maximize profits, given P, W and f(). Assume W is constant, but that P changes, how does firm supply, Q*, change? (Not necessary for class) You can show mathematically that Q* will rise if P rises, for the types of f() we normally assume. You can also show that if P and W both rise by the same amount, Q* stays the same.

Deriving the SR AS curve In the SR, since wages are fixed, a rise in P will have no affect on W, so individual firms will find it profitable to increase output. As all firms are raising output, aggregate supply will increase in the SR if aggregate prices rise. So the SR AS curve is upward-sloping in aggregate prices.

Deriving the LR AS curve We assume that workers are interested in their real wages (wages relative to prices W/P). If P rises, workers will demand a compensating W rise, so as to keep real wages the same as before. In the LR, real wages are unchanged by changes in P, so output is not affected by changes in P. The LR AS curve is vertical.

Review: Aggregate supply There will be a short-run AS curve which is upward-sloping in prices. The long-run AS curve is vertical at the level of potential output, since wages will change proportionately to price changes.

Shifts in the AS curves What factors will shift the AS curves? The AS curves depend on the productivity of Australian workers. What affects labour productivity? Changes in prices of inputs, like land, capital energy or entrepreneurial skill Changes in technology that affect productivity Changes in taxes, subsidies or laws affecting business productivity

Equilibrium Equilibrium occurs at a price level where goods demand (AD) is equal to goods supply (SR AS). P AS P0 AD Y0 Y

Shift in AD (C↑ or G↑ or T↓ or I↑ or NX↑)

Shift in AD We start with an economy of $10tr and a price level of 110. A change in autonomous expenditure causes the AE curve to shift from AE0 to AE1. We move to a new AD curve at AD1. At the old price level of 110, AD > AS by $2tr, so prices rise, pushing AD down and AS up until we reach out new equilibrium. Our new equilibrium will have higher P and Y than when we started.

Shift in AS (rise in oil prices) A rise in oil prices raises the cost of production for all producers and shifts the SR AS curve up/to the left. At the old prices, AD > AS, so prices rise and output falls. P AS0 P1 P0 AD Y1 Y0 Y

Business cycle Over the business cycle, we will have periods of high output (booms) and periods of low output (recessions). In booms, output is high and unemployment is low, while in recessions, output is low and unemployment is high. The “natural rate of unemployment” is the level of unemployment in a “normal” period of the economy. This is achieved when output is at full-employment or SR AS level.

Unemployment LR AS The gap between the “natural rate of output” and current output is called the “recessionary gap”. The level of unemployment depends on the size of this gap. P AS P0 Unemployment AD Y0 YLR Y