THE OPEN AGGREGATE DEMAND AGGREGATE SUPPLY MODEL.

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1 THE OPEN AGGREGATE DEMAND AGGREGATE SUPPLY MODEL. Introduction. This model represents the workings of the economy as the interaction between two curves: - The AD curve, showing the relationship between the price level (P) and aggregate demand (AD), that is, real output (Y) - The AS curve, showing the relationship between the price level (P) and aggregate supply (AS), that is, real output (Y) The Aggregate Supply and Aggregate Demand Model in an Open Economy. The Aggregate Demand Curve Recall that through the expenditure approach to GDP calculation we can figure out which were the uses given to all the goods and services produced during a year (that is, who demanded them). In an open economy: Y = GDP = C + I + G + NX = AD where: C = Consumption (expenditure by domestic households) I = Investment (expenditure by firms), can be domestic or foreign. G = Government Expenditure (you take a guess ;-) NX = Net Exports (expenditure by the rest of the world) = X - M AD = Aggregate Demand = Y = Real Output (recall circular flow diagram) All the components of Aggregate Demand (except G) are inversely related to the price level: - P reduces Consumption ( C) - P reduces Investment ( I) because the nominal interest rate rises ( i) (recall that i = r + π) - P reduces Net Exports ( NX) because the price of X increase relative to the price of M - Government Expenditure (G) does not depend on the price level Therefore the Aggregate Demand curve is going to be a downward sloping line. (See Aggregate Demand curve) How different is this open-economy AD curve from the (mostly closed-economy) one that you saw in Principles or maybe in Intermediate Macro? They are almost identical: 1

2 In an open economy the AD curve is somehow flatter because a higher (lower) domestic price level (P) will have a larger repercussion on AD through lower (higher) X and K IN (foreign I) In an economy with flexible ERs the AD curve will be flatter than in an economy with fixed ERs because a higher (lower) domestic price level (P) increases (decreases) demand for imports M ( M) and that in turn raises (lowers) demand for foreign currency and so ERs. In this case there is an even larger repercussion on AD through the Current Account (CA.) Movements along the AD curve: - We move up along the AD curve only if the price level increases: P Q of AD. - We move down along the AD curve only if the price level decreases: P Q of AD. Shifts in the AD curve: - The AD curve shifts right if: Any of the AD components increases: C, I, G, X, M. Expansionary fiscal policy is applied: T, G. Expansionary monetary policy is applied: M i I The domestic currency depreciates: ER M X - The AD curve shifts left if: Any of the AD components decreases: C, I, G, X, M. Contractionary fiscal policy is applied: T, G. Contractionary monetary policy is applied: M i I The domestic currency appreciates: ER X M The AD curve is basically affected by monetary and fiscal policies ( in M, T, G) that are also known as demand policies (as opposed to supply policies.) - Expansionary monetary or fiscal policies shift the AD line right - Contractionary monetary or fiscal policies shift the AD line left The AD curve is also affected by expenditure switching and direct control policies ( in Tariffs, Quotas, ERs, Capital Controls), directed towards the Balance of Payments. 2

3 The Aggregate Supply Curve We will distinguish between: - The Long-Run Aggregate Supply curve LRAS, that represents the relation between the price level (P) and the level of output (Y) produced by firms in the long-run. Recall the concept of the production function from Principles or Intermediate Macro: LRAS = Y = A. F (K, N) Since the levels of physical capital (K), or labor (N), available in the long-run to any given country do not depend on the price level we can represent the LRAS as a vertical line. (See Long-Run Aggregate Supply line) Shifts in the LRAS curve: - The LRAS curve shifts right if: Any of the factors of production increase: K, N. There is a technological improvement: A. - The LRAS curve shifts left if: Any of the factors of production decrease: K, N. There is a reduction in technology: A. - The Short-Run Aggregate Supply curve SRAS, that represents the relation between the price level (P) and the level of output (Y) produced by firms in the short-run. Private firms increase their output level as the selling price of their goods increase (P) but they also take into consideration the production costs (P of inputs). SRAS = Y = A. F (K, N) / P of inputs We can then represent the SRAS as an upward sloping line. Some authors, in order to simplify their analysis, may consider the aggregate level of output supplied in the short-run to be completely elastic with respect to the price level. In that case the SRAS will be represented with a horizontal line. The conclusions would be identical. (See Short-Run Aggregate Supply line) Movements along the SRAS curve: - We move up along the SRAS curve only if the price level increases: P Q of SRAS. - We move down along the SRAS curve only if the price level decreases: P Q of SRAS. 3

