Aggregate Demand and Aggregate Supply.docx

Aggregate Demand and Aggregate Supply Aggregate Demand Liquidity Preference Perhaps the easiest way to derive an aggregate demand curve is by using something we have already discussed, liquidity preference. Recall from Chapter 5 we looked at the Keynesian demand for money function (also called liquidity preference). One of the graphs we used there showed the relationship between the demand for money and the supply of money. We also used the graph to show what would happen to the demand for money as the price level increased and the subsequent effect on interest rates. Figure 24—1 An increase in the price level shifts the demand for money curve to the right. If the price level rose then people would need to hold more money to purchase the same amount of real goods (they buy the same things but these things cost more). This we represent by shifting the money demand curve to the right. Notice that the effect is to raise interest rates. The effect of a price level increase is to raise the interest rate. But we also learned in an earlier chapter that changes in interest rates affected business investment spending. That is if interest rates increased businesses would be less willing to borrow money to spend on new plant and equipment. Spending on U.S. produced output Next consider the entities that purchase output produced in the U.S. They buyers are consumers ( C ) , businesses ( I(i) ), governments ( G ), and foreigners (NX for net exports). So total spending on U.S. output is What we want to do is to determine what will happen to spending in the economy as prices increase. The logic is So when the price level increases, spending on U.S. output will decrease. This results in the aggregate demand curve as shown in Figure 24—3. In this figure when the price level increases less output is bought. Price changes will also affect net exports. If the price level increases U.S. goods will become more expensive to foreigners and foreign goods will become cheaper to U.S. residents. So net exports should decline Figure 24—3. The aggregate demand curve Thing that might shift the aggregate demand curve Anything that increases while holding prices fixed will shift the aggregate demand curve to the right. Anything that decreases while holding prices fixed will shift the aggregate demand curve to the left. Suppose that consumers decide to begin to spend more of their income (even though there is no change in interest rates). In that case the aggregate demand curve will shift from to as shown in Figure 24—4. .114300016700500FIGURE 24--4 The aggregate demand curve shifts to the right Anything (other than a price change) that makes C(i), I(i), G, or NX get larger will shift the curve to the right. If they get smaller the curve will shift to the left. Keynes believed that business people often made irrational decisions regarding investment spending. We have considered investment spending to be determined by interest rates. Keynes believed that it was largely determined by “animal spirits”. So if animal spirits increase investment spending the curve will shift to the right, if they decrease investment spending the curve will shift to the left (we assume here that interest rate, i, do not change. Suppose that the government increases taxes on households and that households respond by reducing spending If the government decided to increase government spending then Suppose that U.S. residents decide to import more foreign goods (they just like them better) On the other hand if foreigners decide they like U.S. goods better Suppose that the Fed increased the money supply Crowding out The response to an increase in government spending, G, is a bit more complex than indicated above. For one thing the spending increase must be financed. If the spending increase is financed by increasing taxes, the rightward shift due to the spending increase will be largely offset by a leftward shift due to households reducing spending. The Fed could finance the spending increase by instructing the Treasury to sell more securities. In that case the price of bonds will increase and the interest rate will increase. In such case household consumption will likely decrease (households will not borrow as much and will save more) and business investment spending I(i) will decrease. So we have This offsetting shifts in the aggregate supply curve is known as crowding out. Keynesian economists believe that the offset is not very large. Other economists, particularly monetarists, believe the offset is complete. Even if the offset is complete that does not mean that the there is no effect on the economy. What the government gets the private sector does not get. There is yet a further possibility. The government could finance the deficit by printing money. The result would be inflation but the possible shifts in the curves get more complex. This won’t be discussed here. Aggregate supply The short run The aggregate supply curve is a short—run concept. By short run we mean a time period so short that firms can vary output only by hiring more or less labor. There is not enough time for a firm to build a new plant and hire labor to staff it. Labor will have to use existing plant and equipment. Further we will assume that wages and the costs of all other inputs are fixed. Profits are determined by total revenue less total costs, or where is profits, P is the price level, the amount of output produced, w the wage rate, L the number of labor hours