Macro Lecture 4: Aggregate Demand (AD) Curve

Transcription

1 Macro Lecture 4: Aggregate Demand (AD) Curve Review: Market for a Good Figures 4.1, 4.2, and 4.3 illustrate the basics of the market for a good. Equilibrium Quantity Demanded Quantity Supplied Price of Beer ($/can) S P* Quantity of Beer (cans) Figure 4.1: Market Equilibrium D Market Demand Curve Demand Question: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were, given that everything else relevant to the demand for beer remains the same. Price of Beer ($/can) If P2.00 If P1.50 If P1.00 Market Supply Curve Supply Question: How many cans of beer would firms produce (the quantity supplied), if the price of beer were, given that everything else relevant to the supply of beer remains the same. Price of Beer ($/can) If P2.00 If P1.50 If P1.00 S If P.50 D If P.50 Quantity of Beer (cans) Figure 4.2: Demand curve for beer Quantity of Beer (cans) Figure 4.3: Supply curve for beer

2 2 Aggregate Demand/Aggregate Supply Model We will now introduce the aggregate demand/aggregate supply model which in a general sense extends the demand/supply model for a single good to the macro economy. We begin with a preview and then focus on the aggregate demand in this lecture. AS Preview: The aggregate demand/aggregate supply model seeks to explain an economy s GDP and inflation rate. We place final goods and services (G&S) on the horizontal axis and the inflation rate (π) on the vertical axis. The aggregate demand (AD) curve is downward sloping and the aggregate supply (AS) curve upward sloping as illustrated in figure 4.4. The intersection of the aggregate demand (AD) and aggregate supply (AS) curves determines the actual GDP and the actual inflation rate. AD G&S Figure 4.4: Aggregate demand/aggregate supply preview The aggregate demand (AD) curve illustrates how many final goods and services are and the aggregate supply (AS) curve how many final goods and services are produced by answering a series of questions: Aggregate Demand (AD) Curve: AD Question: How many final goods and services would be if the inflation rate (π) were percent, given that all other factors relevant to demand remained the same? Aggregate Supply (AS) Curve AS Question: How many final goods and services would be produced if the inflation rate (π) were percent, given that all other factors relevant to supply remained the same? In equilibrium, the goods and services equal the goods and services produced: Goods and services Goods and services (G&S) (G&S) produced AD AS Recall that GDP measures the final goods and services produced. Also, we divide the into three categories: those by households, firms, and governments. 4 Goods and services Goods and services Goods and services Goods and services + + by households by firms by governments AD C + I + G Let us now summarize the equilibrium: Goods and services Goods and services produced AD AS C + I + G GDP Both the aggregate demand (AD) and aggregate supply (AS) curves answer a series of questions that are similar to the series of questions answered by the market demand and supply curves for a good. As we will see, there are important differences, however. We begin with the aggregate demand (AD) curve. 4 To make our analysis less cumbersome, we begin with a closed economy; that is, we assume that there are no exports or imports and consequently net exports (NX) are 0. This simplifying assumption makes our analysis more straightforward and does not affect any of our conclusions.

3 3 Summary Figure 4.5 summarizes the basics of the aggregate demand/aggregate supply model: AD Question: How many final goods and services would be if the inflation rate (π) were percent, given that all other factors relevant to demand remained the same? AS AD G&S Equilibrium Goods and services Goods and services produced AD AS C + I + G + GDP Figure 4.5: Aggregate demand/aggregate supply AS Question: How many final goods and services would be produced if the inflation rate (π) were percent, given that all other factors relevant to supply remained the same? Aggregate Demand (AD) Curve It is important to remember that while both the aggregate demand (AD) curve and the demand curve for a good are downward sloping, the reasons differ. It is easy to explain why the market demand curve for a good is downward sloping: when a good becomes more expensive consumers purchase less of it. It is a little more difficult to explain why the aggregate demand (AD) curve is downward sloping, however. The Real Interest Rate, the Nominal Interest Rate, and the Inflation Rate The nominal interest rate on a savings account is the interest rate that is advertised by a bank. The real interest rate reflects purchasing power by accounting for inflation: Real interest rate (r) Nominal interest rate (i) Inflation rate (π)

4 4 The Real Interest Rate and the Purchases of Final Goods and Services Higher real interest rates slow down the economy; that is, higher real interest rates reduce the final goods and services. Why? Perhaps the easiest way to understand this intuitively is to focus on the construction of new homes. When real interest rates rise, home mortgages become more costly for households. This discourages households from purchasing new homes. Similarly, as higher real interest rates rise, it becomes more costly for firms to finance new investment projects, purchase new equipment, etc.; consequently, firms finance fewer investment projects. Figure 4.6 sketches out the logic. Summary: The real interest rate (r) affects the final goods and services by households and firms. When the real interest rate (r): Rises, fewer goods and services are. Falls, more goods and services are. Real interest rate (r) increases Loans become more costly Consumers and firms purchase fewer goods Fewer goods and services Figure 4.6: Real interest rate and goods and services The Federal Reserve Board (Fed) and the Real Interest Rate The Federal Reserve Board (the Fed) is charged with stabilizing the economy. It is a semiautonomous government agency. The President nominates members to the Federal Reserve Board and the Senate must confirm them. Once confirmed, however, members of the Federal Reserve Board have a specified term of fourteen years. Consequently, the Federal Reserve Board has considerable independence. The Federal Reserve Board (Fed) is very powerful because it can influence the real interest rate (r). For the moment do not worry about how the Fed does this, we will explain how in a few lectures. For the time being just assume that the Fed can do so. Taylor Principle The Federal Reserve Board (the Fed) seeks to mitigate recessions and to prevent excessive inflation thereby stabilizing the economy. It does so by applying the Taylor principle: An increase in the inflation rate (π) leads the Fed to increase the real interest rate (r). A decrease in the inflation rate (π) leads the Fed to decrease the real interest rate (r). To show why the Taylor principle stabilizes the economy, consider two scenarios: one in which the inflation rate increases and a second in which the inflation rate decreases: Inflation rate increases (π). As a consequence of the Taylor principle, the Fed increases the real interest rate (r) making loans more costly. Households and firms purchase fewer goods and economic activity slows down. The economy is stabilized. Inflation rate decreases (π). As a consequence of the Taylor principle, the Fed decreases the real interest rate (r) making loans less costly. Households and firms purchase more goods and economic activity speeds up. The economy is stabilized.

