Aggregate Demand (AD) Again

Aggregate Demand (AD) and Aggregate Expenditure (AE)  The equations look alike  AD = C + I + G + (X - IM) and  AE = C + I + G + (X - IM)

Difference between AD and AE  AD, Aggregate Demand, refers to the relationship of total spending and general price level  AD is depicted in the P-Y space.  AE, Aggregate Expenditure, refers to the relationship of total spending and the GDP level.  AE is depicted in the AE-Y space.

AE in the AE-Y space 0 Y AE

AD in the P-Y space 0 Y AD P

Effects of Change in P on AE (b) Fall in Price Level Aggregate Expenditure (AE) GDP (Y) AE = C 0 + I + G + (X-IM) Y 0 Y 2 (a) Rise in Price Level Aggregate Expenditure (AE) GDP (Y) Y 0 Y 1 45 E 0 E 0 AE’ (P 1 ) = C 1 + I + G + (X-IM) E 1 E 2 AE’ = C1 + I + G + (X-IM) AE(P 0 ) = C 0 + I + G + (X-IM) P ↑ P↓P↓

Derive AD from AE (b) Fall in Price Level Price (P) GDP (Y) Y 0 Y 1 (a) Rise in Price Level Aggregate Expenditure (AE) GDP (Y) Y 0 Y 1 45 E 0 E 0 AE’ (P 1 ) E 1 E 1 AE(P 0 ) P ↑ P1P1 P0P0 AD

Derive AD from the AE diagram  When price rises from P0 to P1, AE shifts downward correspondingly.  Keynesian equilibrium GDP falls from Y0 to Y1  In the P-Y diagram, we find the corresponding coordinates for the two pairs of P and Y*.  We do that for all price levels, and we have all corresponding pairs of P and Y*  We get the aggregate demand AD curve..

Derive AD from the AE diagram  AD implies all the demand-side equilibriums

Effect of changes in P on AE and AE  Change in P produces a shift in AE  But change in P produces a movement in AD

Derive AD from AE (b) Fall in Price Level Price (P) GDP (Y) Y 0 Y 1 (a) Rise in Price Level Aggregate Expenditure (AE) GDP (Y) Y 0 Y 1 45 E 0 E 0 AE’ (P 1 ) E 1 E 1 AE(P 0 ) P ↑ P1P1 P0P0 AD

Effect of autonomous changes on AE and AD  Autonomous change in C, I, and X-IM, and change in G  will shift AE curve and  Will shift AD as well  The horizontal shift in AD is equivalent to the horizontal change in the AE-Y diagram.

Effects of autonomous changes on AD and AE (b) Fall in Price Level Price (P) GDP (Y) Y 0 (a) Rise in Price Level Aggregate Expenditure (AE) GDP (Y)Y 0 Y 1 45 E 0 E 0 AE’ (I 1 ) E 1 AE(I 0 ) I ↑ P0P0 AD Y 1 E1E1 AD’

Aggregate Supply and Supply-side Equilibrium  The AD-AS diagram revisited  Bring the aggregate supply (AS) to the diagram

From demand-side equilibrium to econ-wide equilibrium Supply-side Equilibrium AD AS AE C I G X technology resource labor Demand-side equilibrium or Keynesian equilibrium

Aggregate Supply and Supply-side Equilibrium  Supply-side equilibrium  Also called Economy-wide equilibrium  The supply-side equilibrium is a more comprehensive concept. It takes account of AD and AS together.  In the previous Demand-side equilibrium, it only looks at the demand side equilibrium. Or it implicitly assumes AS is horizontal.

Supply-side Equilibrium Y* AS Y P 0 AD P*

Aggregate Supply and Supply-side Equilibrium  Determines the supply-side equilibrium price  And supply-side equilibrium quantity

Aggregate Supply (AS) and the AS curve  AS shows the quantity of goods and services that all firms are willing to supply at each price level, holding all other determinants of quantity supplied constant.

Slope of the AS  Upward sloping –When the price is up, production is more profitable, hence firms increase supply.  It gets steeper at higher GDP level –Productions increases and finally strains the existing capacity. Firms have to pay higher rate to get additional unit of labor (such as pay workers the overtime rate) or other inputs.

Aggregate Supply YpYp AS Y P 0 P’

Shifters of the AS  Price of inputs –Labor cost (wage rate) –Price of other inputs  Technology  Size of suppliers  Capital stock  Resource endowment

Shift of the Aggregate Supply Curve Copyright © 2003 South-Western/Thomson Learning. All rights reserved. S 1 S 1 (higher wages) S 0 S 0 (lower wages) 100 6,000 Price Level 5,500 GDP (Y) A B

Movement along the AS curve  Change the price of output P

Movement along the Aggregate Supply Curve Copyright © 2003 South-Western/Thomson Learning. All rights reserved. AS (Change in price) 100 6,000 Price 5,000 GDP (Y) A B80

From AE-Y diagram to the AD-AS diagram  How the demand-side and supply- side equilibrium are related  What happens to the supply-side equilibrium if G changes?  What happens to the supply-side equilibrium if other autonomous changes?  What happens to the supply-side equilibrium if P changes?

