CHAPTER 15. Aggregate Demand & Aggregate Supply. Summary. What is the relationship between equilibrium output and price level?

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1 CHATER 5 Aggregate Demand & Aggregate Suppl Summar What s the relatonshp between equlbrum output and prce level? Ths chapter deals wth such a relatonshp. It does so b ntroducng the neo-kenesan concepts of aggregate demand and aggregate suppl. Sasan Faazmanesh Kenes s Mssng Equaton: rce evel Changes In Kenes s General Theor there s no dscusson of the prce level and ts mpact on output and emploment. The lack of dscusson left a vacuum that was flled later (n the 950s and 60s) b the neo-kenesan theores of aggregate demand and aggregate suppl. Aggregate Demand Curve (AD) What s the relaton between the prce level and output of goods and servces demanded? The relaton s supposed to be nverse. Aggregate Demand Curve (AD) rce level () How can we develop such a relaton? We can do so b lookng at the mone market and Kenesan cross. AD Real output ()

2 Dervaton of AD AE AE 0 The two graphs tell us that f prce s at, the output of goods and servces demanded s 0. Ths gves us one pont on the Aggregate Demand functon, AD. 0 M d0 =f( ) M Mone market Kenesan cross rce level () We need more than one pont for a relaton. What do we do to get a second pont? Change the prce level and look at what happens to the output of goods and servces demanded. Real output () 0 Suppose the prce level ncreases. What happens to the mone demand, nterest rate, spendng and equlbrum level of ncome? rce level ncreases AE M d C, I 2 M d =f( ) M d0 =f( ) M AE AE 0 2

3 Def. Aggregate Demand (AD): s a relatonshp between the prce level and goods and servces demanded n the econom. Everthng else remanng the same, as prce level rses, goods and servces demanded wll decrease. AD 0 Shfts or Shocks n AD Shft n AD: An ncrease n G Def. Demand shock: an event that causes AD to shft at the same prce level. AE Example: An ncrease n government expendtures, G G AE AE Another example An ncrease n mone suppl An ncrease n the suppl of mone ( ): 0 AE Interest rate falls, nterest rate senstve expendtures rse and at equlbrum ncreases. The result s a shft n the AD. 0 M d M AE AE 0 3

4 An ncrease n mone suppl Aggregate Suppl Curve () AE What s the relaton between the prce level and output of goods and servces suppled? AE The usual Kenesan dervaton of s dfferent than the dervaton n our textbook. AE 0 We wll look at both dervatons In ether case, graphcall we wll have: Aggregate Suppl Curve () rce level () ) Curve: Kenesan Explanaton The Kenesan dervaton of reles on the labor market theor and the aggregate producton functon. It assumes that when prce level rses, frms produce more output and demand more labor. But as prces rse and real wage falls, workers don t wthdraw from the labor market. Real output () Recall the labor market and aggregate producton functon w 0 0 w D S 0 S D 0 ( ) Aggregate roducton Functon The two graphs tell us that f prce s at, the output of goods and servces suppled s 0. Ths gves us one pont on the Aggregate Suppl functon,. 0 4

5 rce level ncreases: Demand shfts to the rght rce level () W (Nomnal wage) D 0 D S 0 W 0 Real output () W 0 S 0 D 0 ( ) D ( ) 0 If the workers don t notce that real wages have fallen and don t wthdraw from the market, then output of goods and servces rses. rce level rses: But workers don t respond D w D 0 w S 0 D ( ) w 0 0 S 0 D 0 ( ) 0 AF 0 Kenesans: Aggregate Suppl Curve () rce level () Def. Aggregate Suppl (): s a relatonshp between the prce level and goods and servces suppled n the econom. Everthng else remanng the same, as prce level rses, goods and servces suppled wll ncrease. Real output () 0 5

6 Shfts n the Kenesan Curve Shft n : Technologcal Improvement curve wll shft f technologcal changes shft the aggregate producton functon. 2 0 AF AF Monetarst Argument: Monetarsts argue that n the short-run: ) Kenesan argument mght be rght. 2) Workers mght not see rsng prces and fallng real wages. 3) curve s as Kenesans argue But not n the long-run! Monetarsts: Short-run rce level () 0 (short run) Real output () In the long run, Monetarsts argue, workers: rce level ncreases: Workers respond ) Realze the prce hkes 2) Realze fallng real wages 3) Wthdraw from the labor market Ths means ) Suppl of labor wll shft to the left 2) Emploment and output wll return to what the were ntall 3) curve wll be vertcal! W 0 W W Fnal S D0 S0 D S ( ) S 0 ( ) D 0 ( ) D ( ) 0 = 6

7 w Fnal w 0 rce level rses: Output returns to orgnal state 0 Fnal W D S ( ) D 0 S 0 ( ) S S = Fnal D 0 ( ) AF D ( ) Monetarsts: ong-run Curve rce level () Fnal 0 = Fnal Real output () 2) Curve: Textbook Explanaton Your textbook reles on the markup prcng theor to reach the same Monetarst concluson. What s markup prcng? Example: A car dealer sells a car costng hm $8000 at a 0% markup: rce of the car = $ % (8000) = $8000 +$800 = $8800 Mark up prcng: rce per unt = cost per unt + % markup (cost per unt) Your textbook assumes that over the busness ccle as output of goods and servces rses, cost per unt ncreases, pushng the average prces up: GD Inflaton prospert Note: Text assumes that prce of most nputs rse, but wage ncreases lag behnd n the short-run. Tme 7

8 Textbook: Short-run rce level () Shfts n the textbook Curve curve wll shft n our textbook f there s a shock n the econom, causng the prce level to change at the same level of output. Example of such shocks : Ol prce changes 0 Real output () Textbook: Shft n Short-run rce level () 0 Ol prces ncrease AD/: Macroeconomc Equlbrum Macroeconomc equlbrum occurs when the aggregate demand equals the aggregate suppl at some prce level. Output of goods and servces s nether expandng nor contractng at ths prce level. 0 Real output () Macroeconomc Equlbrum rce level () Changes n the Aggregate Demand: Short-run Analss Both fscal and monetar polces wll shft the demand curve. AD Real output () 0 8

9 Fscal polc (not consderng ) Fscal polc: Short-run 0 * 0 * Fscal polc: Short-run Monetar polc: Short-run G Ms C, I M d C, I M d C, I Monetar polc: Short-run Changes n the Aggregate Demand: ong-run Analss (Monetarsts) In the long-run, the Monetarsts assume, the workers realze that ther real wages have declned as a result of nflaton. The wll ask for hgher nomnal wages to match rsng prces. curve wll shft up. 0 9

10 Fscal olc: ong-run AD and W Fscal polc: ong-run p fnal 0 untl we return to the orgnal level of output. 0 fnal The long-run wll be vertcal for a monetarst! Ths means, once agan, that nether fscal polc nor monetar polc wll have an effect on output and emploment n the long-run. p fnal ong-run (short-run) 0 (short-run) Ths s the same as complete crowdng out. (long-run) 0 fnal Stagflaton In the case of stagflaton prces rse, output declnes and unemploment rses. Stagflaton 0 Ths, as far as textbook s concerned, could be the result of an nput shock to the econom, such as ol prce ncreases. 0 0

11 Is there a wa to stablze prces followng a shock lke ths? What should the fscal polc be? Reduce government spendng What should the monetar polc be? Stagflaton: Stablzng rces 0 Tght mone polc 2 0 Next stop: Chapter 6!