I. Introduction to Aggregate Demand/Aggregate Supply Model

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1 University of California-Davis Economics 1B-Intro to Macro Handout 8 TA: Jason Lee I. Introduction to Aggregate Demand/Aggregate Supply Model In this chapter we develop a model called Aggregate Demand-Aggregate Supply which is used by macroeconomists to explain short-run fluctuations in output and prices. Macroeconomists define short-run as the period in time in which prices are fixed to some extent. With this model, we can start tackling such questions as what causes recessions and what policies could policymakers undertake to either prevent recessions or to lessen the severity of its impact. A. Key Facts Concerning Economic Fluctuations. 1. Economic Fluctuations are Unpredictable Looking at a graph of real GDP since World War II, one can notice that although the trend of real GDP has been increasing throughout the period, there have been periods in which real GDP has fallen. Those sustained periods of falling real GDP (technically defined as 2 consecutive quarters of negative economic growth) are called recessions. As can be seen from Figure 1 in your textbook, recessions do occur periodically, but they do not occur in a predictable pattern. In some periods, recessions occur back-to-back (such as occurred in the early 1980s), while in other points in time, it was a decade between recessions. 2. Macroeconomic Quantities Fluctuate Together Another key fact is that most macroeconomic variables are what we call pro-cyclical, that is they move in the same direction as real GDP. In order to get a sense in which way real GDP is moving, one only has to look at any number of economic variables as indicators of short-run fluctuations. During recessions, variables such as consumption, investment, retail sales, industrial production would all decline. Thus if one hears in the news that retail sales increased in the previous month, that would indicate that real GDP had probably increased as well. Although many economic variables move together with real GDP, they do not move equally. Some variables such as consumption would decline during a recession, but usually the decline would be modest. Other variables such as investment decline sharply during a recession. 3. Unemployment and Real GDP Fluctuate in Opposite Directions A final key fact is that unemployment is counter-cyclical, that is it moves in the opposite direction of real GDP. This should make intuitive sense. During periods of recessions, when demand for goods and services fall, factories will produce less. If factories don t produce as much output as before, there is less need for labor, and firms will start to fire workers which increases unemployment. When the recession ends, demand for products increases, and firms hire workers to meet this increase in production which reduces unemployment. Note that unemployment is never zero, due to the fact that there is always some level of natural unemployment (frictional and structural unemployment).

2 II. Aggregate Demand The aggregate demand curve shows the relationship between the price level and the level of real GDP. It is the demand for all goods and services in an economy. Graphically the aggregate demand is a downward sloping curve. Note that in Figure 1 the y-axis has the price level of the economy (measured by CPI or GDP-Deflator) and the x-axis is represented by real GDP (Y) Figure 1 A. Why is the Aggregate Demand Curve Downward Sloping? What can explain the negative relationship between prices and output? Why does a decrease in the price level lead to an increase in the overall output demanded? Why would an increase in the price level lead to a decrease in the overall output level? There are three explanations. 1. Wealth Effect: As the price level falls, you feel wealthier. As a result you will increase spending on total goods and services. A simple example will illustrate this effect. Suppose you earn $100 a day and the price of DVDs are $10 a disc. Every day you can afford to purchase 10 movies. Suppose however the price of DVDs falls to $5 a disc. All of the sudden your purchasing power has increased to 20 movies. You can afford to