employed, i interest rates, K the amount of capital used, the cost of materials, and is the quantity of materials used in the production. We will also call the aggregate supply curve. Note that we are pretending the entire economy can be modeled using this single relation. Now if the price level increases firm will receive more profit. But note that the price per unit of output has increase while the cost per unit of output has remained fixed (at least in the short run). This suggests that it will be more profitable for firms to increase output. So we will use the following which leads to the aggregate supply curve shown in Figure 24—5. Figure 24—5. The aggregate supply curve. The long run In the long run the factors we held fixed in the previous section can change. These factors will shift the aggregate curve. In the previous section we held wages fixed. Suppose that the wage rate started to increase raising the unit cost of producing output. Firms would respond by reducing output which we will represent by a leftward shift in the aggregate supply curve. Figure 24—6. A leftward shift in the aggregate supply curve due to a rise in the wage rate. If the firms decided to employee more capital that would shift the aggregate supply curve to the right. If capital became more productive that would also shift the curve to the right. A decrease in the cost of materials will shift the curve to the right. Equilibrium in the short run Figure 24—7 Equilibrium in the short run. The macro economy will be in equilibrium at price and level of output . If the price level is above the equilibrium level, supply will exceed demand and prices will fall. If the price level is below the equilibrium level prices will rise until supply equals demand. Equilibrium in the long run Suppose that the economy is in equilibrium at as shown in Figure 24—7. Now suppose that managers animal spirits make them decide to buy less output (investment spending declines). This will shift the aggregate demand curve to the left. This will provide a new short run equilibrium at as shown in Figure 24—8 Figure 24—8. A leftward shift in the aggregate demand curve. What has happened is that the price per unit producers receive has fallen but the cost per unit has remained the same. Producers will respond by producing less output. The economy will remain at this new equilibrium at unless (a) the aggregate demand curve shifts again or (b) the cost per unit changes. One potential outcome is that the cost per unit of production will fall enough that the aggregate supply curve will shift to the right enough to establish a new equilibrium at . This is exactly the long run solution predicted by both Keynesian and monetarist economists. First note that at the initial short run solution there will be less labor hired and fewer materials used. This should start wages and the cost of materials falling. Further because the decrease in price will increase the real money supply, interest rates will fall reducing the cost of capital. You should note the relationship between prices changes and output that occurs when the aggregate demand curve shifts. A leftward shift in the aggregate demand curve will cause a price decrease and output decrease. A rightward shift causes price increases and output increases. Figure 24—9. The long run equilibrium Labor costs account for about 70% of the cost of production. So most of what will shift the aggregate supply curve will be determined by what happens with the wage rate. To give a idea of why the economy should tend to a certain level of output we will have to consider the natural rate of unemployment. The natural rate of unemployment If labor markets are tight (demand exceed supply) then employers will have to compete for additional workers. In such market wages tend to rise. In slack markets (supply exceeds demand) then wages tend to fall as workers compete for available jobs. At the point were the labor market is neither tight nor slack wages will tend to be stable. This point is called the natural rate of unemployment. If the unemployment rate falls below this, wages will tend to rise. If the unemployment rate if above the natural rate wages will tend to fall. This will tend to drive the economy to the natural rate. Suppose that the level of output that can be produced with the natural rate of unemployment is as shown in Figure 24—10. The level of output is called the natural rate level of output. Figure 24—10. The natural rate level of output Suppose the economy is initially in equilibrium at where and intersect but animal spirits shift the aggregate demand curve to . At any point to the left labor markets will be slack and wages will continue to fall until the economy comes back to the natural rate level of output. But as wages begin to fall the aggregate supply curve will tend to shift to the right lowering prices. Long run equilibrium is re—established at where both the price level and the wage rate have fallen. The real wage rate will not have changed however. Suppose that the wage rate initially is (and the price level is ) at the new equilibrium the wage rate is (at the price level ). By real wages being the same we mean . Workers ought to supply the same amount of labor in the long run because the real return to them for an hours work has not changed. The long run effect of a leftward shift in the aggregate demand curve is to lower the price level. There is no long run effect on output. The effects of a rightward shift in the