Demand and supply sides equilibrium (b) Price (P) GDP (Y) Y’ 0 (a) Aggregate Expenditure (AE) GDP (Y)Y* 0 45 E 0 E 0 AE(P 0 ) P0P0 ADAS

Effects of autonomous changes on AD and AE: Initial change (b) Price (P) GDP (Y) (a) Aggregate Expenditure (AE) GDP (Y)Y* E 0 E 0 AE’ (I 1 ) E 1 AE(I 0 ) I ↑ P0P0 AD Y’ 1 E1E1 AD’ Y’ 0 AS E2E2 shortage

Effects of autonomous changes on AD and AE: Final outcome (b) Price (P) GDP (Y) (a) Aggregate Expenditure (AE) GDP (Y)Y* E 0 E 0 AE’ (I 1 ) E 1 AE(I 0 ) P ↑ P0P0 AD Y’ 1 E1E1 AD’ Y’ 0 AS E2E2 Y’ 2 AE(P 2 ) P2P2 Y* 2

Dampening the multiplier effect  As can be seen, the rise in the price will dampen the original increase in the equilibrium GDP  Represented by the green arrow in the diagram  This is another reason that the oversimplified multiplier is oversimplified

Changes in P and Y depend on the slope of AS  If AS is flat, the dampening effect by price is small  If the AS is completely horizontal, there is no dampening effect.  That is what is assumed in the Keynesian model  Changes in G is very powerful

AS horizontal (b) Price (P) GDP (Y) (a) Aggregate Expenditure (AE) GDP (Y)Y* E 0 E 0 AE’ (I 1 ) E 1 AE(I 0 ) P0P0 AD Y’ 1 E1E1 AD’ Y’ 0 AS E2E2 Y’ 2 AE(P 2 ) Y* 2 E2E2

Changes in P and Y depend on the slope of AS  If AS is steep, the dampening effect by price is great  If the AS is vertical, there is 100% dampening effect.  Changes in G or autonomous changes would cause only inflation but no effect on GDP.

AS vertical (b) Price (P) GDP (Y) (a) Aggregate Expenditure (AE) GDP (Y)Y* E 0 E 0 AE’ (I 1 ) E 1 AE(I 0 ) P0P0 AD Y’ 1 E1E1 AD’ Y’ 0 AS E2E2 Y’ 2 AE(P 2 ) Y* 2 E2E2 P2P2

Recessionary gap and Inflationary gap again  The supply-side equilibrium GDP Y’ can be greater or smaller than the potential GDP level.  If Y’ < Y p : Recessionary gap  If Y’ > Y p : Inflationary gap, an overheating economy

Supply-side Equilibrium and Recessionary gap Y’ AS Y P 0 AD P’ YpYp Recessionary gap

Supply-side Equilibrium and inflationary gap Y’ AS Y P 0 AD P’ YpYp Inflationary gap

Market self-correcting mechanism  Classical economics argues that the market mechanism would bring the economy back to the potential GDP, the full employment GDP level, through the price adjustment. This is called market self-correcting mechanism.

Market self-correcting mechanism  If a recessionary gap, there will be high unemployment rate, an excess supply of labor, wage rate falls  Cost of production falls, and AS shifts downward.  Returns to the full employment level.  GDP increases and prices fall

Close a recessionary gap by market self-correcting mechanism (b) Price (P) GDP (Y) E 0 P0P0 AD Y’ p E1E1 0 AS E2E2 Wage falls AS’ P1P1

Market self-correcting mechanism  As price falls, through the wealth effect, AE shifts up  GDP increases by a multiplier effect

Close a recessionary gap by market self-correcting mechanism (b) Price (P) GDP (Y) (a) Aggregate Expenditure (AE) GDP (Y)Y* 0 p 45 E 0 E 0 AE’ (P 1 ) E 1 AE(P 0 ) P↓P↓ P0P0 AD Y’ p E1E1 0 AS E2E2 Wage falls AS’ P1P1

Why does the market fail in closing the recessionary gap  Wage is rigid to go downward  Price is also rigid to go downward  Households may still hold consumption even if goods price falls (in this case the AD is vertical).  Hence the market self-correcting mechanism does not work

Why does the market fail in closing the recessionary gap  The adjustment time takes long time.  It may take so long that “all of us would die during the adjustment process.”  Keynes: “The long run is a misleading guide to current affairs. In the long run we are all dead. ”  Keynes: “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”

Close an inflationary gap  If an inflationary gap, there is shortage in the labor market, i.e. excess demand for labor, wage rate will be pushed up  AS thus shifts up.  Close the inflationary gap.  Returns to the full employment level

Close an inflationary gap by market self-correcting mechanism (b) Price (P) GDP (Y) E 0 P0P0 AD Y’ p E1E1 0 AS Wage up AS’ P1P1

Close an inflationary gap by market self-correcting mechanism (b) Price (P) GDP (Y) (a) Aggregate Expenditure (AE) GDP (Y)Y* 0 p 45 E 0 E 0 AE’ (P 1 ) E 1 AE(P 0 ) P↑P↑ P0P0 AD Y’ p E1E1 0 AS Wage up AS’ P1P1

Close an inflationary gap  The market self correcting mechanism is more effective in closing inflationary gap because the wage rate and price are flexible to go upward.  Yet it is a painful process too. During the adjustment process, GDP falls but prices go up.  Stagflation.

Close an inflationary gap by market self-correcting mechanism (b) Price (P) GDP (Y) E 0 P0P0 AD Y’ p E1E1 0 AS Wage up AS’ P1P1