3 purchase the same number of movies and still have $50 to spend on other goods and services. Thus falling prices would lead to an increase in output. Conversely, an increase in the price level will make households feel poorer and they will consume less goods and services. An increase in the price level, will make households feel poorer, which reduces the consumption level in the economy, and causes real GDP to fall. 2. Interest Rate Effect: It turns out that higher price levels will increase the real interest rate. The logic is as follows. If the price level increases, households will have to hold more money in order to purchase the same amount of goods and services. Households will have to borrow money from banks in order to obtain the needed funds. The increase in the demand for money will push the price of borrowing money higher. As we discussed earlier, the cost of borrowing is called the interest rate. As the interest rate increases, it will reduce the demand for investment (recall there is a negative relationship between investment and the interest rate). Additionally, consumption may also fall as consumers find that borrowing money to purchase homes and cars is also more expensive. In the end, both investment and consumption will fall because of higher interest rates. An increase in the price level will cause an increase in the real interest rate which will cause both investment and consumption to fall which will cause real GDP to fall. 3. et Exports and the Exchange Rate Effect: The effect that prices have on interest rate is not limited to a closed economy. Consider what would happen in an open economy. Suppose that there was an increase in prices that increased the interest rate in the United States. The interest paid by U.S. bonds would increase as well making U.S. bonds more attractive to foreign investors (assuming that interest rates elsewhere in the world are held constant). The result would be that foreigners will demand more U.S. dollars to purchase these attractive American bonds. Like any good, an increase in demand for U.S. dollars will drive up the price of dollars which is measured by the exchange rate. The exchange rate is the number of foreign currency that can be purchased by a unit of domestic currency. In other words the exchange rate of the U.S. dollar will increase, meaning that the U.S. dollar can purchase more foreign currency (and conversely foreign currency can purchase less U.S. dollars). This appreciation (increase in the exchange rate) of the U.S. dollar will make foreign goods cheaper for U.S. consumers and thus increase imports, while it will make U.S. goods more expensive to foreign consumers and reduce U.S. exports. Net exports which is the difference between exports and imports will fall overall. Since net exports is a component of real GDP, real GDP will fall because of the increase in the price level. A simpler and perhaps more intuitive explanation on the effect of prices on net exports could be the following. Suppose the prices in the United States were to fall. That would mean that goods in the United States are now cheaper than before. Foreigners will

4 demand more U.S. goods and the amount of exports will go up. Net exports will increase. Since net exports is one of the components of GDP this will mean that output will increase. In either explanation an increase in the price level will cause net exports to fall which will cause real GDP to fall. B. Shifts in the Aggregate Demand We saw in Figure 1 that changes in the price level will result in movement along the aggregate demand curve. If another variable, other than the price level, were to change that would lead to a shift in the aggregate demand curve. Let us consider what are some of these potential causes of shifts in the aggregate demand. 1. Changes in Consumption. Any shock that causes a change in household consumption behavior will shift the aggregate demand curve. For example, consider what would happen if the government decreased taxes. Households would have more disposable income (income after taxes) than before. They would be able to purchase more goods and services at any price level. Thus the aggregate demand curve will shift to the right. Other factors that might cause consumption to change are changes in saving behavior, or an increase in income. 2. Changes in Investment: Any shock that causes a change in investment decisions will shift the aggregate demand curve. For example, tax policies could also affect investment decisions. Consider what would happen if the government imposed an investment tax credit (rebate for investing). This will give firms incentive to increase their investment spending at any price level which would increase the real GDP. Another important shock that affects investment is changes in the money supply. As we ll soon discuss, an increase in the money supply has the effect of lowering the real interest rate. Lower interest rate will make the investments more attractive, and firms will invest more. 3. Changes in Government Spending: Recall that government spending was one of the components of GDP. Obviously, an increase in government spending will cause output to increase, even if the price level was held constant. An increase in government spending will shift the aggregate demand curve to the right. 4. Changes in et Exports: Shocks that causes a change in the demand for U.S. exports or foreign imports into the United States will affect the aggregate demand curve. Consider what would happen if Greece s debt problems cause a recession within Europe. European consumers will demand less goods and services (including U.S. imports). As a result, U.S. real GDP will fall at any price level because net exports have fallen. Consider what would happen if the U.S. started promoting a Buy American program that would reduce foreign imports consumed in the United States. The net result would be higher net exports, and real GDP would increase at any price level. These examples show that in an open economy, shocks from foreign counties have an effect on the domestic economy.