aggregate demand curve would be to initially raise prices and output. But now labor markets will become tight and wages will start to increase. The cost of materials used in the production process will also start to increase. These will shift the aggregate supply curve to the left. The long run result will be a return to the natural rate level of output and unemployment and a higher price level. Aggregate demand shocks Aggregate demand shocks are a potential source of instability to the economy. Animal spirits on the part of business managers (reducing investment spending) or on the part of households (reducing consumption) can shift the aggregate demand curve to the left causing a recession. A shift to the right would be inflationary. The question is what, if anything, can be done about these shocks. Both monetarists and Keynesians believe that the economy will tend to the natural rate level of output and the natural rate of unemployment. The chief questions are (a) how long does the adjustment take and (b) can we speed up the adjustment process without creating new problems. Briefly the monetarists believe that the adjustment process occurs very quickly and the economy will correct itself without government intervention. They further believe that Fed intervention is probably the primary cause of any difficulty in the first place. One of the reasons why monetarists believe the adjustment process operates quickly is that the believe labor markets are very flexible. They believe that workers are very sensitive to changes in real wages. If the price level falls then workers will be willing to lower wages so that the real wage remains unchanged. Keynesians believe that the adjustment process can be quite lengthy and the government should do what it can to speed it along. In Keynes phrase “In the long run we are all dead’. So even if the long run adjustment is to the natural rate, it may get there far too late. One of the reasons that Keynesians believe that the adjustment process is so slow is that they think labor markets are not very flexible. They believe that workers are very reluctant to reduce the wage rate even if prices have fallen. Keynesians believe that a leftward shift in the aggregate demand curve should be offset by the government of the Fed doing something to shift the aggregate demand curve back to the right. What sort of things could the government do to shift it to the right? Fiscal policy Monetary policy The monetarists believe that fiscal policy is largely ineffective. Recall that the budget deficit will have to be financed by borrowing. This will raise interest rates reducing consumer spending and business investment spending (crowding out). Keynesians will argue that consumption and business investment spending are not as interest rate sensitive as the monetarists claim. If monetarists believe that consumer and business spending is strongly influenced by interest rates, they must believe that monetary policy is effective. The monetarists do believe that monetary policy is a powerful tool, but that powerful tools are dangerous. They argue that an increase in the money supply will reduce interest rates, but that we just can’t be sure how long it will take. Suppose that it takes a year before interest rates fall. In that time a recession might already have cured itself (remember monetarists believe that the economy will return to the natural rate position fairly quickly). Suppose after a year that the economy has cured itself and now the interest rate decrease kicks in. Now we get a shift of the aggregate demand curve to the right of the natural rate level and price increases. The monetarists believe that monetary policy, rather than being a stabilizing tool, is more likely to be a destabilizing tool. They think that we just don’t know enough about how money supply changes will effect the economy (how long will the take? what will be the size of the change?). They think than many recessions have been caused by bad monetary policy. Monetarists believe that the Great Depression was caused by mismanaged monetary policy. At the start of the banking panics the Fed could have acted as the lender of last resort but refused to do so. Banks found out that they would have to protect themselves against bank runs. So how do you do that? Build up excess reserves, which is just what they did. The initial bank panics reduced the money supply and banks building up excess reserves continued the decline in the money supply. Another prime example of monetary policy mismanagement from a monetarist point of view occurred in the late 1970’s and early 1980’s. This was the period of time with the greatest rate of inflation in the U.S. during the 20th century. The Fed reduced the money supply to increase interest rates thus shifting the aggregate demand curve to the left. The aggregate demand curve shifted too far with a resulting recession. Keynesian view of monetary policy Keynesians believe that the monetarists critique is largely overblown and that the Great Depression had causes other than the reduction in the money supply. They also believe that while the aggregate demand curve will eventually return to the natural rate level, the length of time required to do so will result in unnecessary economic hardship. They believe that consumer spending and business investment spending is not as strongly determined by interest rates as the monetarists believe and that crowding out is not very severe. If so, the government can use fiscal