5 5 Figure 4.7 provides a summary: Inflation rate (π) increases Inflation rate (π) decreases Taylor principle Fed increases the real interest rate (r) Fed increases the real interest rate (r) Loans become more costly Loans become less costly Households and firms purchase fewer goods and services Households and firms purchase more goods and services Fewer goods and services More goods and services Economy slows down Economy speeds up é ã Economy stabilizes Figure 4.7: Taylor principle and stabilizing the economy It is useful to think of the real interest rate (r) as the economy s throttle. The Fed controls the throttle. When the inflation rate (π) increases the Fed pulls back on the throttle slowing down the economy by raising the real interest rate (r). When the inflation rate (π) decreases the Fed steps down on the throttle speeding up the economy by lowing the real interest rate (r). Taylor Principle and the Fed Policy (FP) Curve The Fed policy (FP) curve quantifies the Taylor principle illustrating precisely how the Fed responds to inflation. The Fed policy (FP) curve describes the Fed s policy toward inflation by answering a series of questions: FP Question: What would the real interest rate (r) equal, if the inflation rate (π) were percent, given that the Fed does not change its inflation policy? FP r (%) As shown in figure 4.8, we place the inflation rate (π) on the vertical axis and the real interest rate (r) Figure 4.8: Fed policy (FP) curve: Taylor principle FP curve positively sloped on the horizontal axis. The upward sloping Fed policy (FP) curve reflects the Taylor principle: An increase in the inflation rate (π) leads the Fed to increase the real interest rate (r). A decrease in the inflation rate (π) leads the Fed to decrease the real interest rate (r). The positive slope of the curve captures the Taylor principle. Macro Lab 4.1 allows us to check our logic: Macro Lab 4.1: Taylor Principle and the Fed Policy (FP) Curve

6 6 Downward Sloping Aggregate Demand (AD) Curve We now apply the Taylor principle to derive the aggregate demand (AD) curve. When the inflation rate (π) increases, the Fed applies the Taylor principle and raises the real interest rate (r). The higher real interest rate (r) makes loans more costly. Household and firms respond by purchasing fewer goods and services. That is, when the real interest rate increases, final goods and services decrease as illustrated in figure 4.9: FP Question: What would the real interest rate (r) equal, if the inflation rate (π) were percent, given that the Fed does not change its inflation policy? AD Question: How many final goods and services would be, if the inflation rate (π) were percent, given that all other factors relevant to demand remained the same? FP Inflation rate (π) increases Fed increases the real interest rate (r) r (%) Loans become more costly Households and firms purchase less AD G&S Fewer goods and services (G&S) Taylor principle (FP curve) C and I decrease AD C+I+ G decreases Figure 4.9: Downward sloping aggregate demand (AD) curve Macro Lab 4.2 allows us to check our logic: Macro Lab 4.2: Deriving the Aggregate Demand (AD) Curve

7 7 Federal Reserve Board and the U.S. Treasury The U.S. Treasury and the Federal Reserve Board are two different government agencies. As we will see, both of these agencies play important roles in our economy, but the roles are different. It is always important not to confuse the two agencies: The U.S. Treasury is part of the President s cabinet. The President nominates the Treasury secretary and the Senate must confirm him/her. Once confirmed, the Treasury Secretary serves at the pleasure of the President. The President could fire the Treasury Secretary at any time. Like a treasury in any organization, the U.S. Treasury is responsible for collecting revenues and paying expenses. The Federal Reserve Board (Fed) is a semi-autonomous government agency. The President nominates members to the Federal Reserve Board and the Senate must confirm them. Once confirmed, however, members of the Federal Reserve Board have a specified term of fourteen years. Unlike the Treasury Secretary, members of the Federal Reserve do not serve at the President s pleasure; the President cannot fire them. This gives the Federal Reserve Board considerable independence. The Fed is responsible for the health of the economy s financial system, in particular the banking system. In doing so the Fed can control the real interest rate (r). Strategy We have shown that the real interest rate (r) plays a critical role in the economy. It acts as the economy s throttle which the Fed applies. If it seeks to slow down the economy it raises the real interest rate (r). Alternatively, if it wants to speed up the economy, it lowers the real interest rate (r). Our goal is to understand how the Fed accomplishes this: Goal: Show how the Federal Reserve Board (Fed) affects the real interest rate(r). The next three lectures are designed to achieve the goal. We will introduce the following topics: Financial Assets The banking system Money and the Federal Reserve Board.