The Aggregate Demand Schedule
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1 The Aggregate Demand Schedule Pedro Serôdio July 20, 2016
2 Learning objectives To understand: An essential part of the tool-kit. How the quantity theory of money, IS-LM and IS-MP models give rise to the Aggregate Demand curve. The potential importance of wealth effects and forwardlooking behaviour for Aggregate Demand. How various assumptions about expectations, the workings of the labour market, and price-setting affect the shape of the Aggregate Supply curve and give rise to different empirical predictions and policy prescriptions.options.
3 Outline Derivation of AD curve in the IS-LM, quantity theory and IS-MP models. The slope of the AD curve. Wealth effects.
4 The AD schedule The AD curve shows combinations of the price level and real output (for the IS-LM and quantity theory models) and between inflation and real output gap for the IS-MP model. In any of these 1. Actual and planned expenditure on real output are equal; 2. The price level (inflation) and real output (output gap) correspond to an equilibrium in the money market (or operation of the monetary rule). The AD curve plots the price level (inflation rate) at which the IS and LM (MP) curves intersect, for all levels of output gap (the output gap).
5 The AD schedule Taking the expression for equilibrium output in the IS-LM model, we have that: y = h (1 c)h + dk (a ct + b + g) + d (m p) (1 c)h + dk Differentiating p with respect to y, we get: p y = (1 c)h + dk d Which gives us the slope of the aggregate demand schedule in (p, y) space.
6 The AD schedule In the IS-MP framework, the equilibrium level of output is given by: y 1 = (a ct + b + g) + 1 c dφ y d + ( r + φ y ȳ φ π π) 1 c dφ y Differentiating π with respect to y, we get: π y = (1 c) + dφ y dφ π Which gives us the slope of the aggregate demand schedule in (π, y) space.
7 The AD schedule The equation of exchange and the aggregate demand schedule. The equation of exchange is a useful identity that holds in any monetary economy and is a useful starting point for a number of important theories: MV PY, where M is total amount of money, V the velocity of transactions, P the aggregate price level and Y the level of output. Here, we focus on the implicit relationship it has for the shape of the aggregate demand schedule. Solving the equation for P, we have: P = Ms V (i) Y
8 The AD schedule Taking logs, we have: p = m + ηi y Notice that this is simply an alternative formulation for a linear money demand function: (m p) d = y ηi Under this specification, the aggregate demand schedule will again be a negative function of the price level and, therefore, the aggregate demand schedule will be downward sloping.
9 Aggregate Demand MP 0 r MP 1 A π A B B IS y The AD curve has a negative slope in (p, y) space p y < 0. as long as: 1. The real rate rises when output increases because the money supply falls. 2. A rise in the real interest rate is associated with a fall in real output. These effects can be shown in r y space, as here, or in a combination of r π and r y spaces. AD y
10 Aggregate Demand r MP 0 π IS 1 IS 0 y AD 1 AD 0 y The AD curve will be flatter in (p, y) space: 1. The larger is the MPC; 2. The larger is the responsiveness of consumption and investment to the real interest rate C r, I r (d in the expression above) (shown left). 3. The less monetary policy responds to output fluctuations (the lower is φ y ); 4. The more monetary policy responds to inflation fluctuations (the larger is φ π );
11 Criticism The MP model improves on the LM model by more accurately capturing policy and response to inflation. It is possible to criticise the basic IS curve: 1. The interest rate relevant for spending might differ from the policy target rate. 2. Wealth effects are absent, though they can be added to the model (we ll discuss these ahead). 3. A third objection is that the IS curve remains Keynesian in nature. It is static and not explicitly microfounded. An alternative, microfounded, Dynamic IS curve (DIS) has been developed, and is currently used in modern New Keynesian models, which we ll cover in when we discuss the New Keynesian model.
12 Aggregate Demand r IS 1 LM 0 A special case of the aggregate demand schedule occurs when the interest sensitivity of both investment and consumption to the interest rate is zero. IS 0 y We know that the slope of the aggregate demand schedule is given by: π AD 1 p y = (1 c)h + dk d Taking the limit as d 0, it is clear that: AD 0 y p lim d 0 y =
13 Aggregate Demand If the planned expenditure function (here, planned consumption and investment) is interest-inelastic C r = 0, I r = 0, where C r is the interest elasticity of consumption and I r interest elasticity of investment), then monetary policy is ineffective : it cannot alter output, although it can affect the price level. If AS is also inflation-inelastic, an AD-AS equilibrium might not exist. In that case, if the AD curve lies to the left of the AS curve, the level of output is demand- determined. Furthermore, the excess supply could not be eliminated by disinflation or falling prices.