policy to shift the aggregate demand curve to the right to cure a recession. The role of monetary policy would be to keep interest rates low to prevent crowing out (if any) from occurring. Monetarists view of monetary policy From what we said above it seems fairly clear that the monetarists do not feel very comfortable with the Feds ability to successfully manage monetary policy. So what do the monetarists recommend? They suggest a monetary policy that leads to price stability. They do not recommend a monetary policy that tries to control interest rates. If you try to control interest rates you will have to change the money supply and this leads to price instability. So how do you achieve price stability? If the money supply grows at the same rate as the rate of growth, prices should be stable (the same proportion of dollars chasing the same proportion of goods). So if the economy grew at 3% a year then the money supply should grow at 3% a year as well. The economy does not grow at precisely the same rate every year and the rate of growth is not well known at any time. So what to do then? Milton Friedman suggests that we pick the average rate of growth over the past several years and set the money supply growth rate at that level. Sometimes you will have money growing at a higher rate than the rate of growth, at other times lower, but on average you won’t be to far off. At any rate this is much better that giving the Fed a chance to foul up. Friedman believes our knowledge of how money affects the economy is far to limited to allow the Fed control of an extremely powerful tool. Aggregate supply shocks. A supply side shock is illustrated in Figure 24--11. Such a shock occurred in the 1970’s when the Organization of Petroleum Exporting Countries (OPEC) tried to increase the world price of oil by an embargo (restring output). This raised the cost of raw materials that shifted the aggregate supply curve to the left. Figure 24—11. An increase in the cost of raw materials shifts the aggregate supply curve to the left raising prices and reducing output. Note here that we have a case where price increases are associated with output decrease (known as stagflation). Suppose something had happened to reduce input costs—this would have shifted the aggregate supply curve to the right causing a price decrease and output increase. In any case the movement away from the natural rate level will set forces in motion to drive the aggregate supply curve back to its original position (assuming no change in the aggregate demand curve in the meantime). In Figure 24—11 the short run equilibrium is one where labor markets are slack. This will causes wages to fall and the aggregate supply curve to shift to the right. Monetary and fiscal policy are called demand management policies because the operate to shift the aggregate demand curve. They do so by either buying output directly (G) or by encouraging members of the private sector to buy output (C,I). The government does not have any short run supply management tools. The government could, I suppose, direct workers to take an immediate pay cut. I doubt that said government would be around very long. Questions A decrease in the price level leads to an increase in aggregate demand because Governments will buy more output. The demand for money increases, raising interest rates and stimulating investment spending and consumption. The demand for money decreases, lowering interest rates and stimulating investment spending and consumption. Foreign goods become cheaper None of the above According to the monetarists an increase in the money supply will shift the aggregate ____________ curve to the ____________. demand, left, supply, left demand, right supply, right According to the Keynesians an increase in the money supply will shift the aggregate ____________ curve to the ____________. demand, left, supply, left demand, right supply, right 4) The Keynesian analysis of aggregate demand indicates that an increase in exports shifts the aggregate demand curve to the right shifts the aggregate demand curve to the left C) moves the economy along the aggregate demand curve rather than shifting it. D) has no effect on aggregate demand. 5) The Keynesian analysis of aggregate demand indicates that an increase in imports shifts the aggregate demand curve to the right shifts the aggregate demand curve to the left C) moves the economy along the aggregate demand curve rather than shifting it. D) has no effect on aggregate demand. 6) According to the Keynesians, an increase in government spending, other things equal, shifts the aggregate _____ curve to the _____. A) demand; right B) demand; left C) supply; left D) supply; right 7) According to the Keynesians, a decrease in government spending, other things equal, shifts the aggregate _____ curve to the _____. A) demand; right B) demand; left C) supply; left D) supply; right 8) According to the Keynesians, an increase in taxes, other things equal, shifts the aggregate _____ curve to the _____. A) demand; right B) demand; left C) supply; left D) supply, right 9) An increase in the price of raw materials shifts the aggregate supply curve to the right shifts the aggregate supply curve to the left C) moves the economy along the aggregate demand curve rather than shifting it. D) has no effect on aggregate supply. 