5 Aggregate Supply Aggregate supply shows the relationship between the price level and the total supply of final output produced by firms. However, unlike the aggregate demand curve, the shape of the aggregate supply curve will depend on our assumptions of the time horizon we are talking about. There are two different types of aggregate supply curves: (1) Long-Run Aggregate Supply Curve (LRAS): In the long-run, the aggregate supply curve is vertical. and (2) Short-Run Aggregate Supply Curve (SRAS): In the short-run, the aggregate supply curve is upward sloping We ll take a look at each of them in turn. We can define long-run as the period of time in which prices are fully flexible (they can change), whereas we define short-run as the period of time in which prices are sticky (it is harder to change). I. Long-Run Aggregate Supply Curve (LRAS) We saw earlier that in the long-run prices are fully flexible. In theory that would imply that firms could respond to higher price levels by supplying more goods. However, we will assume that in the long-run the amount that firms can supply is limited by an economy s factors of production. Firms have to use labor and capital in the production process. Even if prices were extremely high, firms would not be able to produce as much output as they would want because they face constraints on the availability of inputs. In the long run we assume inputs such as labor (L), capital (K), and natural resources (N) are fixed at some level. Since we have assumed that capital (K), labor (L) and natural resources (N) are fixed in the long-run then it must be the case that real GDP (Y) is also fixed in the long-run. Long-run supply of output is not determined by the price level. Figure 2 Note that output is fixed in the long-run and does not depend on the price level.

6 The level of real GDP that is produced in the long run is also known as the natural rate of output or potential output (Y n ). This output level just reflects the level of output that could potentially be produced if all the factors of production are used in the production process. When the economy is at potential output there is no cyclical unemployment or to put it another way the natural rate of output is the level of output that would be produced at the natural rate of unemployment. A. Shifts in LRAS What might cause the LRAS curve to shift? Clearly since LRAS is determined by factors of production, any change in the factors of production or technology will cause the LRAS curve to shift. We will briefly discuss each of these factors. 1. Changes in labor force (L): A change in the labor force will affect the LRAS since labor is a factor of production. An increase in the labor force will cause the LRAS to shift to the right. The reason is that the presence of more workers will mean that the economy could potentially produce more output than before. Thus the natural rate of output will be greater. The converse will be true if labor decreased. Any change in the natural rate of unemployment will also affect the LRAS. If some policy were enacted that decreased the rate of natural unemployment (i.e. job training programs), more workers will be employed and producing goods and services that will increase the potential output level. 2. Changes in capital (K): As with labor, an increase in the capital stock (either physical capital or human capital) will increase the ability of the economy to produce more goods and services, thus increasing the natural rate of output. An increase in capital (K) will increase LRAS, while a decrease in capital will decrease LRAS. 3. Changes in natural resources ( ): If an economy found new deposits of minerals or oil, they may be able to produce more goods and services thus increasing the potential output level. An increase in natural resources will increase LRAS, while a decrease in natural resources will decrease LRAS. 4. Changes in technology: Recall that we defined technology in this course as the ability to produce more output with the same amount of resources. If we assume that capital, labor and natural resources are fixed, but technology has improved then an economy would be able to produce more output with the same amount of inputs. Clearly the potential output of an economy will increase with the advancement of technology. An increase in technological knowledge will increase LRAS. In situations where there is some type of technological knowledge is lost, this will decrease LRAS. II. Short-Run Aggregate Supply Curve (SRAS) Unlike the long-run aggregate supply curve, in the short-run prices do matter in determining the amount of real GDP in the economy. As seen in Figure 3, the SRAS is upward sloping. When the price level is higher, firms in the economy will produce more goods and services. When the price level is lower, firms in the economy will produce less goods and services. As with our discussion with aggregate demand, we must take a

