Aggregate Demand and Aggregate Supply: Explaining economic fluctuations - Revision of main concepts Francesco Daveri

Two key facts on fluctuations 1.Economic fluctuations occur systematically, but they are irregular, for their timing and duration is unpredictable Macroeconomic variables behave as random variables 2.Most aggregate variables fluctuate together: macro-economic variables are closely related Yet: even if most variables move together, their volatility differs across variables

Growth: usually positive but not constant. One episode of growth<0 GDP growth in the world economy: fluctuating with irregular and unpredictable timing Source: IMF World Economic Outlook Database, April 2014

We want to develop basic model to explain economic fluctuations Two variables are used to develop a model to analyze the short-run fluctuations : The economy’s output of goods and services measured by real GDP The overall price level measured by the CPI or the GDP deflator We use the model of aggregate demand and aggregate supply (AD-AS) to explain short-run fluctuations in economic activity around long-run trends

What the basic model says Three main things Monetary, fiscal and exchange rate policies (AD policies) affect real GDP in the short run but not in the long run Money and policy do not affect “real” variables” (Gdp, C, I) in the long run, but they do in the short run. Long-run Money and policy neutral in the long run, not in the short run Hence: when studying year-to-year changes in the economy, we will not assume money and policy neutrality

The model of aggregate demand and aggregate supply Equilibrium output Quantity of Output Price Level 0 Aggregate supply Aggregate demand

AD and AS The aggregate demand (AD) curve shows the quantity of goods and services that households, firms, and the government are willing to buy at any price level –Note: The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy The aggregate supply (AS) curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level –Note The AS curve is not a market supply curve, and it is not the sum of all market supply curves in the economy

AD curve The four components of GDP (Y) contribute to the aggregate demand for goods and services: Y = C + I + G + NX Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 Y2Y2 P2P2 1. A decrease in the price level 2. …increases the quantity of goods and services demanded.

Why the AD is downward sloping Price level   Quantity of good demanded  Pigou (wealth) effect price level   consumers feel wealthier  Encouraged to spend more  larger quantity of goods and services demanded Keynes (interest rate) effect price level   Lower domestic interest rate  Firms encouraged to invest more  greater spending on investment goods Mundell-Fleming (exchange rate) effect (domestic) price level   Lower interest rate, capital goes abroad  Exchange rate depreciates, gain in competitiveness  increase in exports and decrease in imports, increase in net exports

Pigou’s effect (or real balance effect): Keynes’ effect (or interest rate effect): Mundell-Fleming’s effect (or exchange rate effect):

Shifts in the AD curve Anything that makes buyers more or less willing to buy goods and services for any given level of price shifts the AD curve. Consumers, firms: exogenous changes in spending plans by consumers or firms (e.g. household savings before the Iraq war; pessimism after Lehman Bros bankruptcy) Government: exogenous changes in fiscal, monetary and exchange rate policy Output Price 0 P1P1 Y1Y1 Y2Y2 AD 1 AD 2

The multiplier: by how much AD shifts Extent of the AD shifts determined by size of multiplier  Multiplier: process that makes initial increase in income bigger due to further increases in C and I triggered by initial increase in GDP Example: Suppose Govt raises defense spending   G  income of G producers  consumption of G producers  income of C producers and so on  Total rightward shift of AD given by sum of all income increments  If GDP very close to full employment, demand increase feeds into higher inflation and not Gdp gains

Aggregate supply curve Preview of main arguments In the short run, the aggregate-supply curve is upward sloping In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services The price level does not affect these variables in the long run Hence: In the long run, the aggregate-supply curve is vertical

The short run AS curve In the short run An increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied for given costs of production A decrease in the level of prices tends to reduce the quantity of goods and services supplied (see picture) Y1Y1 P1P1 P2P2 1. A decrease in the price level Quantity of output Price Level 0 Short-run aggregate supply Y2Y2 2. reduces the quantity of goods and services supplied in the short run