10) An increase in the wage rate shifts the aggregate supply curve to the right shifts the aggregate supply curve to the left C) moves the economy along the aggregate demand curve rather than shifting it. D) has no effect on aggregate supply. The monetarists believe that changing the money supply has a very powerful effect on the economy and should be used in preference to fiscal policy in order to stabilize the economy. has a very little effect on the economy so we don’t need to worry to much about it. Has such a powerful effect and dangerous effect on the economy that it should not be used to try to cure recessions. Will lead to crowding out. 12) Monetarists argue that the Federal Reserve should pursue A) an interest-rate targeting strategy. B) an exchange-rate targeting strategy. C) a discretionary monetary policy. D) a constant rate of growth of rule. the money supply. 13) While both monetarists and Keynesians view the aggregate demand curve as downward-sloping, monetarists argue that A) changes in government spending and taxes are the only factors causing the aggregate demand curve to shift. B) a change in the quantity of money is the primary factor causing the aggregate demand curve to shift. C) changes in government spending and taxes, in addition to changes in the money supply, cause the aggregate demand curve to shift. D) a change in the quantity of money will have no effect on the aggregate demand curve. 14) Keynesians believe that an increase in taxes will shift the aggregate ________ curve to the __________. demand, right supply, right demand, left supply, left 14) Keynesians believe that a decrease in taxes will shift the aggregate ________ curve to the __________. demand, right supply, right demand, left supply, left 15) Keynesians believe that the economy will return very quickly to the natural rate level of output never return to the natural level of output return only slowly to the natural level of output always be unstable due to crowding out. 16) Monetarists believe that the economy will return very quickly to the natural rate level of output never return to the natural level of output return only slowly to the natural level of output never be unstable due to crowding out. 17) A decrease in investment spending on the part of businesses will shift the aggregate demand curve to the left shift the aggregate demand curve to the right shift the aggregate supply curve to the left shift the aggregate supply curve to the right none of the above. 18) According to the monetarists a shift in the aggregate demand curve will be followed by a fairly rapid shift back to the original position of the aggregate demand curve a slow shift back to the original position of the aggregate demand curve a rapid shift of the aggregate supply curve so that a new equilibrium is established at the natural rate level of output. a slow shift of the aggregate supply curve so that a new equilibrium is established at the natural rate level of output. none of the above 19) According to the Keynesians a shift in the aggregate demand curve will be followed by a fairly rapid shift back to the original position of the aggregate demand curve a slow shift back to the original position of the aggregate demand curve a fairly rapid shift of the aggregate supply curve so that a new equilibrium is established at the natural rate level of output. a slow shift of the aggregate supply curve so that a new equilibrium is established at the natural rate level of output. none of the above 20) Although _____ contend that an increase in government spending will "crowd out" private spending, _____ contend that only partial crowding out occurs. A) Keynesians; monetarists B) Keynesians; Hicksians C) monetarists; Keynesians D) monetarists; Hicksians Figure 24-1 21) In Figure 24-1 the economy could be in long-run equilibrium only at point 1. point 2. point 3. points 1 and 3. points 1, 2, 3, and 4. 22) Monetarists believe that using monetary policy to change aggregate demand is the best way to cure a recession is needed to make the economy return quickly to the natural rate level of output. Is very useful because the effects of changing the money supply are so powerful has often caused business cycles. 23) Stagflation results from a leftward shift in the aggregate demand curve a rightward shift in the aggregate demand curve a leftward shift in the aggregate supply curve a rightward shift in the aggregate supply curve. 24) Which of the following is true regarding a recession caused by an aggregate supply shock: The best way to cure it is by increasing government spending The best way to cure it is by decreasing taxes The best way to cure it is by increasing the money supply Neither monetary of fiscal policy is effective against aggregate supply shocks. 25) In the 1970s the Organization of Petroleum Exporting Countries reduced the worlds’ supply of oil resulting in an increase in oil prices. This resulted in An increase in output and decrease in the price level An increase in output and an increase in the price level A decrease in output and an increase in the price level A decrease in output and a decrease in the price level. 26) An increase in aggregate demand will result in More output and higher prices More output and lower prices Less output and higher prices Less output and lower prices 27) An increase in aggregate supply will result in More output and higher prices More output and lower prices Less output and higher prices Less output and lower prices 28) A decrease in aggregate supply will result in More output and higher prices More output and lower prices Less output and higher prices Less output and lower prices