7 deeper look at the SRAS curve and try to explain why we see this positive relationship between the price level and real GDP produced. A. Why does the SRAS curve slope upward? We will discuss three theories to help explain why the SRAS curve slopes upward. Each of these theories are based on the assumption that when the price level deviates from the expected price level the amount of real GDP produced in the economy will differ from the natural rate of output. Formally we can write this as follows: Y = Y n + a (P P e ) Here Y = quantity of real GDP produced Y n = natural rate of output a = positive constant P = observed price level P e = expected price level The general idea, is that firms have no idea what the prices are going to be in the future and thus they have to form some type of expectations over future prices. If they correctly predict the level of prices then they will end up producing exactly at the natural rate of output. If on the other hand the actual price level is greater than the expected price level, firms will end up producing more output than potential output, and if the actual price level is below the expected price level, firms will end up producing less output than potential. Hopefully, the three theories explaining the positive slope of SRAS will help make this point clearer. 1. STICKY WAGE THEORY: The key assumption of this theory is that what workers and firms really care about is not nominal wages (wages measured in $) but rather real wages (nominal wages divided by the price level). Real wages tells you how many goods you can buy with your wages. Consider a very simple economy where the only good produced is bread. Suppose that the price of bread was $2 a loaf. Suppose you work at a factory that paid you $10 an hour. In this example, your nominal wage is $10 while your real wage is $10/$2 = 5 loaves of bread. Suppose that there was inflation in this economy and the price level increases to $5 a loaf while your nominal wages are unchanged. Your nominal wage is still at $10, however your real wage is now only $10/$5 = 2 loaves of bread. Even though your wages measured in dollars has not changed, you are clearly worse off, thus its not unreasonable to assume that it is real wages (and not nominal wages) that matters to workers and firms.

8 With this understanding we can explain sticky wage theory. In this theory, workers and firms form long-term contracts where they get together and try to agree on a real wage that will be paid for several years. However, the key problem is that in order to figure out the real wage, you must know what the price level will be in the future. This is information that neither the firm nor workers have in their possession. What they can do, however is form, expectations of future price level to determine a targeted real wage. Expected real wage = (Nominal wages/ Expected Price Level) = W/P e Eventually, both workers and firms will observed the actual price level (P) which may or may not be equal to the expected price level. Consider the following scenarios: (1) Expected price level (P e ) = actual price level (P): If the firm correctly forecasted the actual price level, then there is no problem. The real wage they are paying their employees is exactly what they expected to pay their employees, so they will continue to employ the same amount of workers and produce at their current production level. (2) Expected price level (P e ) > actual price level (P): In this scenario the firm overestimated the price level. They thought that prices would be growing faster than what they had thought. Will this be good or bad for the firm? Recall that the firm was expecting to have to pay the expected real wage (W/P e ). Actual real wage (W/P) > Expected real wage (W/P e ). We know this to be true since P e > P. The firm has to pay a higher real wage than they were expecting to have to pay. In other words, the wage has increased for the firm. When actual price level is less than the expected price level, the firm is worse off because it has to pay higher actual real wages. They will respond to this increase in real wages, by cutting their workforce and as a result produce less goods and services. A decrease in the price level (lower than expected price) will cause firms to hire less workers since actual real wages is lower than expected which in turn will cause a decrease in output produced. (3) Expected price level (P e ) < actual price level (P): In this scenario, the firm has underestimated the price level. In this scenario the actual price level has risen faster than the firm thought it would. The result would be the following: Actual real wage (W/P) < Expected real wage (W/P e ). The firms end up paying less in real wages than they were expecting. As a result firms will respond to this decrease in real wages, by increasing their workforce and producing more goods and services. An increase in the price level (higher than expected price) will cause firms to hire more workers since actual real wages is lower than expected which in turn causes an increase in output produced.