Why the short run AS is upward sloping Price level   Quantity of good supplied  New classical misperceptions theory Aggregate price   producers temporarily perceive it as a decline in ‘their’ individual sale price  decrease of goods and services supplied Keynesian sticky wages theory Aggregate price   nominal wages do not fall immediately  labor costs go up  firms reduce production New Keynesian sticky prices theory Aggregate price   some firms do not adjust their own price to save on “menu costs”  sales reduced, hence firms reduce production Bottom line: Experts’ opinions vary as to why, but – reassuringly - the SLOPE of the AS is anyway positive!

Shifts in the short run AS curve Y1Y1 P1P1 output Price 0Y2Y2 AS 2 AS 1

Why AS might shift In a nutshell: Anything that shifts costs of production shifts AS AS shifts to the right if: Imported or domestic input prices go down Costs of production going up for given price, output to be cut Factor productivity goes up (thanks to new technologies) allows firms to produce more at a lower cost for an unchanged sale price Government cuts distorting taxes and regulations hampering business practices Reduction of social security contributions reduces labor costs; reduced tax on profits raises net profitability Expectation of lower price level in the future This feeds into lower wage claims and thus decrease labor costs today

Implication: GDP gains due to AD shifts do not last long Let’s see why  Short run AS drawn for given nominal wages  As nominal wages change,  short-run AS (entire curve) Why do wages change?  Today’s  P makes  wage claims at next wage negotiation round So what happens? As AD shifts to the right, this also gives rise to  P. This results in rising inflation expectation for the future  Higher expected inflation raises wage claims  Short run AS shifts to the left  Short run AS keeps shifting leftwards until GDP above its long-run average

AD SRAS AD’ SRAS’ E GDP P Permanent GDP E’ E’’ Why AD-originated Gdp gains do not last: graphics

As a result: The long run AS curve is vertical at the natural rate of output. Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P1 1. A change in the price level… P2 2. …does not affect the quantity of goods and services supplied in the long run.

Long run equilibrium The intersection of the AD curve and the long-run AS curve determines the economy’s equilibrium output and price level (E) Output is at its natural rate The short-run AS curve goes through the point of intersection Natural rate of output Output Price 0 Equilibrium Price Long-run AS E Short-run AS AD

Now ready to study the causes of recessions There are two causes of recessions AD shift to the left AS shift to the left See them in turn

Recession I: a leftward shift of AD A decrease in one of the determinants of AD shifts the curve to the left. Hence, (i) output falls below the natural rate of employment; (ii) unemployment rises, (iii) the price level falls 0 AS 1 A B C P1P1 P2P2 P3P3 Y1Y1 Y2Y2 AD 2 AS 2 1. A decrease in aggregate demand… 3. …but over time, the short-run aggregate-supply curve shifts (B to C)… 2. …causes output to fall in the short run (A to B)… 4. …and output returns to its natural rate. Long-run AS Price Output AD 1

Recession II: a leftward shift of AS A decrease in one of the determinants of AS shifts the curve to the left: hence, (i) output falls below the natural rate of employment; (ii) unemployment rises; (iii) the price level rises 0 AS 1 B A P1P1 P2P2 Y1Y1 Y2Y2 AS 2 2. …causes output to fall…. 3. …and the price to rise. Long-run AS Price Output 1. An adverse shift in the short-run AS curve… AD 1

Recession II = Stagflation Adverse shifts in aggregate supply cause stagflation - a combination of recession and inflation Output falls and prices go up Policymakers can influence the level of aggregate demand (by increasing public consumption), much less so the level of aggregate supply Hence, they cannot offset both adverse effects simultaneously

26 How to read supply and demand shocks in the data: the US in the 1990s 1990s: GDP up & inflation down, symptom of positive supply shock : both GDP & inflation down, symptom of negative demand shock US economy GDP growth Inflation