4 Shifts in the SRAS curve: - The SRAS curve shifts right if: Any of the factors of production increase: K, N. There is a technological improvement: A. There is a decrease in production costs: P of inputs. - The SRAS curve shifts left if: Any of the factors of production decrease: K, N. There is a reduction in technology: A. There is an increase in production costs: P of inputs. Notice that fiscal nor monetary policies affect the supply side of the economy. Only long-run government policies (e.g: universal education, support of scientific enterprises) have an impact on aggregate supply. How different is an open-economy SRAS curve from the (mostly closed-economy) one that you saw in Principles or maybe in Intermediate Macro? This is a very good question. The study of the impact that free trade and free capital mobility has on the supply side of the economy is a fertile field of research in economics. What do we know so far? Increased international competition by foreign firms forces most domestic firms to increase their productivity, reduce their price markups, and expand their scale of operations (allowing for increased returns to scale.) Some firms will have to shut-down, though. Unfortunately, most of this analysis falls outside the material generally covered in undergraduate macroeconomics courses and will not be discussed in class. Translated into the AS-AD model these conclusions can be represented with a somehow flatter SRAS curve, or even a LRAS curve that is further to the right of a closed economy situation. Equilibrium At any given moment in time the level of economic activity is going to be determined by the intersection of the aggregate demand and the aggregate supply curves. The different phases of the business cycle can be described in terms of the AS-AD model When the SRAS and AD curves intercept to the left of the LRAS curve the short-run level of output is below the full-employment level of output (Y*>Y E ), creating what is known as a recessionary gap (u E > u*). 4

5 When the SRAS and AD curves intercept to the right of the LRAS curve the short-run level of output is above the full-employment level of output (Y E > Y*), creating what is known as an inflationary gap (u*>u E ). When the SRAS and AD curves intercept over the LRAS curve the short-run level of output is the same as the full-employment level of output (Y*=Y E ), a situation known as a long-run equilibrium (u*=u E ). Keep in mind that neither fiscal nor monetary policies can promote long-run economic growth. Both of them are short-run demand-side policies, that don t have an immediate, direct impact on the determinants of potential (full employment) GDP (i.e.: K, L, and A.) An excessive growth of AD will create rapid growth (Y E >Y*) but as the general price level rises, the cost of inputs increase and so the SRAS curve shifts left (so Y*=Y E, with P E > P*). A depressed AD will create large unemployment (Y*>Y E ) but as the general price level falls, the cost of inputs decrease and so the SRAS curve shifts right (so Y*=Y E, with P E < P*). We can now use this model to analyze how the tools of macroeconomic policy can be used to achieve internal and external balance in a variety of scenarios. Internal Macroeconomic Analysis with the AS-AD Model The crossing of the AD and SRAS curves (Y E ) will represent the short-run equilibrium in the economy, defining the equilibrium price level (π E ) Whether or not that short-run equilibrium represents the full employment (Y*) of all factors of production (K and N) can be seen on the graph: When Y E < Y*, and therefore, u E > u*, there is a recessionary gap. When Y E > Y*, and therefore, u E < u*, there is an expansion, and an inflationary gap. Two different types of economic policies can be applied to close a recessionary gap: - Expansionary fiscal policy: T or G (at the new equilibrium Y but also P) G or T may cause some crowding out of private investment - Expansionary monetary policy: M (at the new equilibrium Y but also P) M may be ineffective if there is a liquidity trap or inflationary expectations by households. Regardless of the economic policy employed, the general price level will be likely to rise. 5