9 2. STICKY-PRICE THEORY: In this theory we assume that there are two types of firms. Firms that change their prices constantly, and other firms that fix their prices years in advance. For some industries it is very costly for firms to constantly keep changing their price, this is known as menu costs. A restaurant that had to keep constantly changing its prices would have to constantly keep printing new menus to reflect the price changes. For a restaurant it might be cheaper to just set the prices fixed for a year or two. The fact that some industries cannot change their prices can help explain the upward sloping SRAS curve. Consider what would happen if the price level were to suddenly increase faster than what was expected. The firms with sticky prices cannot charge more for their good and they are stuck at an artificially low price. As a result, the prices of these goods will be cheaper relative to the prices of all other goods and services in an economy. This will temporarily increase demand for the product. Firms with sticky prices will respond to this increase demand by hiring more workers and ramping up production. The end result is that an increase in prices caused an increase in the amount of real GDP produced. 3. MISPERCEPTIO S THEORY: Firms produce more if the relative price of their good is high. From microeconomics recall that if a firm produces a good, and the price of that good increases (holding everything else-including the prices of other goods-constant) then the firm will supply more of that product. The problem is that firms don t have the ability to observe relative prices. In order for firms to observe relative prices, they would have to know information for thousands of prices which is hard to do. Question: Suppose you are a owner of a sock factory. Suppose the price of your socks is higher than expected? In that case there is two possibilities: (1) The relative price of your product had gone up. That means that only the price of your socks have gone up, all other prices in the economy stayed the same. (2) All other prices have also risen. If (1) occurred you would want to produce more socks, however if (2) is true, then you wouldn t want to produce the extra socks. Since you don t know which of the possibilities occurred, you assume that the relative price of your good has risen somewhat and you will produce more. Conclusion: When prices rise more than expected some people conclude that the relative prices of their good have increased and they will produce more output. B. Shifts in Short-Run Aggregate Supply SRAS will shift if the costs for firms changes. This is also known as supply shocks. Some examples include: Change in input prices (higher oil prices or higher wages)

10 Change in technology (would lower costs for firms) Taxes or subsidies (would affect costs for firms) egative supply shocks are shocks that increase the costs for firms and would result in the curve shifting to the left if the SRAS is slightly upward sloping. Positive supply shocks are supply shocks that decrease the costs for firms and would result in the curve shifting to the right. The book also describes how the changes in factors of production may also change the SRAS. This can occur because costs for firms will change with an increase or decrease of factors of production. For example, consider what will occur if labor in the economy suddenly increased (due to immigration). With a greater workforce available, there will probably be more workers than jobs available which should drive down wages. At lower wages, firms will have lower costs. This will be true for changes in capital and natural resources as well. III. Causes of Economic Fluctuations With the tools of aggregate demand and aggregate supply in place we can now talk about what might cause economic fluctuations in the short-run. To start with we need to put the aggregate demand and aggregate supply curves all on the same graph. Once we do that we can see how an economy moves from a short-run equilibrium to a long run equilibrium. We define a long-run equilibrium where the LRAS curve intersects the AD curve. Whereas we define a short-run equilibrium where the SRAS curve intersects the AD curve. Easy (Hopefully) Step by Step Guide Step #1: An economy will always start off from a long-run equilibrium/short-run equilibrium situation. In other words, the LRAS, SRAS and AD curve all intersect initially. Step #2: There is a shock in the economy that shifts will shift either the AD curve, the SRAS curve or the LRAS curve. You must correctly identify which of the curves will be affected by the shock and in which direction it will shift. Step #3: Find the EW short-run equilibrium. Find where the AD and SRAS intersects after the shift in Step #2. Step #4: Find the EW long-run equilibrium. Find where the AD curve now intersects the LRAS curve. Let us look at an example. Suppose that there is an increase in government spending (due to a new stimulus package). First we must draw the initial equilibrium situation. In the initial equilibrium all three curves will intersect at one point. This will always be our starting point. See Figure 4. In Figure 4, point A represents the initial situation.