14 The Pigou effect A response of consumption to real wealth can be captured fairly easily by simply making consumption respond directly to wealth. This effect is named the Pigou effect, after Cambridge economist Arthur C. Pigou. Pigou suggested real wealth could be modelled as A = M/P + (P B /P)B, but Ricardian Equivalence (Barro: government bonds are not net wealth) would suggest just including real money balances. The Pigou effect is also known as the real balance effect. How does the Pigou effect operate? A reduction in the price level raises consumers net real wealth at any given income level. Reducing saving (since there is less need to accumulate wealth to fund future consumption) and Increasing current consumption demand.
15 The Pigou effect Going back the planned expenditure function introduced earlier, we can see that consumption depends partly on the amount of assets owned by the households. Recall that: Y = C (Y T, r, MP + Pb P B ), where 0 < C A < 1 Real balances, MS/P, affect the position of the IS curve. A rise in real balances shifts the IS schedule outwards, for any given level of the real interest rate. The Pigou effect is probably best known for its implications concerning the effect of deflation - and the consequences for the possibility of a liquidity trap. If the Pigou effect operates, a reduction in the price level can cause a direct increase in AD. Direct effect: It occurs even without a reduction in the interest rate.
16 The Pigou effect Deflation is more expansionary. The AD curve is flatter than it otherwise would be. In a liquidity trap (not shown here), the Pigou effect acts contrary to the negative impact of deflation via the autonomous rise in the real interest rate p and via expectations of future lower prices. In practice, real money balances are a small fraction of real wealth. The marginal propensity to consume out of real wealth is estimated to be about C A = 0.1, whereas that out of disposable income is around C Y = 0.8. Thus the size of the Pigou effect is likely to be small.
17 The Pigou effect The type of money supply increase relevant here is a helicopter drop. Ricardian Equivalence states that government bonds are not net wealth, implying that an increase in the money supply due to central bank bond purchase would also increase net wealth. But: Does Ricardian Equivalence hold? If not, bond-money swaps have less/no effect on net wealth. If their nominal value (asset price) remained unaltered, the real value of other forms of wealth would also rise following deflation, which could boost consumption through a wealth effect. However, price deflation - particularly in a liquidity trap - is often accompanied by falls in asset prices (so no increase in real wealth from that source).
18 The Tobin-Fisher effect The Tobin-Fisher effect is also known as the redistribution effect, or the debt-deflation effect. An unexpected reduction in the price level (deflation) can cause a direct decrease in AD, if it changes the distribution of wealth from high-spending borrowers to low-spending lenders.
19 The Tobin-Fisher effect: Intuition Debt contracts are usually set in nominal terms, i.e. they specify interest (and capital) payments in money value. Suppose that there is a reduction in the price level that was not anticipated by either creditors or debtors at the time of signing the debt contract. Moreover, suppose that the nominal debt contract is neither indexed to the price level, nor can be renegotiated by the parties.
20 The Tobin-Fisher effect: Intuition Borrowers (e.g. people with mortgages, entrepreneurs, farmers) see that the real value of their debt has increased, which implies that lenders (banks, savers) receive more payments in real terms. In other words, there is a redistribution from debtors to creditors. If debtors have a higher marginal propensity to spend than creditors, this redistribution effect causes a reduction in AD: creditors spend a smaller fraction of their additional income, and debtors are forced to cut back consumption and investment to reduce/repay their debts. Eventually, debtors can become insolvent (e.g. firms can shut down plants).
21 The Tobin-Fisher effect: Intuition r LM 0 LM 1 A C B IS 0 The Tobin-Fisher wealth redistribution effect counteracts monetary policy The AD curve is steeper than it otherwise would be. π A C B IS 1 y In a liquidity trap (not shown here), the Tobin-Fisher effect adds to the negative impact of deflation via the autonomous rise in the real interest rate and via expectations of future lower prices. AD 1 AD 0 y
22 Summary and Look Forward We have defined the AD curve. We have seen what determines its slope. You should also make sure that you can pinpoint everything that will shift the AD curve. The simple AD model can be extended to capture financial frictions, confidence and wealth effects, which all affect the IS curve. - These are important to capture accurately responses to financial crises, monetary expansion and deflation. We will see ahead that the static IS curve can be replaced with a dynamic version. Next: We summarise what the AS curve looks like under various assumptions about wage-setting, price-setting and expectations.
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