11 Figure 4 Step #2: You are given a shock to the economy in the form of an increase in government spending. Which of the curves will be affected by this shock? You should be able to rule out the LRAS and SRAS. LRAS will only shift if there are changes in the factors of production while SRAS would shift if there is a change in costs to firms. Thus neither curve will be affected by an increase in government spending. However, AD will certainly be affected. We saw that one reason why the AD curve might shift is if there are changes in government spending. An increase in government spending will cause the AD curve to shift to the right. Thus we will shift the AD curve to the right. See Figure 5 Figure 5

12 Step #3: We must now identify the new short-run equilibrium. This is where the SRAS curve intersects the new AD curve. This point (Point B) represents where the economy will be in the short run. Notice that at Point B, the economy is now producing beyond our natural rate of output in the short-run (the economy is experiencing a boom) and the price level is higher than before. You might ask how could the economy produce more than the natural rate? If firms experience a increase in demand, they can temporarily increase production by running their factories longer hours and forcing their existing workforce to work overtime. Step #4: We must now find the new long-run equilibrium. Long-run equilibrium will occur where the new AD curve intersects the LRAS curve. This is shown in Figure 6 in the diagram at Point C. But how does the economy move from Point B (short-run equilibrium) to Point C (the long-run equilibrium)? The intuition behind the answer is as follows. Note that at Point B (short-run equilibrium) the economy is producing at a point beyond the natural rate of output. To produce that high level of output, firms in the economy have to be running their factories 24/7 and offering their workers overtime to meet increased demand. Additionally, unemployment will be exceedingly low during this period and firms will find that they will have to compete with each other for scarce workers. Wages will increase as firms compete for these workers. This increase in labor costs will increase the overall costs for the firm. We know that anything than increases the cost to a firm will shift the SRAS curve to the left. Thus the SRAS curve will shift to the left until it intersects the LRAS. See Figure 6. Note that in the end, the increase in government spending had no long-run effect on output, only a temporary boost in real GDP. But that temporary boost came at a cost of permanently higher prices. Figure 6

13 In summary, any shock that increases aggregate demand will temporarily cause an economic boom in the short-run but in the long run real GDP will be unaffected, but prices will be permanently higher. Conversely, any shock that decreases aggregate demand will temporarily cause an economic recession in the short-run, but in the long-run the economy will return to the natural rate of unemployment, with prices being permanently lower. Let us consider another shock and work our way though the AS/AD model to see how the shock will affect the economy. Suppose that oil prices where to suddenly double overnight. How would that shock affect the AD/AS model? We generally associate oil as being essential to the production process. Oil is an important input to many industries and an increase in the price of this input will raise the cost to firms. Additionally firms need to ship their goods to stores so any increase in oil prices will raise the cost to firms. Step #1: Start at initial equilibrium. LRAS=SRAS=AD. (Point A) Step #2: Shock of an increase in oil prices will raise the costs of firms to produce goods and services. This will cause the SRAS curve to shift to the left. Step #3: The new short-run equilibrium will be at Point B where the new SRAS intersects the AD curve. Note that at this new short-run equilibrium, the price level is higher and the economy is producing at a lower output level. This situation with a recession and inflation both occurring is called stagflation. Step #4: The new long-run equilibrium will actually be back at Point A. The reason is that at Point B (the short-run equilibrium) the economy is in a recession. Firms are not producing as much output and have started to lay off workers increasing unemployment. Workers who are out of work will eventually be willing to accept lower wages in order to get hired. Labor costs for firms will be lower which will reduce overall production costs for firms. This reduction in overall production cost will shift the SRAS to the right. This will continue until the SRAS curve intersects the LRAS and the AD curve (at our initial equilibrium). In the end nothing changes. The price level and the output level is back at its initial long-run level. See Figure 7

14 Thus one option when the economy is going through a recession due to a supply shock is to do nothing. Eventually we know that the economy will return to full employment (natural rate of output). However, what is uncertain is how long that process might take. It might take several years to go from Point B back to Point A. With that in mind, some policymakers might feel that some active policy (such as increasing G or decreasing T) might get the economy to return to real GDP faster. As an exercise you should see what would happen if the government tried to reduce T when the economy is at Point B.

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